Reconsider the Question That Why the Firm Exists

It is one of my unpublished papers below.

Reconsider the Question That Why the Firm Exists

Yandong Xiao*

This paper addresses the question that why the firm exists in a rigorous and fundamental manner. It also provides a clear perspective to find the answer.

                                                   I. Coase’s Misleading Argument

Despite the emergence of different versions of firm theories in the past 70 years, the basic question that why the firm exists remains hard to answer. The most well-known paper interpreting why the firm exists may be the one written by Ronald Coase, The Nature of the Firm, which was published in 1937. In this paper, Coase contributed the primary factor determining the existence of the firm to transaction cost, a new concept conceived by him. However, he started out his argument by coming up with some non-primary factors in his own view and then excluded them to reach his conclusion that transaction cost should be the primary factor. No convincing evidence has been provided in his argument that transaction cost is a necessary and sufficient determinant to the existence of the firm.

Furthermore, the concept of transaction cost is extremely ambiguous in that of Coase’s paper (See Coase 1937). Though some important testable implications of the concept (See Williamson 1979, 1985) had been developed by Oliver Williamson a few decades later, the issue that whether transaction cost is a necessary and sufficient determinant to the existence of the firmstill needs to be verified. 

                                                 II. Is There Any Primary Factor?

The problem that whether some primary factor is a necessary and sufficient determinant to the existence of the firm matters much. We firstly take those necessary factors into account. It is not difficult to propose a great many factors. For example, we can ask that whether the firm would still emerge if everyone in the world used to have the same amount of wealth denoted by some specific currency. If everyone had possessed the same amount of money, who would have been employed? If nobody had been employed, how could the firm exist? The apparent disadvantage of most of employees that they had less money leads to our consideration that the difference in wealth may be a necessary factor to the emergence of the firm.

Further, if everyone has had the identical ability on each job involved in any process of production, could the firm emerge? In this circumstance, who should be the manager or worker in the firm? Or there would be no manager and worker? Can the firm coordinate successfully the human resources within it? It is believable that division of labor becomes a tricky issue if everyone has had the same ability. Consequently, we may also consider the difference of ability among employees as a necessary factor to the existence of the firm.

A more interesting example is to ask whether the firm would exist if market trade had been forbidden. If market trade had been forbidden, how could the firm obtain its materials to make their products? Even though they had solved the material supplying problem, who would buy their products? Responding to these issues, it is reasonable to conclude that the permission of market trade is a necessary factor to the existence of the firm.

It is natural to further discuss if there exists any primary necessary factor. Can we single out one factor from the three above factors to be primary? The most probable answer is we are not eloquent enough to select any of them or to propose some other unmentioned factor as a primary necessary factor.

We now turn to discuss those sufficient factors to the existence of the firm. Can transaction cost be a primary sufficient factor to determine whether the firm exists or not? Unfortunately, we find all the proponents of the concept of transaction cost implicitly assume the existence of the firm to expand their arguments (See, e.g., Coase 1937, Williamson 1979, 1985, Cheung 1983). Before a firm exists, we are unable to compare the effectiveness of those inputs integrated within the firm to they are coordinated by the market, because we cannot predict in what manner that the firm as a whole will act. In fact, the concept of transaction cost is always applied to explain the existence of those existing or ever-existed firms. It fails to predict the emergence of any completely new firm advanced by the developing market environment.

In another respect, can contract, property right, reputation or power to be a primary sufficient factor determining the existence of the firm (See, e.g., Alchian and Demsetz 1972, Hart 1995, Rajan and Zingales 1998)? We should admit that these factors are to some extent relevant to the advantages of the firm. But since they all widely influenced human societies before the emergence of the firm, it is hard to believe they are sufficient enough to independently bring about the emergence of the firm.

Regard the above reasoning, we find it is also unlikely to specify some known factor as a primary sufficient factor. Together with the previous reason that no primary necessary factor has been persuasively selected, we sum up to our conclusion that no primary factor has been found necessary and sufficient enough to cause the existence of the firm.

                                        III. A Distinction Between Two Concepts

None of the prevailing firm theories carefully distinguishes the concept of the emergence of the firm from that of the existence of the firm. The former is usually associated with historical facts while the latter, without any time restriction, points directly to general principles. More often than not, it is much harder to deal with the latter than the former. In the above section, we tended to somehow avoid putting our discussion under the background of the concept of existence of the firm. For instance, it is unclear to decide if everyone in the world has had the same amount of wealth then the firm would not exist. Nevertheless, we are more confident to say the firm may not emerge in the past if everyone in the world used to have the same amount of wealth. To precisely address the concept of the existence of the firm, we need to clarify which “firm” definition we take.

                                     IV. A Clear Perspective to Find the Answer

The most significant thing ignored by all the current firm theories is to follow a clear and broad definition of firm to organize their evidences and theoretical arguments. Definitely, these firm theories sound plausible once they restrict the domain of the definition of firm to a narrow scope. However, the most widely acceptable identification for a firm should be to regard it as a profit-oriented organization. Under this definition, it becomes clear that the intersection set of determinants which determine both the existence of profit-oriented behavior and the existence of an organization is what we seek for solving our question that why the firm exists.


Alchian, Armen A., and Harold Demsetz, 1972. “Production, Information Costs and Economic Organization”, American Economic Review, 62(50): 777-795.

Bolton, Patrick, and Mathias Dewatripont, 1994. “The Firm as a Communication Network”, Quarterly Journal of Economics, 115: 809-839.

Cantwell, John and Felicia Fei, 1999. “Firm as the Source of Innovation and Growth: the Evolution of Technological Competence”, Journal of Evolutionary Economics, 9: 331-366.

Coase, Ronald, 1937. “The Nature of the Firm”, Economica, 4: 386-405.

Cheung, Steven, 1983. “The Contractual Nature of the Firm”, Journal of Law and Economics, 26: 1-21.

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Hart, Oliver, 1995. Firm, Contract and Financial Structure, Oxford University Press.

Hart, Oliver and John Moore, 1990. “Property Rights and Nature of the Firm”, Journal of Political Economy, 98(6): 1119-1158.

Holmstrom, Bengt and Paul Milgrom, 1994. “The Firm as an Incentive System”, American Economic Review, 84(4): 927-991.

Jensen, Michael and William Meckling, 1976. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”, Journal of Financial Economics, 3:305-360.

Rajan, Raghuram G., and Luigi Zingales, 1998. “Power in a Theory of the Firm”, Quarterly Journal of Economics, 2:387-432.

Williamson, Oliver E., 1979. “Transaction-Cost Economics: The Governance of Contractual Relations”, Journal of Law and Economics, 22(2): 233-261.

______, 1985. The Economic Institute of Capitalism, New York: Free Press.

*E-mail address: 


About Yandong Xiao

I graduated from Shenzhen University with a bachelor's degree in Economics in 2007.
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