3  Why firms?

A fundamental question concerning firms is why they exist. Why isn’t all production and exchange done through market transactions between individuals?

Below I discuss the main theoretical challenge to the existence of firms, the absence of price signals, and the classic answer concerning contracting costs.

3.1 The price system

There is much evidence that the price system is more efficient at controlling and coordinating production and consumption decisions than central planning. Market economies are characterised by the production of goods valued by consumers while avoiding large shortages. Planned economies such as the former Soviet Union are characterised by poor customer choice, shortages and other production mistakes.

Two of the reasons why this is argued to be the case are:

  • The price system motivates better use of knowledge and information in decision making
  • It provides stronger incentives to make productive decisions

3.1.1 The dispersion of knowledge

Think about some of the knowledge that might be critical in allocating resources in a firm (Jensen and Heckling (1995)).

  • Idiosyncratic knowledge: Knowledge about the skills or preferences of staff, the characteristics of particular machines, the presence of unemployed resources (such as the fact there is space in the back of the truck)
  • Scientific knowledge: The knowledge how to make a silicon graphics processing unit. Even if readily available, it is not easily transferred to those without technical skills
  • Assembled knowledge: A storekeeper who has worked in a local store for years will have assembled a unique body of knowledge about the needs of local customers, and the local suppliers.

The knowledge for decision making is not held by any one individual. It is distributed across people in the economy.

This specific knowledge is critical in properly allocating resources, yet it is costly to transfer. It can be impossible to aggregate for a central decision maker. Even if it could be aggregated, it would require massive mental ability or computing power to process it.

In a market economy, the decentralised holders of the specific information make the decisions. They do not need to transfer their knowledge somewhere else, but can act on it themselves.

What coordinates these decentralised decision makers are prices. Prices create an economical way of effectively transferring information to coordinate decisions.

3.1.2 Incentives

Private property rights create the incentives for decentralised decision makers to act on their specific information. The wealth effects of the decision are borne by the resource owner.

In a centrally planned economy, a decision maker has limited or less direct incentives to act on their information as they do not own the resources they control. People under direction of those making decisions (i.e. bureaucrats) may have limited incentive to carry out instructions. Profits do not go to them, but to the state.

3.1.3 Friedrich Hayek on the price system

In his famous paper The Use of Knowledge in Society, 1974 Nobel Memorial Prize winner Friedrich Hayek (1945) provides an illustration of the price system in action.

Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose — and it is very significant that it does not matter — which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all his without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity — or rather that local prices are connected in a manner determined by the cost of transport, etc. — brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.

3.2 Contracting costs and the existence of firms

If private ownership and market exchange trumps state control, why does organisation into a firm, which breaks down the price mechanism and private ownership, occur? It seems to be introducing the same problems suffered by a centralised state, with decisions by managers akin to central planning. Managers do not hold all of the specific information required to make decisions, nor do they hold direct property rights that enable them to capture the full value of their decisions.

A classic answer to the question of why firms exist came from another Nobel Memorial Prize recipient, Ronald Coase (1937). His idea was that contracting costs explain the existence of the firm. Firms incur search costs, bargaining costs, decision costs, monitoring costs and enforcement costs in any economic transaction. There is also an opportunity cost if the transaction results in an inefficient allocation of resources. The optimal method of organisation is the one that minimises contracting costs.

This provides a basis for economic activity occurring both within firms and markets. Contracting costs may make organisation into firms the more efficient mode of exchange for some forms of transactions. Rather than having to specify every detail into a myriad of contracts, people can become employees with more scope to vary in their actions and duties as required.

Conversely, where the inefficient allocation of resources outweigh the contracting costs, the optimal method will be market exchange.

This division between firms and markets can also be blurred. Firms may use pricing systems inside to allocate resources. For example, teams may be required to work on a consulting model. Those who use them will be charged against their internal budget.