What Makes a Business Successful? - Theory of The Firm
New Jersey Forensic Accountant here. Today we're gonna discuss what is called the economic theory behind a successful business or theory of the firm. One question I'm often asked is what makes a firm successful? Why do some firms flourish and others go out of business? Obviously, this is a very difficult question to answer. There are many reasons why some firms fail and some succeed. Some has to do with luck, but most of the time it's the result of hard work, solid strategies and the ability of the entrepreneur to run the company that makes the firm successful.
If you really wanna understand what makes a firm successful, it's important to go back to Adam Smith's book, "Wealth of Nations," which was written in 1776. You know, Adam Smith, most people don't realize, was also a moral philosophy and he wrote a book called "The Theory of Moral Sentiments." And the reason I'm telling you this is because, when you look at Adam Smith's book where he basically created the four cornerstones of economics, most people think economics has to do with, you know, being selfish and that type of stuff, but really it doesn't. It has to do with self-interest. And what I mean by self-interest is that if you run a company, it's in your self-interest to treat your employees good, to be a good member of the community, and not be selfish. And that was one of the first cornerstones of his economic philosophy.
The second was division of labor. By dividing labor, you become more efficient. If you try to do everything, it usually doesn't work out well. If you look at the car industry in the early 20th century, when Ford motor company started up, they did everything in-house. They made the tires, they made the steel. But now you look at a car company, everything is specialized. They buy tires from the tire company, they get their metal from the company, they outsource a lot of the stuff. And this is a big part of being successful. And also the importance of free markets. Less regulation is usually good for business. I'm not an anarchist, I don't think we need no regulation, but less is usually better. Look at the deregulation of the telephone company, of the airplane industry, they all benefited by deregulation. And also to understand that market is self-organizing. If you apply the first three cornerstones, the market will take care of itself. And Adam Smith had some good examples where he showed that when you divide the job between several specialists, it's much more efficient.
But, you know, something that is a concern is why do we even have firms? And this was addressed by Coase in his 1934 article that appeared in the "Economics Journal." Coase basically stated that firms exist because they can reduce costs. It makes sense, right? firms create internal hierarchies that allow them to operate at lower cost. For example, in a market, you have to negotiate with each person. But if you have a firm, they work together in the firm, you don't have to have contracts with every employee. And that's what makes firms more efficient than the market if you had to go out and buy all the separate services.
Now, if we look at the next step, it's where economists like Adam Smith implied that markets are very similar in traits to biological evolution. And there was a paper actually written by Nelson and Winters, and that's exactly what they talked about. And they said that they evolve, companies evolve because markets select traits that are appropriate to the environment. The market selects business traits that can thrive and grow. Companies that have appropriate competencies, learning ability routines, and that are in line with the current market conditions, what, they'll produce excess profits. The companies that produce excess profits will thrive and grow, for those that don't wind up in bankruptcy.
Now, why do some firms succeed and others fail? Stephen Klepper, an economist, did an extensive study that was published in a paper in 2002. And what he found was that companies that enter markets early and grew rapidly produced excess cash flow. And if this excess cash flow is invested in R&D, those companies survived and flourished. So think about what's happening here. You have companies that went into a market, they had excess cash flow, they invested into the business, which made them even more efficient. Those companies that weren't efficient were driven out of business, right? And companies thinking of entering that market, they said, "I'm not going in that market, it's too competitive."
So if we summarize what makes a firm successful, it's basically Adam Smith's lessons that said that if you focus on self-interest, you specialize in high-value core competencies, you'll produce excess profits. Firms that are more efficient than the market have lower cost and will be able to reinvest in research and development. And what happens when they do that? Well, they improve their product and reduce their cost by improving the products that are needed and wanted by consumers and delivering them efficiently at lower costs. This will drive out and keep competition limited. The cycle will perpetuate itself and companies will grow until it exceeds a specific scale where the law of diminishing returns will stop its growth.
I noticed this was a high-level discussion and mainly involved economics. But this is really what happens in small business even it's a mom-and-pop store in your local town. This is what they do to become successful. So you probably have some questions, just leave them below on my YouTube channel. One of my analysts or I will get back to you and I really would appreciate it if you would subscribe to my additional videos, which we're gonna be coming out with shortly.