Question

Analyze & explain the following statement:-

The formation of firms reduces the number of transactions we would encounter in the market in the absence of firms.

Answer 1

The concept of transaction costs and the formation of firms, is a widely established one, and was primarily developed to highlight the very nature of why a firm exists in the market place. It was first developed by an economist by the name of Ronal Coase and is correct even today when evaluated.

Firms exist so that people can come together to earn profits for the entrepreneur that develops an organization in which people belonging to different sectors can come together and become profitable for one another and for the firm as a whole.

In the absence of such firms, people would have to make singular transactions with one another in order to be able to get their work done or to be able to sell the products and services respectively.

Thus, the formation of firms brings in people from different firms together with one another to reduce the total number of transactions and their overall costs which a person requires to bare in order to make economic profit for one another.

For Example:-

Consider a situation in which a new product was to be developed. A designer is required subsequently through each stage of production. Further, with new products being needed a designer is again needed subsequently every single time.

This would mean, that separate transactions would be required at 1) Each Stage of Production 2) Each New Product. To avoid this, firms come into existence, which hire designers and everyone else such as laborers, lawyers etc. which may be required for various interactions. This helps by reducing the total number of interactions which would occur thus lowering costs also.

Conclusion:-

The reason why a firm exists is because transactions have costs involved in them. Instead of hiring people at each stage of production which would increase the costs of production as well as the total number of transactions, firms come into existence that hire people for work in a single transaction and get specialized work done from them which reduces both costs and frequency of transactions respectively.

Please feel free to ask your doubts in the comments section if any.