Corporations: Why do firms exist?

The East India House in Leadenhall Street, London, c. 1817

A business is any activity entered into for-profit, and humans have engaged as such since time immemorial with artifacts of trade and commerce found at Ebla dating back to 3000 BC. The story of business is the story of inventors, entrepreneurs, and visionaries. It is the story of ideas such as branding from 2700 BC and concepts such as risk, born on high seas tracing its origins to maritime voyages during the age of discovery. It would not be very reasonable to mark any one point in time and call it the beginning of this story.

However, for much of its history, family-owned or localized firms dominated the business environment. Land, the most crucial asset in the feudal community during the medieval era, was tied to a family rather than an individual.

Poor connectivity and prohibitions on usury enforced by the church hindered lending and development of markets. There was little incentive for improving productivity.

Technologies like Gutenberg’s movable-type press, as well as the spread of literacy, gave rise to critics and undermined the authority of the church. A number of monarchs seized the opportunity to consolidate power by allying themselves with the merchant class.

Nation-states usurped power from the church by establishing a monopoly on the military. They provided legal protection to private property and a constitutionally limited government. They fueled the expansion of markets as a means of collecting revenue for maintaining armies and administrative capacity.

The growth of railways, improvements in communication and maritime technology, and the Industrial Revolution in the 1800s enabled businesses to grow beyond national boundaries, giving rise to enterprise markets replacing localized businesses. Yet these businesses were limited in scope.

By the middle of the twentieth century, businesses had realized administrative coordination by application of scientific methods permitted greater productivity, lower costs, and higher profits than passive coordination by market mechanisms alone.

Individuals began to provide their services to other individuals within the firm boundary according to the firm’s organizational structure rather than independent market participation under contractual obligations. This removed transaction costs such as hold up, information asymmetry, escrow, contract, negotiation, compliance, etc. and risks of protecting trade secrets from outside market participants.

Such conditions gave way to ever-larger business enterprises, characterized by the presence of multiple units and a hierarchy of managers making resource allocation decisions. The visible hand of management replaced the invisible hand of market forces.

The firm as a nexus of contracts. Source:

These enterprises employed hundreds of middle and top managers who supervised the work of hundreds of operating units employing thousands of workers. They were owned by hundreds of thousands of shareholders and carried out billions of dollars of business annually. Rarely in the history of the world had an institution grown to be so important and so pervasive in such a short period.

The point is that the ownership of market transactions provides firms with residual rights of control and enormous power. That is why firms exist.

If that is the case, then why do several firms co-exist instead of a single firm?

Ford River Rogue Complex: Henry Ford’s ultimate goal was to achieve total self-sufficiency by owning, operating, and coordinating all the resources needed to produce complete automobiles.

In “The Nature of the Firm,” Coase predicted that ecosystems with higher transaction costs would tend to develop larger firms. On the other hand, smaller transaction costs tend to develop smaller firms. In the limit where transaction costs go to zero, the firm will go extinct, and everyone will be self-employed. With the advent of technologies like the telephone and the internet, many transaction costs from the past mitigated over time.

Transaction costs also depend on the complexity of the transaction itself. With an increase in complexity, it becomes challenging to encompass all possibilities in a contract. However, when the transaction is less complex, the bureaucratic and associated agency costs of enterprises are much more than merely transacting with external players in the market. This limits the scope of firms.

Another variable limiting business scope is the inability of a group of people to make rational decisions reliably. This proposition is derived from Arrow’s impossibility theorem. It implies that a single individual will always be more consistent in making rational decisions than a group of people.

Therefore, a firm can reliably make rational decisions only if its members are irrational or decision making is concentrated in the hands of a single individual (dictator). However, it is an arduous task for a single individual to make timely decisions for a large enterprise. That is why senior leaders are paid handsomely for their ability to make efficient decisions with imperfect information. But that is not a robust solution as evidenced by the concept of bounded rationality, which states under complex situations rather than optimizing humans opt for satisficing solutions.

Technologies might enable another leap in firm scope where algorithms might provide large firms with the ability to centralize all decisions.

Throughout history with the ever-increasing geographic scope and size of firms, they need to balance the benefits of scale with the costs of co-ordination. In short, businesses always needed management.

MBA — Mechanical Engineer, curious !