Why Do Firms Exist?

Why do firms exist?

Approach: Brief essay narrative style, arguing the main salient economic points. You may use your own company, or a company that you are familiar with or a hypothetical case.

If the market is so efficient, why do firms exists? Ronald Coase, the Nobel Prize winning Economist, introduced the transaction cost approach to the theory of firm in 1932. Transaction cost is the costs associated with exchange of goods or services and incurred in overcoming market imperfections which includes searching for information costs, bargaining and negotiation costs, and policy enforcement costs. According to Coases’ article of “the Problem of Social Cost”, transaction cost is to deal with, conduct negotiation, draw up the contract and execute monitoring system to ensure the contract is properly taking place.

Firms exist because it makes contracts and carries out the economic activities through various contracts. Firm can reduce transaction costs in the principle-agent relationship including bounded rationality, opportunism and asset specificity. Bounded rationality means individual access to limited knowledge which creates uncertainty in decision making of transaction. Opportunism arouses because different degrees of information of an individual, which leads the more informed party to use her knowledge and take advantages. (Example) Asset specificity refers to an asset is designed for a single purpose with no alterative value, which creates the high transaction cost because of “hold-up” issue.  (Example) In short, firms make contracts and generate the competitive conditions within the firm than the total market cost.

Firm is described as a ‘nexus of contracts’, which transaction cost determines whether markets or firms or a combination of both are more efficient in coordinating exchange and transactions. To reduce the transaction cost, the key issue of firms is how to organise vertical chain which refers the process that begins with acquisition of raw materials and ends with sales of finished goods. The coordination of the activities in the vertical chain can be a problem, so it needs to define the vertical boundaries of the firm. It refers to which activities in the vertical chain of a firm should perform itself and which it should rely on independent firms in the markets which is also known as “make-or-buy” problem. (Example). The “make-or-buy” decision does not eliminate or reduce number of steps of production, instead it is about the decision on which firms should perform vertical integration (make) on which steps or purchase from independent firms from market (buy).

Given all the firms are rational players in market for profit maximisation, it is suggested to consider the costs and benefits analysis to illustrate the economic trade-off of the extreme “make-or-buy” dilemma. The key benefit of using market is to achieve economies of scale and learning curve which means the independent market firms should focus on a specific activities on what they do best and leave the rest to market. (Example: patent or proprietary information). Using independent market firms can also avoid the inefficiencies and costs of managing the complex monitoring and rewarding system of vertically integrated firm. Independent market firms also need to keep themselves very competitive in market and are keen to be innovative to survive. (Example). Most importantly, market firms are able to aggregate market demand and produce at lower cost for economy of scale. (Example).

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