Williamson and Coase: why do firms exist?

By Kelvin Tai - Economics and Management Student @ Harris Manchester College, Oxford

You probably have interacted with a multitude of firms throughout your life. Whether it is Sainsbury’s, a corner store, or a kebab van, these are businesses with which you might have traded your money for goods and services.

It may surprise you that prior to the industrial revolution, many firms were largely limited to shopfronts run by individuals or families, in a mercantile system. They traded among themselves, creating a supply chain with raw materials at the start and finished products at the end. Subsequently, the invention of the steam engine was quickly followed by the rise of capital-intensive machinery that facilitated an increase in productivity. Spinning jennies could churn out vast quantities of textiles as compared to a handloom. Along with the development of railways, this meant that production could become more centralised and factories were constructed to take advantage of these economies of scale and spread out the fixed costs of machinery.

Where then does the firm begin and where does it end? The iPhone is assembled through the contributions of a multinational coalition of factories. Adam Smith has expounded on the benefits of specialisation (check out The Wealth of Nations!) and the concept holds true for firms as well. By being focused on a narrow segment of the supply chain, each individual firm can reap the benefits of economies of scale and also invest resources into innovation. However, some firms choose not to outsource, but control multiple segments of the supply chain. Tesla has produced batteries for its electric vehicles and recently announced plans to enter the lithium mining business. This is known as vertical integration.

The choice between subsuming production under a firm or relying on market production is dictated by transaction economics, a field most commonly associated with Oliver Williamson. He built upon the work of Ronald Coase, who noted that the point of a firm is to suppress the price mechanism. While there are inefficiencies when one deviates from the free market, the transactions costs involved with negotiating contracts for each economic exchange can outweigh these efficiencies, whether this be regarding labour or raw material. After all, market trading is not frictionless and the uncertainty surrounding contracts mean that these contracts will often have to be negotiated.

Such uncertainty is especially pronounced in the labour market, as the tasks performed by employees are unlikely to be fully defined at the time of contract signing and the contributions of a single employee can be difficult to measure. Hence, a compelling reason for firms to form is the elimination of such uncertainty, since the allocation of resources would be directed by an entrepreneur. Firms would be able to govern internal transactions instead of hoping that their suppliers of raw materials and labour as well as their downstream customers would deal with them in good faith. As such, firms can be viewed as a response to the real-life imperfections of the free market.

The concept of a firm has evolved over time and will likely continue to do so. Gig economy platforms such as Uber are challenging traditional business models by reducing transaction costs for economic agents on both sides of the market in return for a commission. The past decades of globalisation have also spurred a tendency to outsource production in countries with a lower cost of production. Is this a return to a pseudo-mercantilist economy, where individuals make their own output decisions under the frameworks laid down by larger platforms? We can expect the structure of firms to continually modify as technological advancements and economic conditions change the dynamics between suppliers and customers, firms and individuals.

Further reading:

  1. Smith, A. (1977). The wealth of nations (Everyman's library ; 412-413). London ; New York: J.M. Dent ; E.P. Dutton.

  2. Williamson, O. (1981). The Economics of Organization: The Transaction Cost Approach. American Journal of Sociology, 87(3), 548-577.

  3. Coase, R. (1937). The Nature of the Firm. Economica, 4(16), new series, 386-405. doi:10.2307/2626876