The Theory of the Firm

Colony unlocks countless new organizational possibilities.

It's worth taking a step back and asking: why do companies exist in the first place?

In short, companies exist to coordinate the production of goods and services. Transaction Cost Economics (TCE) theory, popularised by Ronald Coase’s ‘The Nature of the Firm’, postulates that companies form, employ people, and invest in capital because there is a threshold at which it is more efficient to control the factors of production directly than to coordinate production via the market mechanism, once transaction costs are accounted for. These transaction costs come in three flavours:

• Search & information: Costs associated with finding information to inform decisions, and discovering and evaluating suppliers.

• Bargaining: These are costs associated with reaching an agreement with a supplier. Bargaining costs can be very low (e.g. buying a coffee), or very high (e.g. buying a company).

• Monitoring & enforcement: The costs of ensuring adherence to the terms of an agreement (e.g. that widgets are manufactured on time and to the agreed quality). People often deviate from the agreed terms due to chance, negligence, or malice, and potentially high enforcement costs (e.g. legal fees) are required to resolve disputes.

TCE theory states that firms are more efficient than the market mechanism at coordinating production due to imperfect information and bounded rationality. Given perfect information, companies would not be necessary, as market forces would provide the necessary mechanisms to incentivise and coordinate production — everyone would know the exact value of their and other’s contributions. As this is not the case in traditional markets, these knowledge and trust barriers are overcome by due diligence and contracts, and require a legal system to provide recourse when things go wrong. These processes are expensive, and so traditional firms often find that replacing free-market bargaining with command-and-control hierarchy makes them more efficient and competitive.

As new technologies have improved the diversity and flow of information, new organizations are emerging which are able to merge the efficient decision-making of a market with the shared value-capture of a traditional firm. Gig economy platforms (e.g. Uber, Airbnb), market networks (e.g. eBay, Amazon Marketplace), and cryptocurrencies (e.g. Bitcoin, Ethereum) have demonstrated that if the product is sufficiently well defined, and the supply sufficiently large, fungible, or diverse, then it is possible to dramatically reduce the transaction costs of the market mechanism by making search and information discovery easy, bargaining straightforward, and having policing and enforcement provided essentially for free by the platform. This has enabled these new platforms to be orders of magnitude more efficient than had they attempted to coordinate equivalent supply within the hard boundaries of a firm.