Main reason for establishing firm – Cost of using Price Mechanism.

 Cost of negotiating and concluding a separate contract for each exchange transaction.
In firms, contracts are not eliminated, but greatly reduced. A factor of production
(owner of some resource) will not have to make separate contracts with other factors –
mutual cooperation. Contract character – Factors agree to obey the directions of
Entrepreneur under certain limits.
 If Long term supply of some service or item is desired (owing to risk attitude of
people, difficulty of forecasting) - one contract for longer period instead of several
shorter ones. Cost for each contract avoided. Where short-term contracts become
unsatisfactory. More in case of service-labor than commodity purchase.
 According to Professor Knight – fixed income guaranteed
 Governments and other regulatory bodies treat transactions on market and same
transactions within a firm differently.

A firm consists of a system of relationships which comes into existence when the direction of
resources is dependent on the entrepreneur.

A firm becomes larger – Additional transactions organised by entrepreneur rather than

exchange transactions coordinated through price mechanism.

 As the firm gets larger – returns to entrepreneurial functions decrease.

 As the transactions increase – entrepreneur fails to place the factors of production on
the uses where their value is greatest.
 Supply price of one or more factors may rise – because of other advantages of a small
firm.
 First two points – Diminishing returns to management

Other things being equal, therefore, a firm will tend to be larger:

 the less the costs of organizing and the slower these costs rise with an increase in the
transactions organized.
 the less likely the entrepreneur is to make mistakes and the smaller the increase in
mistakes with an increase in the transactions organized.
 the greater the lowering (or the less the rise) in the supply price of factors of
production to firms of larger size.

 Apart from variations in supply price of factors to firms of different sizes, it would
appear that costs of organising and losses through mistakes will increase with increase
in spatial distribution of transactions organised, dissimilarity of transactions.
 Inventions bring factors closer, hence tend to increase the size of the firm.

Transaction Costs

Coase noted that there are a number of transaction costs to using the market; the cost of
obtaining a good or service via the market is actually more than just the price of the good.
Other costs, including search and information costs, bargaining costs, keeping trade secrets,
and policing and enforcement costs, can all potentially add to the cost of procuring something
with a market. This suggests that firms will arise when they can arrange to produce what they
need internally and somehow avoid these costs.

Overhead and Bureaucracy Costs

There is a natural limit to what can be produced internally, however. Coase notices a
"decreasing returns to the entrepreneur function", including increasing overhead costs and
increasing propensity for an overwhelmed manager to make mistakes in resource allocation.
This is a countervailing cost to the use of the firm.

Hypotheses

Coase argues that the size of a firm (as measured by how many contractual relations are
"internal" to the firm and how many "external") is a result of finding an optimal balance
between the competing tendencies of the costs outlined above. In general, making the firm
larger will initially be advantageous, but the decreasing returns indicated above will
eventually kick in, preventing the firm from growing indefinitely.

Other things being equal, therefore, a firm will tend to be larger:

 the less the costs of organizing and the slower these costs rise with an increase in the
transactions organized.
 the less likely the entrepreneur is to make mistakes and the smaller the increase in
mistakes with an increase in the transactions organized.
 the greater the lowering (or the less the rise) in the supply price of factors of
production to firms of larger size.

Coase does not consider non-contractual relationships, as between friends or family

members.