Discovering the Role of the Firm: The Separation Criterion and Corporate Law

The article presents a theory of the firm based on the ability to separate the objectives of the firm from those of its owners. The discussion introduces a separation criterion that defines a firm as a transaction institution such that the consumption objectives of the institution's owners can be separated from the objectives of the institution itself. The separation criterion provides a bright line distinction between firms and other types of transaction institutions. Firms under this criterion include profit-maximizing sole proprietorships, corporations, and limited-liability partnerships. Institutions that are not classified as firms include contracts, clubs, workers' cooperatives, buyers' cooperatives, merchants associations, basic partnerships, government enterprises, and government-sponsored enterprises. The separation theory of the firm yields insights into corporate law that extend and complement the standard contractarian approach. The separation theory of the firm places emphasis on shareholder property rights and corporate governance.