Why Companies Exist

In the modern economy, it is not individuals but firms that play the important role. That is because they are economic actors especially well suited to production and competition. A firm is a contractual entity created by people to engage in better economic activity. It is a cooperative body in which people promise to act together in certain ways and, by carrying those promises out, achieve better results. Because its essence is contractual, it must be built on trust that each party will keep its promises. In that sense, it is a community that places greater importance on promises and creditworthiness than society at large.

Individuals are the agents of final consumption, but at the stages of production and sales, they generally act through firms. Individuals enter into relationships with corporations through voluntary cooperation. They may work for a certain period or lend something and receive compensation in return, invest capital and earn profits, or gain mutual benefits through transactions.

People take firms for granted as economic actors. Yet few can give a clear answer as to why firms exist. The person who focused on the reason for their existence was Ronald Coase, who won the Nobel Prize in Economics. He sought a clear and convincing answer to the essence of the firm.

Coase explained the reason firms exist through the concept of “transaction costs.” Costs arise whenever economic actors engage in transactions. For example, deciding which store to buy from and examining which product is best among similar goods are also costs. There is the cost of time and effort involved, and if one uses a purchasing agent, one must also pay a fee. If one shops online, one must also pay delivery charges. In this way, all additional costs incurred in a transaction beyond the price of the product itself fall under transaction costs.

Coase saw the reduction of these transaction costs as the very reason firms exist—that is, the essence of the firm. There are limits to how much an individual can minimize costs and carry out efficient economic activity through market transactions alone. Suppose, for example, that an individual produces and sells furniture. That person must buy wood, process it, design the product, and sell it. Searching for all the necessary information and transacting with others at every stage of that process entails enormous costs.

But the situation changes completely if, instead of having separate producers handle each stage of production, one organization is created to internalize the entire process from purchasing raw materials to producing the finished product. Not only do the production costs of furniture fall substantially, but the price of the final product also drops sharply.

A firm is precisely this: an entity that reduces transaction costs so that products can be produced and sold at lower cost. Firms lower transaction costs by internalizing market transactions within an organization.

Because firms are tools designed to achieve that purpose well, they evolve toward more efficient forms. Moreover, when environmental change is rapid, as with technological development, corporate culture and business methods must also change quickly. Changes in the environment require firms to fundamentally alter existing ways of doing business. Since past methods are no longer efficient, firms must restructure themselves in ways that further reduce costs. This is also why the lifespan of firms is becoming shorter. It is also important to discover new ways of organizing firms that were not possible in the past but are possible now.

Sung-no Choi, Vice President, Center for Free Enterprise (CFE)

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Original title: 기업의 존재 이유

Author: Sung-no Choi

Date: 2017-09-06

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&pn=27&idx=10648