What is a firm?

By John Dudovskiy

 What is a firm? In essence, as private sector organisations firms pursue the main objective of profit maximisation. However, this is the most basic approach to firms and roles and responsibilities of firms can be studied in a greater level of depth with the application of relevant theoretical frameworks.

There are several main theories of the firm and distinction can be made between these theories on the basis of approach adopted towards relationships between the firm and society (Sloman et al., 2013).

For example, one of the earliest approaches to firm, ‘black box’ perspective perceives firms as economic entities that transform input into output in a profitable manner. ‘Black box’ perspective involves “how production and cost functions interact with demand on the market, i.e. the emphasis is on technical matters and how firms function in the context of the market” (Dietrich, 2007:19).

‘Black box’ perspective to firms can be criticised on the grounds of being overly abstract and general, and it does not take into account the impact of firm-specific factors. Transaction cost can be defined as “the costs incurred when firms buy inputs or services from other firms as opposed to producing them themselves” (Sloman et al., 2013:33).

Transaction cost economics originates from the work of Ronald Coase who argued that “firms exist to economise on the costs of using the market” (Sykuta, 2010: 39). In other words, Coase perceives the cost of using the price mechanism as the main profit motivation for firms. Coase insisted firms to be perceived in real-life environment taking into account specifications of the real world, as well as, transaction costs of alternative organisational structures.

Transaction cost economics is associated with Oliver Williamson, who expanded the work of Coase (1937) by increasing the levels of focus on organisational forms and associating business management with the areas of law, organisational theory and business history to a greater extent. Transaction cost can be explained as costs that incur during the process of facilitating economic exchange and they include costs of searching and finding information, costs associated with bargaining and decision-making, and costs related to policing and enforcements.

According to Williamson (1979), transactions associated with greater levels of uncertainty in relation to their outcome at the same time when requiring transaction investments such as cash and time occur in hierarchical organisations to a greater extent compared to alternative forms of organisations.

Williamson’s (1979) main argument can be explained in simple terms in a way that large hierarchical corporations are able to achieve their core objective of profit maximisation with higher levels of effectiveness due to their abilities to internationalise transaction costs which results on savings on transaction costs.

Alternatively, Powell (1990) discusses advantages of network form of organisations and refers to the case studies in craft and high-technology industries in an attempt to justify his stand. It has to be acknowledged that emergence of many successful high-technology organisations since Powell’s study in 1990 proved viability of his argument to a certain extent. As it is illustrated in Figure 1 a set of human and environmental factors cause the emergence of transaction costs. To be more specific, human factors include bounded rationality and opportunism, whereas environmental factors consist of asset specifity, uncertainty and complexity (Williamson, 1979).

What is a firm

Transaction Cost Framework

Adapted from Mikkonen (no date)

The idea of bounded rationality proposed by Herbert A. Simon focuses on the limits of human rationality and this limit is associated with inability of people to analyse all of the available information in a comprehensive manner in order to be able to engage in totally rational decision-making (Simon, 1997: 291).

In Figure 1 increased degree of environmental uncertainty coupled with bounded rationality of human decision-making cause transaction costs to increase to a certain extent. Opportunism behaviour in transaction cost model, on the other hand, represented in Figure 1 may be explained by referring to oligopoly market situations where limited number of players in the market may exploit their oligopoly situation by increasing transaction costs.

Moreover, in his follow-up study Williamson (1998) divides economic institutions into four different layers according to their purpose: social theory, economics of property rights, transaction cost economics, and neo-classical economics or agency theory.

Social theory, economics of property rights, and neo-classical economics are associated with different perspectives compared to transaction cost economics in several levels.

Social theory perspective to economics is associated with norms, traditions, customs etc. Williamson (1998) rightly argues that implementation of organisational changes at this level is a difficult task from a practical viewpoint.

 Economics of property rights perspective, on the other hand, perceives economics from jurisdiction and bureaucracy viewpoint and focuses on improvement of institutional environments.

Lastly, neo-classical approach represents fundamentally different perspective to firms compared to transaction cost economics and price vs. quantity relationship represents the core of this approach.


Coase, R. (1937) The Nature of Firm, Economica, 1937, Vol. 4, No.16

Dietrich, M. (2007) Economics of the Firm: Analysis, Evolution and History, UK: Routledge

Mikkonen, I. (n.d.) Real Property Transaction Costs in Slovenia Online at http://www.theslovenian.com/articles/mikkonen.htm [Accessed 24 July 2022]

Powell, W.W. (1990) Neither Market nor Hierarchy: Network Forms of Organisation, Research in Organisational Behaviour, 1990, Vol.12

Sloman, J., Hinde, K. & Garratt, D. (2013) “Economics for Business” 6th edition, UK: Pearson

Sykuta, M.E. (2010) Ronald H. Coase in Klein, P.G. & Sykuta, M.E (ed) The Elgar Companion to Transaction Cost Economics,. Chelthentam, UK: Edward Elgar Publishing

Williamson, O. (1979) Transaction-Cost Economics: The Governance of Contractual Relations, Journal of Law and Economics, 1979, Issue 22

Williamson, O. (1998) Transaction Cost Economics: How It Works: Where It Is Headed, De Economist, 1996, 146, No. 1

Category: Economics