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 negot