Why Firms and Markets in Economics?

Abstract

In this paper, by carefully reflecting on the modern transaction costs approach to the Theory of the Firm, we try and understand better the economic nature of firms vis-à-vis markets to derive important corporate policy implications. By following the idea of Coase that firms come to existence to economize on transaction costs, we specifically put it that the firm does so by internalizing factor market rather than product market activities. We also establish that the firm is essentially characterized by its vertical structure where the coordination function is realized through 'command and control,' while markets are horizontal, democratic and spontaneous. This paper goes further to redefine the firm as a collection of nontransparent economics activities. Although the term 'transparency' has been commonly used in the media and in policy debates, its precise economic interpretation has been so far unsatisfactory in the economics literature. This paper attempts to provide an economic meaning of transparency, which is placed in the context of firms and markets. Various corporate issues including its governance, policy, and transparency, as well as the role of market disciplinary mechanisms are clarified through theoretical extensions and discussions regarding the theory of the firm.