Why do firms exist? What determines whether an activity will be provided by a market or by a firm?

The logical starting point in discussing these questions is to define both the firm and the market. A firm is an economic institution that transforms the factors of production into goods and services; organizes factors of production, produces goods and/or services, and sells goods/services to consumers, business or government. A market is a grouping of people or organizations unified by a common need; a gathering of sellers and purchasers to exchange commodities.

Why do firms exist? Why are firms even necessary if markets are the perfect mechanism for exchange? As Ronald Coase, Nobel laureate in Economics demonstrated, there is an inherent cost to using the market mechanism. Coase viewed firms as instruments for reducing transaction costs. It is because of these costs of using a market that firms are, at times, more efficient at coordinating and organizing resources. Outside of the firm, production is directed by the price mechanism; coordination through a series of exchanges of tra...