Friday, January 6, 2012

Why do firms exist? What determines whether an activity will be provided by a market or by a firm?

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The logical starting point in discussing these questions is to define both the firm and the market. A firm is an economic institution that transforms the factors of production into goods and services; organizes factors of production, produces goods and/or services, and sells goods/services to consumers, business or government. A market is a grouping of people or organizations unified by a common need; a gathering of sellers and purchasers to exchange commodities.


Why do firms exist? Why are firms even necessary if markets are the perfect mechanism for exchange? As Ronald Coase, Nobel laureate in Economics demonstrated, there is an inherent cost to using the market mechanism. Coase viewed firms as instruments for reducing transaction costs. It is because of these costs of using a market that firms are, at times, more efficient at coordinating and organizing resources. Outside of the firm, production is directed by the price mechanism; coordination through a series of exchanges of transactions on the market. Within the firm, we see an elimination of transactions in the complex market structure, replaced by an entrepreneur-coordinator who directs production.


As Coase demonstrated in his paper ‘The Nature of the Firm’, the main reason why it is profitable to establish a firm is the obvious cost of using the price mechanism. One very obvious cost of coordinating production in the market would be discovering what the relevant prices are. Another relevant cost would be that of drafting contracts for each mutually dependant exchange transaction. Without transaction costs, market transactions are efficient and firms are redundant. Within the market these costs can be reduced, but never completely eliminated. The same can be said for the firm, however in most cases, these costs are greatly reduced within the firm. As Coase demonstrated, by coordinating activities, forming an organization and allowing for some authority to direct production, certain marketing costs are eliminated.


Uncertainty, which is extremely prevalent in today’s global economy, can have a profound impact on the theory of the firm. Economic decision makers’ inability to accurately predict the outcome of any action or event creates risk, and subsequently the possibility of reward (profit) for risk takers (entrepreneurs) willing to take a business risk. How it is that uncertainty can create an opportunity for the firm to emerge lies in the relationship between parties. Without uncertainty, two parties are able to engage in a long-term contract with full realization of future demand. In Coasean terms, firms would be unnecessary as the markets would be efficient in drawing up long-term contracts.


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One traditional economic view as to the existence of firms looks at the diverse imperfections that can be resolved at lower cost through internal corporate markets (firms) rather than through external transactions. Information was seen to flow more freely within firms and the cost of bargaining over quasi rents (the short-run excess earnings made by a firm, or the difference between production cost and selling cost) is lower within the firm. With the introduction of more imperfections, the potential advantages of the firm as a cost reduction vehicle tend to increase, making the firm even more useful in a global setting. These views certainly have a profound impact on the firm, whose survival is dependent upon cost savings and efficiency gains.


Transaction costs model theory (Coase referred to these costs as marketing costs) is important even for today’s changing economy. If we look back at the industrial era where consumers wanted basic goods in their cheapest form, we saw firms respond with an approach to economies of scale; the creation of mass produced commodities at the lowest possible price. The result was no large market for unique goods and a strong demand for the firm versus the market.


Another school of thought regarding the existence of the firm is that of property rights theory, which formalizes some of the concepts introduced in transaction cost economics. In essence this theory strives to prove that because of contract incompleteness, relationship specific investments can hold up production. We see a situation where asset specificity can create a potential for hold-up and therefore the requirement for a governance structure. With a lower level of asset specificity, governance is provided by credible contracting without forming a firm. However, in most cases, contracts specifying all contingencies are just not feasible; thus the need for the firm as a governance structure.


What determines whether an activity will be provided by a market or by a firm? To answer this question, one only need reflect on the above mentioned points. Property rights theory can determine the answer between a market structure and a firm structure by examining the asset specific nature of a contract. Where contracts are too complex and the cost is too high, the firm as a governance structure will prevail. In a large global environment where economies of scope and economies of scale are necessary for low cost production, the firm will usually emerge, as transaction (marketing) costs are usually lower within the structure of the firm. Uncertainty has a strong bearing on whether a firm or a market will provide an activity due to the inherent risks involved. Take a situation where future demand for a product is unknown. The entrepreneur will step in as risk taker, with the hope of realizing great profits. The market is unable to function; because this uncertainty (risk) prevents a long-term contract (the market therefore loses its advantage). If the activity is complex in nature with many players and steps in the transaction process, the firm will usually emerge over the market structure. This is because with the addition of more and more imperfections the firm is better suited to act as a cost reduction vehicle; demonstrated through efficient information flow and the lower cost of bargaining over quasi rents.


In conclusion, the firm exists for many reasons including transaction costs, property rights theory, uncertainty in the market, and diverse imperfections that occur within any production process or service industry. The distinction between the firm and the market structure as a vehicle for providing a particular activity lies in the ability of one versus the other to eliminate or reduce these inherent costs to make the particular activity feasible and cost effective (profitable), while providing the same level (quality) of output.





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