Why Do Firms Exist

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.

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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.

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). On the contrary, the opportunity cost of the firms using independent market firms is the risk of ‘incomplete contract’ with market firms.

It is difficult to guarantee the market firms respect and perform the responsibilities within the conditions of contract. Coordination is a major issue for firms producing special designed goods which require ‘perfect-fit’ amongst different components to assemble the finished products. The most critical consideration of using market firms is about sharing private information of firms to market firms which is a particular sensitive to the future development of the firms. (Example).

It is important to take into consideration of the competition and understand the game dimension in order to define the boundaries of firm by determining the make-buy dilemma. Assuming all players are rational, game theory is what its name implies. It analyses different game situations which are available to different firms in order to anticipate potential outcomes. Game theory applies perfectly with the breaking news this week about the exclusive acquisition of Nokia’s mapping system jointly by three leading German carmakers, Daimler, BMW and Volkswagen Group.

The industry analyst regards this Nokia’s best mapping software in market with more precise and reliable mapping (than Google and Apple map) for car industry. This vertical integration of three German carmakers is to own the best mapping system which is the most critical device in connecting the vehicle and topographical data. The formation of this first-ever strategic partnership of three German leading carmarker is to prepare for the battle of the driverless car manufactured by Apple and Google.