Why do firms exist?

By | December 29, 2010

Ronald Coase, the economist who theorised the reason for the existence of firms, turns 100 today. The Economist’s Schumpeter column has this really nice piece about him:

His central insight was that firms exist because going to the market all the time can impose heavy transaction costs. You need to hire workers, negotiate prices and enforce contracts, to name but three time-consuming activities. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. But if markets are so inefficient, why don’t firms go on getting bigger for ever? Mr Coase also pointed out that these little planned societies impose transaction costs of their own, which tend to rise as they grow bigger. The proper balance between hierarchies and markets is constantly recalibrated by the forces of competition: entrepreneurs may choose to lower transaction costs by forming firms but giant firms eventually become sluggish and uncompetitive.

Of course, things are not that neat (read the rest of the article) but his central ideas in ‘The Nature of the Firm’ (1937) survive in the work of New Institutional Economists, with transaction cost remaining central to much of their theorising.

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