Firms Markets and Efficiency

Abstract

If the price system is superior to central planning, why do firms exist with sub-economies that are very large, approximating small capitalist economies? In a principal-agent setting we compare a market, in which two principal-agent pairs trade, to a corporation in which a single principal hires both agents. In a market principals motivate their agents to make efforts by writing contracts contingent on observed prices, some of which are negotiated between the agents themselves. These prices may be informative, allowing principals to induce high effort at a lower cost. But, principals in different firms cannot coordinate their contract choices since each lacks authority over the other's agent. Authority over both agents' efforts occurs when a corporation is formed, where one principal contracts directly with both agents, a sub-economy. Information from market prices is then lost and cannot be replicated by internally generated transfer prices. Whether a market or a firm is optimal is determined by the relative value of managerial authority over agents (the visible hand) versus information from market prices (the invisible hand).