Why do firms exist PDF

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An essay for Microeconomics about the economics of firms...

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Why do firms exist? Since Adam Smith’s famous ‘pin factory’ example, it has been acknowledged amongst economists that cooperation and trade lead to increased efficiency, as it allows for specialisation, leading to a lowering of opportunity costs, making the whole greater than the sum of the parts. A firm, however, is not precondition for cooperation as companies can simply trade between one-another. Whilst not necessary, it has been suggested that firms are useful, and therefore exist, for two main reasons. The first, as put forward by Coase, is called transaction cost theory. The second, as suggested by Williamson, deals with market power and asset specificity as the reason for the existence of firms. The first reason is that market trading is expensive, due to costs that can be divided into three sections. The first of these are known as ‘search and information’ costs, which entail costs such as finding out whether a certain good is available, discovering prices, comparing products and so on. The second are ‘bargaining’ costs, which include the costs made during the transaction, namely those of negotiating and drawing up a contract. These contracts can be very expensive to produce where there is uncertainty, as this leads to incomplete contracts which require frequent renegotiation. These will also be high due to the nature of legal costs, and because mistakes in contracts will be costly. The final type of costs are ‘policing and enforcement’ costs, which involve the costs of making the other party comply to the terms of the contract, and usually taking legal action against the offending party if the terms are not met. Costs here are again high due to the expense of legal costs – hiring lawyers, court costs etc. With firms, these costs are limited as the contracts drawn up are less competitive and can be much longer term in nature, reducing the need for constant revision, thus reducing legal costs. Coase argues that a situation where the transaction costs of the external markets exceed those that would exist internally will lead to the existence of a firm. However, when the internal costs exceed the external costs, firms will look for ways to reduce their size through, for example, outsourcing. The second major theory was developed by Williamson who, like Coase, attributes the existence of firms to the imperfections of the market. This failure comes from the market power caused by asset specificity. Asset specificity arises where the opportunity cost of a good is low i.e. its value in its second-best use is low due its limited, niche uses. This leads to the existence of a firm in situations where there are a small number of buyers and sellers of the item, due to the reduction of competition and therefore increased market power of all parties. This leads to an increase and protraction of bargaining over trade gains, leading to an increase in transaction costs. Furthermore, this bargaining can lead to the hold-up problem, which occurs where two parties can mutually benefit from a transaction, but are unwilling to help one another, and thus both parties lose out. This reduces cooperation and therefore efficiency. Firms eliminate this issue and that of strategic bargaining by merging the two potentially competitive parties into one, whereby they may pursue their joint interests for their mutual benefit....