Why Firms Exist

The idea in plain words

If markets are so efficient, why does anyone have a boss? Why don’t all workers contract with one another, task by task, at market prices? The answer, according to Ronald Coase, is that using the market is not free. Finding suppliers, negotiating, writing contracts, checking quality and resolving disputes all cost time and money. A firm exists where it is cheaper to organise activity by direction, someone telling someone else what to do, than by negotiation.

This is the deep logic underneath every “build, buy or partner” decision. The price on the supplier’s invoice is only part of the cost of buying. The rest is the cost of depending on someone you do not control.

Where it comes from

Coase began working out the idea as a young student visiting American factories in the early 1930s, and published “The Nature of the Firm” in 1937. Its argument was simple and largely ignored for decades: there are costs of using the price mechanism, and the boundary of the firm sits where the cost of organising one more activity internally equals the cost of buying it on the market. Coase received the Nobel Prize in economics in 1991.

Oliver Williamson turned the insight into a working theory in the 1970s and 1980s. He identified what makes market transactions costly. The most important is asset specificity: when one party makes an investment that is valuable only in the relationship with the other, such as a factory built next to a single customer, tooling for one product or software written for one platform. Once that investment is made, the other party can renegotiate, knowing the investor has nowhere else to go. This threat is called hold-up. The more specific the assets, the more likely it is that bringing the activity in-house, vertical integration, makes sense. Williamson shared the Nobel Prize in 2009.

The classic example, offered by Benjamin Klein, Robert Crawford and Armen Alchian in 1978, was General Motors’ acquisition of the car-body maker Fisher Body in the 1920s, described as a response to hold-up. Coase himself later disputed that reading, arguing from the archives that the relationship had been cooperative. The debate shows both the power and the limits of the theory: it explains a great deal, but particular cases rarely fit cleanly.

What it does to the mind

Build-or-buy decisions are distorted by more than economics. Engineers often prefer to build, because building is interesting and controllable, and because external products never fit exactly. Executives sometimes prefer to buy, because buying looks fast and puts a number on the cost. Each side tends to underestimate the costs the other side sees: integration and dependence on one side, time and opportunity cost on the other.

There is also an identity element. Firms come to believe certain capabilities define them, and resist outsourcing those even when markets supply them well, or outsource them too readily when they are not seen as glamorous.

Where it shows up

The blind case The Giant’s Small Computer puts you in front of what may be the most consequential make-or-buy decision in the history of computing; decide it before reading the reveal. The compute essay and the virtualization essay trace how cloud computing turned infrastructure from something firms built into something they bought, a shift you can decide for yourself in the blind case The Retailer’s Servers. Steve Yegge’s Platforms Rant is about the internal version: making a company’s own parts usable by others as if through a market. Facebook’s purchase of Instagram, in the Instagram emails, shows the buy option used to acquire a position rather than a capability.

What it asks of someone deciding

Ask about specificity. The more an activity requires investments that only make sense with one partner, the more dangerous it is to buy, and the stronger the case for building or owning.

Ask about control of the future. A component that is generic today may become the place where value concentrates tomorrow. IBM’s suppliers became more valuable than IBM’s PC business.

Weigh capability as well as cost. Building something teaches you things that buying it does not. Sometimes the learning is the real return on doing it yourself.