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Institutional economics proposes a clear theory to explain the origin of the firm and its limits. It offers entrepreneurs a valuable theoretical framework with which to clarify the issues they face when selecting which organizational arrangements—market or hierarchical—to employ. However, institutional economics does not address two important dimensions that influence this choice: the entrepreneur’s cognition and emotions. In this paper, we propose that entrepreneurs make this choice not simply through a rational evaluation of transaction attributes such as uncertainty, repetitiveness and specificity, but that the way they process information and experience emotion will influence their decision.

In selecting which organizational arrangement to employ, entrepreneurs have to cope with the problems inherent to market transactions: information asymmetry, moral hazards, opportunistic behavior, uncertainty and complexity. They are influenced by their present and anticipated emotions. We propose that the firm, as a hierarchical organization, is an effective way to fight cognitive limitations and/or to cope with emotions. We suggest that the choice that entrepreneurs make between market or hierarchy is mainly driven by their cognition and emotions. By relying on a hierarchy, entrepreneurs are in better position to close off a too-complex economic system. They are in a better position to force cooperation by fiat and to monitor potentially opportunistic behavior through the exercise of power. They can have greater control over what they perceive as conducive to favorable and unfavorable emotions. Finally, within a hierarchy emotions can easily play a crucial role in decision-making. They mediate rational choice in situations of uncertainty where information is incomplete. We propose that expression of the entrepreneur’s full cognitive capabilities and control of his or her emotions is functional to the firm’s survival.