In simplified terms, the theory of firm aims to answer these questions:
Despite looking simple, these questions are not answered by the established economic theory, which usually views firms as given, and treats them as black boxes without any internal structure.
The First World War period saw a change of emphasis in economic theory away from industry-level analysis which mainly included analysing markets to analysis at the level of the firm, as it became increasingly clear that perfect competition was no longer an adequate model of how firms behaved. Economic theory till then had focussed on trying to understand markets alone and there had been little study on understanding why firms or organisations exist. Market are mainly guided by prices as illustrated by vegetable markets where a buyer is free to switch sellers in an exchange.
The need for a revised theory of the firm was emphasised by empirical studies by Berle and Means, who made it clear that ownership of a typical American corporation is spread over a wide number of shareholders, leaving control in the hands of managers who own very little equity themselves. Hall and Hitch found that executives made decisions by rule of thumb rather than in the marginalist way.
Firms or organisations exist as an alternative system to the market mechanism when it is more efficient to produce in a non-price environment. For example, in a labor market, it might be very difficult or costly for firms or organisation to engage in production when they had to hire and fire everday their employees depending on demand/supply conditions. It might also be costly for employees to shift companies everyday looking for better alternatives. Thus, firms engage in a long-term contract with their employees to minimize the cost.
Klein (1983) asserts that “Economists now recognise that such a sharp distinction [between intra- and inter-firm transactions] does not exist and that it is useful to consider also transactions occurring within the firm as representing market (contractual) relationships.” The costs involved in such transactions that are within a firm or even between the firms are the transaction costs.
According to Putterman, this is an exaggeration - most economists accept a distinction between the two forms, but also that the two shade into each other; the extent of a firm is not simply defined by its capital stock . Richardson for example, notes that a rigid distinction fails because of the existence of intermediate forms between firm and market such as inter-firm co-operation.
Ultimately, whether the firm constitutes a domain of bureaucratic direction that is shielded from market forces or simply “a legal fiction”, “a nexus for a set of contracting relationships among individuals” (as Jensen and Meckling put it) is “a function of the completeness of markets and the ability of market forces to penetrate intra-firm relationships”.
Ronald Coase set out his transaction cost theory of the firm in 1937, making it one of the first (neo-classical) attempts to define the firm theoretically in relation to the market. Coase sets out to define a firm in a manner which is both realistic and compatible with the idea of substitution at the margin, so instruments of conventional economic analysis apply. He notes that a firm’s interactions with the market may not be under its control (for instance because of sales taxes), but its internal allocation of resources are: “Within a firm, ... market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur ... who directs production.” He asks why alternative methods of production (such as the price mechanism and economic planning), could not either achieve all production, so that either firms use internal prices for all their production, or one big firm runs the entire economy.
Coase begins from the standpoint that markets could in theory carry out all production, and that what needs to be explained is the existence of the firm, with its "distinguishing mark ... [of] the supersession of the price mechanism." Coase identifies some reasons why firms might arise, and dismisses each as unimportant:
Instead, for Coase the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism. These include discovering relevant prices (which can be reduced but not eliminated by purchasing this information through specialists), as well as the costs of negotiating and writing enforceable contracts for each transaction (which can be large if there is uncertainty). Moreover, contracts in an uncertain world will necessarily be incomplete and have to be frequently re-negotiated. The costs of haggling about division of surplus, particularly if there is asymmetric information and asset specificity, may be considerable.
If a firm operated internally under the market system, many contracts would be required (for instance, even for procuring a pen or delivering a presentation). In contrast, a real firm has very few (though much more complex) contracts, such as defining a manager's power of direction over employees, in exchange for which the employee is paid. These kinds of contracts are drawn up in situations of uncertainty, in particular for relationships which last long periods of time. Such a situation runs counter to neo-classical economic theory. The neo-classical market is instantaneous, forbidding the development of extended agent-principal (employee-manager) relationships, of planning, and of trust. Coase concludes that “a firm is likely therefore to emerge in those cases where a very short-term contract would be unsatisfactory,” and that “it seems improbable that a firm would emerge without the existence of uncertainty.”
He notes that government measures relating to the market (sales taxes, rationing, price controls) tend to increase the size of firms, since firms internally would not be subject to such transaction costs. Thus, Coase defines the firm as "the system of relationships which comes into existence when the direction of resources is dependent on the entrepreneur." We can therefore think of a firm as getting larger or smaller based on whether the entrepreneur organises more or fewer transactions.
The question then arises of what determines the size of the firm; why does the entrepreneur organise the transactions he does, why no more or less? Since the reason for the firm's being is to have lower costs than the market, the upper limit on the firm's size is set by costs rising to the point where internalising an additional transaction equals the cost of making that transaction in the market. (At the lower limit, the firm’s costs exceed the market’s costs, and it does not come into existence.) In practice, diminishing returns to management contribute most to raising the costs of organising a large firm, particularly in large firms with many different plants and differing internal transactions (such as a conglomerate), or if the relevant prices change frequently.
Coase concludes by saying that the size of the firm is dependent on the costs of using the price mechanism, and on the costs of organisation of other entrepreneurs. These two factors together determining how many products a firm produces and how much of each.
The weakness in Alchian and Demsetz’s argument, according to Williamson, is that their concept of team production has quite a narrow range of application, as it assumes outputs cannot be related to individual inputs. In practice this may have limited applicability (small work group activities, the largest perhaps a symphony orchestra), since most outputs within a firm (such as manufacturing and secretarial work) are separable, so that individual inputs can be rewarded on the basis of outputs. Hence team production cannot offer the explanation of why firms (in particular, large multi-plant and multi-product firms) exist.
If the transaction is a recurring or lengthy one, re-negotiation may be necessary as a continual power struggle takes place concerning the gains from trade, further increasing the transactions costs. Moreover there are likely to be situations where a purchaser may require a particular, firm-specific investment of a supplier which would be profitable for both; but after the investment has been made it becomes a sunk cost and the purchaser can attempt to re-negotiate the contract such that the supplier may make a loss on the investment (this is the hold-up problem, which occurs when either party asymmetrically incurs substantial costs or benefits before being paid for or paying for them). In this kind of a situation, the most efficient way to overcome the continual conflict of interest between the two agents (or coalitions of agents) may be the removal of one of them from the equation by takeover or merger. Asset specificity can also apply to some extent to both physical and human capital, so that the hold-up problem can also occur with labour (eg labour can threaten a strike, because of the lack of good alternative human capital; but equally the firm can threaten to fire).
Probably the best constraint on such opportunism is reputation (rather than the law, because of the difficulty of negotiating, writing and enforcement of contracts), if a reputation for opportunism significantly damages an agent’s dealings in the future: this alters the incentives to be opportunistic.
Williamson sees the limit on the size of the firm as being given partly by costs of delegation (as a firm’s size increase its hierarchical bureaucracy does too), and the large firm’s increasing inability to replicate the high-powered incentives of the residual income of an owner-entrepreneur. This is partly because it is in the nature of a large firm that its existence is more secure and less dependent on the actions of any one individual (increasing the incentives to shirk), and because intervention rights from the centre characteristic of a firm tend to be accompanied by some form of income insurance to compensate for the lesser responsibility, thereby diluting incentives. Milgrom and Roberts (1990) explain the increased cost of management as due to the incentives of employees to provide false information beneficial to themselves, resulting in costs to managers of filtering information, and often the making of decisions without full information. This grows worse with firm size and more layers in the hierarchy.
George Akerlof (1982) develops a gift exchange model of reciprocity, in which employers offer wages unrelated to variations in output and above the market level, and workers have developed a concern for each other’s welfare, such that all put in effort above the minimum required, but the more able workers are not rewarded for their extra productivity; again, size here depends not on rationality or efficiency but on social factors. In sum, the limit to the firm’s size is given where costs rise to the point where the market can undertake some transactions more efficiently than the firm.
Recently, Yochai Benkler further questioned the rigid distinction between firms and markets based on the increasing salience of “commons-based peer production” systems such as free software (e.g. Linux), Wikipedia, Creative Commons, etc. He put forth this argument in The Wealth of Networks: How Social Production Transforms Markets and Freedom, which was released in 2006 under a Creative Commons share-alike license.