A Theory of Firms and Markets

Abstract

This paper develops an explanation for why some economic activities are organized through markets and others through firms. A basic economic problem is how to coordinate the plans of individuals in a system where information is widely dispersed. In the market, coordination happens through a process of decentralized interactions. In the firm, an entrepreneur centralizes information and makes plans to coordinate activities. Using the market mechanism entails the cost of finding potential exchange partners and agreeing on terms of trade. The cost of using the firm mechanism is that the plans made by the entrepreneur will be only as good as the quality of information that can be centralized. Information that changes frequently is difficult to centralize. So is information that is not easy to communicate. The relative cost of two mechanisms depends on the nature of information. The organization of an economy into markets and firms of different sizes may reflect the underlying information problems.