The Nature of the Firm — Why Start a Company?

He who gets commoditized last, wins. —Andy Grove

Background

In 1937, Ronald Coase, an economist, asked the question, why do firms (companies) exist? His answer appears to be a simple observation but one that has completely changed the way I think about markets and companies. This was something Coase made a habit of — simple observations with profound impacts — and which won him a Noble Prize in 1991. He lived an incredibly productive and long life, writing a book on China’s economy at the age of 100.

Why Start a Company?

I’ve started a number of companies but never really asked the question, why? And which companies? I think my answer — and the answer most entrepreneurs would give — is that I saw a problem and wanted to fix it. I believe most entrepreneurs would explain that there was no solution to a particular problem or that they thought they could do it better themselves. (The other reason I’d say is freedom — I wanted to control my time.)

[T]he operation of a market costs something and by forming an organization and allowing some authority (an “entrepreneur”) to direct the resources, certain marketing costs are saved. The entrepreneur has to carry out his function at less cost, taking into account the fact that he may get factors of production at a lower price than the market transactions which he supersedes, because it is always possible to revert to the open market if he fails to do this.

What Coase proposed was that firms were created when the internal transaction costs (decisions orchestrated by the entrepreneur) were less than the external transaction costs (decisions set by a price mechanism in a market) — i.e., “I’ll just do it myself.”

A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.

This was actually very counter to the traditional theory at the time. Adam Smith had shown that markets were efficient (the invisible hand and all): the market works so that the entity that can best provide a good or service mostly cheaply would do so. Thus it would always be better to contract the best than to hire someone who was suboptimal. So while we hear about the efficiency of markets all the time, what Coase proposed is that there is a real cost to operate and participate in a market and that firms are created to avoid this cost. Markets do have a cost and a value; you can simply look at the market capitalization of the Chicago Mercantile Exchange, one of the largest marketplaces in the world, to see this: it has a market capitalization of $27 billion and nearly $3 billion in revenue. These are market costs.

Examples/Firm Size (Internal vs. External)

Every day, general contractors pick up day laborers or subcontractors for a day or week of work. They’ve made the decision to use the pricing mechanism of a market to pay for a small unit of labor. Most of us use outside services for our firms — accounting, legal, benefits. We do this because it’s cheaper “to buy than to build” these services in-house —  i.e., the market pricing mechanism is more efficient than we could be.

But let’s look at a bigger business, a vertically integrated commodity producer, like a large farm, for example. Their product’s price is transparently set by the market (corn is listed in the Chicago Mercantile Exchange, for example). The founders of this hypothetical firm made the decision to create a company because they believed that their internal costs would be less than the market’s, that they could produce corn for less than the market price. It doesn’t stop there though — should they buy fertilizer, or should they produce their own? Should they process and package their product or just sell a commodity? Should they own or lease their land? All of these are decisions based on internal vs. external transaction costs. Large firms can gain tremendous advantages — internal information, bargaining costs, the effective protection of their intellectual property and trade secrets; thus, we see the success of large, vertically integrated businesses. Often, the more transactions, the more economies of scale, the lower the coordination costs. Think about Amazon in this context — they own retail because they have the lowest coordination costs due to their size and efficiency.

However, there is a limit to the size of the firm. There is a reason we often describe big firms as slow or bureaucratic.

First, as a firm gets larger, there may be decreasing returns to the entrepreneur function, that is, the costs of organizing additional transactions within the firm may rise.

As a firm scales, overhead costs go up‚ and it becomes harder to orchestrate lots of people and to share information. The better the entrepreneur’s management skills, the better he or she can coordinate an organization, and the more the organization can scale without losing efficiency. But eventually, forces start to work against the firm — orchestration costs rise; smaller, more nimble competitors can deliver similar services less expensively.

Conclusions, Observations, and Questions

If you are going to start a firm, you better believe you can minimize the transaction costs, which for almost everything — from software to manufacturing — are collapsing. And you need to believe that you can not only minimize them initially but also keep them lower over the long haul. Secondly, what gets internalized is again a function of transaction costs. During the life of a company, there is a perpetual debate about “buy vs. build” (a dichotomous analysis that, by the way, could be extended to the question of buying from the market or starting a new company in the first place). Before you make that hire, are you sure it’s cheaper? Does the cost of managing more people outweigh the benefit you could find in the market? We like to measure and judge companies by their number of employees, which is often the wrong metric. Bigger doesn’t always mean better. It often means plodding and inefficient.

Additional Reading

The Theory of the Firm, Ronald Coase, 1937

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