1937 article by Ronald H. Coase which attempted to explain the existence of the firm, i.e. business organization. He asked the remarkable question(s):
...in view of the fact that it is usually argued that coordination will be done by the price mechanism, why is such organization necessary? Why are there these "islands of conscious power"? Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these markets transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-coordinator, who directs production. It is clear that these are alternative methods of coordinating production. Yet, having regard to the fact that if production is regulated by price movements, production could be carried on without any organization at all, well might we ask, why is there any organization?
In other words, if economists are so excited about how well the price mechanism and free markets do, how do they explain these organizations which decide economic activity with little or no use of prices and markets internally? Why do firms decide what to do with hierarchical processes?
He also asks the question from the other side. If the hierarchical management process of the firm works, why not use this for the entire economy?
Coase goes so far as to make this issue definitional, "that the distinguishing mark of the firm is the supersession of the price mechanism.".
He argues that in certain cases there are expenses to using the price mechanism, which can be avoided by organization into a firm. For instance, generating complete contracts between two entrepreneurs may be extremely difficult, and the situation could be eased by having one become the employee of the other, with an incomplete contract that the employee will do more or less whatever the employer asks.
So, in general when the transaction costs of using the market to get stuff done exceed those of non-price management, the economic activity will take place inside a firm. Coase then pointed out that this could explain the limited size of firms as well. In the organization of a firm, consider those activities best organized in a non-market fashion as being in the center of a circle. Moving out from the center, the differential cost between market and non-market organization lessens until, at the margin, the price mechanism and entrepreneurial management have equal costs. From there on out, the price mechanism is cheaper, and activity will be organized by the marketplace.
Interestingly, the information age is predicted by different people with different focuses to shrink or grow the optimal firm size. On the one hand, high-tech management could be expected to reduce the cost of having a large firm. On the other hand, it could very well reduce search costs via the online marketplace, and therefore lead to a shrinking of the firm. Going back to the employment example, this would imply everyone eventually becoming a temp worker, or independent contractor.
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