The Nature of the Firm

The Nature of the Firm

• The defining characteristic is the supersession of the price mechanism
• Outside the firm, price movements coordinate production through market transactions
• Within a firm, market transactions are eliminated
• Instead, an entrepreneur-coordinator directs production

Why Firms Exist

• There is a cost for using the price mechanism
• A cost exists in discovering relevant prices
• Costs exist for negotiating and concluding separate contracts for each transaction
• Dahlman (1979) identified transaction costs: search and information costs, bargaining and decision-making costs, monitoring and enforcement costs
• Firms emerge when short-term contracts become unsatisfactory
• A firm encompasses the system of relationships dependent on an entrepreneur's direction of resources

Factors Determining Firm Size

• The marginal cost of organizing/managing increases with the number of transactions
• The limit of the firm is reached when the marginal cost of organization equals the marginal cost of market usage
• Firm transaction costs depend on the geography of transactions, the dissimilarity of transactions, and probability of price changes.

Williamson's Puzzle

• Key incentive for vertical integration is to avoid ex-post opportunism with specific investments according to Williamson (1975)
• The puzzle questions why a large firm cannot replicate the functions of several small firms
• Incentives change within a merged firm relative to independent firms
• Mergers present a problem, individual incentives within a firm change
• Owners in an integrated firm have different incentives than owners in non-integrated firms
• Also true for managers
• Market incentives cannot be reproduced within a firm
• Mergers succeed or fail at a rate of 50:50

Influence Costs Within a Firm

• Influence costs stem from a tendency to intervene too often 'from above' (Milgrom/Roberts, 1990)
• Influence costs stem from time used for influencing activities ('office politics') (Milgrom/Roberts, 1990)
• Influence costs stem from inefficient decision proceedings due to information losses (Milgrom/Roberts, 1990)
• Influence costs stem from resources used lower influence costs (Milgrom/Roberts, 1990)

Ownership and Control

• The separation of owners and managers causes principal agent problems

Solving the Principal-Agent Problem

• Capital markets may take over if control/supervision is inefficient according to Manne (1965)
• The threat of a takeover can discipline management
• Minimizing agency costs motivates a firm's capital structure, with debt and equity linked to different agency costs based on the debt-equity ratio, according to Jensen/Meckling (1976)
• Equity financing enhances owner monitoring but may lower management's performance incentives
• Debt financing boosts incentives for risky projects, limiting potential losses for owners and managers in bankruptcy
• Fama (1980) finds that the labor market serves as a check as managers who mismanage a firm do not find new jobs
• Incentive contracts in internal incentive schemes can be used
• Product market forces can mitigate the problem
• Hart (1983) and Holmstrom & Tirole (1989) highlight how the product market sorts out inefficient firms, as they cannot pass high costs to consumers in competitive markets