Managerial Economics

Why do firms exist?

A firm is a commercial enterprise, a company that buys and sells products and/or services to
consumers with the aim of making a profit. A business entity such as a corporation, limited
liability company, public limited company, sole proprietorship, or partnership that has products
or services for sale is a firm.
The main objectives of firms are: Profit maximization, Sales maximization, increased market
share/market dominance.
Financial Objectives: The four main financial objectives of an enterprise are
1. Profitability
2. Liquidity
3. Efficiency and
4. Stability.
Profitability is the when the firm is able to earn a profit.
Firms exist because the founder wants to earn profits by producing a specific product and
selling it into the market for a price higher than the cost incurred in producing it. This is the
incentive for the producers to run a firm. Both the consumers and producer are benefitted from a
firm's existence. Thus, firms came into being to make it easier and less costly to get work done.
A well managed company strives to achieve an optimal balance between what works gets done
within and outside its boundaries. As The Economist article points out, market frictions and
transaction costs are not the only reason why firms exist. Firms exist to economize on the cost of
coordinating economic activity. Firms are characterized by the absence of the price mechanism.
Sources of transaction costs: costs of learning prices.
The Nature of the Firm (1937) by Ronald Coase. Coase observes that market prices govern the
relationships between firms but within a firm decisions are made on a basis different from
maximizing profit subject market prices. Within the firm decisions are made on through
entrepreneurial coordination.
Firms exist as an alternative system to the market-price mechanism when it is more efficient to
produce in a non-market environment. For example, in a labor market, it might be very difficult
or costly for firms or organizations to engage in production when they have to hire and fire their
workers depending on demand/supply conditions. It might also be costly for employees to shift
companies every day looking for better alternatives. Similarly, it may be costly for companies to
find new suppliers daily. Thus, firms engage in a long-term contract with their employees or a
long-term contract with suppliers to minimize the cost or maximize the value of property rights.
According to Ronald Coase's essay The Nature of the Firm, people begin to organize their
production in firms when the transaction cost of coordinating production through the market
exchange, given imperfect information, is greater than within the firm. Ronald Coase set out his
transaction cost theory of the firm in 1937, making it one of the first (neo-classical) attempts to
define the firm theoretically in relation to the market. One aspect of its 'neoclassicism' lies in
presenting an explanation of the firm consistent with constant returns to scale, rather than
relying on increasing returns to scale. Another is in defining a firm in a manner which is both
realistic and compatible with the idea of substitution at the margin, so instruments of
conventional economic analysis apply. He notes that a firm's interactions with the market may
not be under its control (for instance because of sales taxes), but its internal allocation of
resources are: “Within a firm, … market transactions are eliminated and in place of the
complicated market structure with exchange transactions is substituted the entrepreneur who
directs production.” He asks why alternative methods of production (such as the price
mechanism and economic planning), could not either achieve all production, so that either firms
use internal prices for all their production, or one big firm runs the entire economy. Coarse
begins from the standpoint that markets could in theory carry out all production, and that what
needs to be explained is the existence of the firm, with its "distinguishing mark the super session
of the price mechanism." Coarse identifies some reasons why firms might arise, and dismisses
each as unimportant:
  If some people prefer to direct others and are prepared to pay for this (but generally people
are paid more to direct others);
 If purchasers prefer goods produced by firms

Williamson sees the limit on the size of the firm as being given partly by costs of delegation (as a firm's
size increase its hierarchical bureaucracy does too), and the large firm's increasing inability to replicate
the high-powered incentives of the residual income of an owner-entrepreneur. This is partly because it is
in the nature of a large firm that its existence is more secure and less dependent on the actions of any one
individual (increasing the incentives to shirk), and because intervention rights from the centre
characteristic of a firm tend to be accompanied by some form of income insurance to compensate for the
lesser responsibility, thereby diluting incentives. Milgrom and Roberts (1990) explain the increased cost
of management as due to the incentives of employees to provide false information beneficial to
themselves, resulting in costs to managers of filtering information, and often the making of decisions
without full information. Firms exist in order to maximize profits, according to firm theory. The goal of
maximizing profits drives all decisions that a company makes. When a company determines prices,
allocates resources, and hires employees, its underlying motivation is to maximize profits. For example,
in a labor market, a company will hire workers for the long term in order to maximize profits by retaining
workers. In a market of high unemployment, profits may be maximized by contracting with workers for
the short term as demand dictates. According to this firm theory, the company is basing its hiring
practices on the present economic conditions, and is selecting the method that allows it to maximize its
profits in that particular market.