Introduction
It may seem an odd question but it is an important one. Why do firms exist? Consider an example. Why do travel agents exist? It would be perfectly possible for ·an individual to arrange their own holiday. They can book a flight with the air¬ line and they can also arrange hotel accommodation when going abroad. Many do just that and yet many others choose to use a travel agent, that is, a firm, a business, rather than use indi-vidual markets to achieve what they want. So why does the travel agent exist?
Travel agents exist because they can minimise transactions costs.
Firms, Hierarchies and Transactions Costs
When a firm exists, the way it alloc¬ates its resources within the firm is not that of a market. When people arrive for work in the morning, there is not a labour market to find who will do a particular task for the least reward. Within the firm resources are not allocated on a market basis, but on the basis of a management decision. Once a firm is established, markets are not generally operating within the firm.
We could put it like this. If we look outwards from the firm at the way in which that firm relates to other organisations, we find relationships usually on the basis of markets. If we look inwards, markets are not being used.
Rather, within the firm, it is hierarchies, that are the basis of resource allocation, not markets. The term hierarchy concerns the arrangement and organization of individuals within a firm according to power, status, and job function, rather than on the basis of markets and prices.
So how do we explain the existence of firms such as travel agents? Is such an arrangement the best use of society’s scarce resources? One of the first people to address this problem was Ronald Coase, who introduced the idea of transactions costs. His work has subsequently been developed and enriched by others, notably Oliver Williamson.
Ronald Coase taught for most of his career at the University of Chicago.
Trans actions costs are the costs associated with the organising and arranging of exchanges. Going back to the example of the travel agent, I could organise a flight and a hotel, but I now have to have an exchange with one or more hotels. I need another exchange with the airline and there may be others depending upon the exact form of the holiday. If I go to the travel agent, she can organise the whole thing for me in just one go. She can do this for thousands of other people too. So she makes one exchange with each of a few hotel operators, which will replace a whole series of individual exchanges. So the number of exchanges that takes place is considerably reduced by having the travel agent. Each exchange involves transactions costs, The existence of the firm with its hierarchy minimises the transactions costs and therefore can be more efficient use of resources than using a market.
So it may be more efficient, then, to have a firm, even though resources within the firm may not be allocated on a market basis. If an organisational arrangement is less costly than the use of a market, firms will come into existence. So the presence of transactions costs is a key explanation of why firms exist at all.
The Size of the Firm
Now let’s look at a related question. What stops firms becoming ever bigger over time? Why isn’t all world production carried on by firms, or even a single, big firm? Coase gives the following as his answer.
As a firm gets larger, the cost per unit that we call average cost may well fall. There are economies to being larger. They are the economies of scale we mentioned earlier. However, at some level of output organising additional transactions within the firm may rise. Beyond a certain size, the gains from economies of scale are defeated by the costs of firm bureaucracy. In other words, an increase in firm size may be efficient when firms are small but inefficient when firms are already large. This places a constraint on firms’ potential size.
Businesses exist because of the existence of transactions costs. However, they are limited in size by the costs of firm bureaucracy.