What Is a Firm?
A firm is an organization that combines production factors (land, labor, capital) to transform inputs into goods and services worth more than the inputs.
A bakery buying flour for 2€ and selling bread for 5€ creates 3€ of value added. Value added is not profit; wages, rent, and interest are paid from it, and profit is what remains.
Ronald Coase explained firms exist because markets have transaction costs (searching, negotiating, enforcing). Firms form when internal coordination is cheaper than market contracts.
| Coordination via | Cost that rises |
|---|---|
| Market contracts | Search, negotiation, enforcement |
| Internal authority | Bureaucracy, blurred incentives |
Common pitfall: Assuming bigger is always better. The firm stops growing when internal bureaucracy catches up with market transaction costs.
The Boundary of the Firm
A firm's boundary sits where internal costs equal market costs:
The efficient firm expands make decisions until the marginal cost of making equals the marginal cost of buying.
| Signal | Make (inside) | Buy (market) |
|---|---|---|
| Asset specificity | High, custom | Low, standardized |
| Contract complexity | Hard to enforce | Easy to price |
| Strategic value | Core value added | Generic support |
Activities with high asset specificity migrate inside the firm, while standardized ones stay in the market.
Common pitfall: Outsourcing an activity just because it is cheap today, ignoring future dependence on your core value added.