1  The importance of firms

In a market economy, economic activity largely comprises voluntary transactions between individuals or firms. Decisions about what will be produced or consumed are made in response to price signals.

Yet, much economic activity in market economies is conducted within firms. The economic decisions within firms are not typically guided by prices, but rather by the allocation of decision rights, often to central authorities, and creation of incentive systems and controls. Most workers in developed economics are employed within firms.

Nobel Memorial Prize winner Herbert Simon (1991) asked what a mythical visitor from Mars would see if they looked at this.

A mythical visitor from Mars, not having been apprised of the centrality of markets and contracts, might find the new institutional economics rather astonishing. Suppose that it (the visitor — I’ll avoid the question of its sex) approaches the Earth from space, equipped with a telescope that reveals social structures. The firms reveal themselves, say, as solid green areas with faint interior contours marking out divisions and departments. Market transactions show as red lines connecting firms, forming a network in the spaces between them. Within firms (and perhaps even between them) the approaching visitor also sees pale blue lines, the lines of authority connecting bosses with various levels of workers. As our visitor looked more carefully at the scene beneath, it might see one of the green masses divide, as a firm divested itself of one of its divisions. Or it might see one green object gobble up another. At this distance, the departing golden parachutes would probably not be visible.

No matter whether our visitor approached the United States or the Soviet Union, urban China or the European Community, the greater part of the space below it would be within the green areas, for almost all of the inhabitants would be employees, hence inside the firm boundaries. Organizations would be the dominant feature of the landscape. A message sent back home, describing the scene, would speak of “large green areas interconnected by red lines.” It would not likely speak of “a network of red lines connecting green spots.”