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What can economic analysis say about the likely ways in which firms are organ-

ized? This section considers each of these questions.

The Nature of the Firm

As recently as 100 years ago the typical firm in the industrial world was a very

small concern, managed by its owner and employing a small number of workers.

Only the railroads, steel producers, and a handful of other manufacturers con-

stituted the realm of large firms. Today, there are over 50 corporations of more

than 250,000 employees each, including Walmart, which has more than 2 million.

Although firms range in size from the single proprietor to the largest Fortune 500

companies, the vast majority of managers work for firms with 50 or more employ-

ees. Thus, in the present discussion we focus primarily on this category.

We begin our study of the firm with the following proposition first articu-

lated by Ronald Coase.^14

Firms will be organized to minimize the total cost of production including trans-

action costs.

In other words, competition among firms will ensure that only the most effi-

cient organizational forms will survive and prosper.

In applying Coase’s proposition, let’s start with the owner-managed firm,

the norm in the nineteenth century and still represented today. Consider a

small clothing producer, run by a sole proprietor who was both owner and man-

ager. The proprietor procured the necessary equipment, hired workers, and

made all important decisions. As sole owner, the proprietor claimed all profits

(and paid all losses) from the business. The proprietor held the relevant infor-

mation about how to run the business and had a strong incentive to take opti-

mal actions because his or her ultimate profit depended on it. With

management and ownership vested in one individual, the informational and

moral hazard problems were minimized.

Contrast this with the large-scale firm of today. Because of economies of scale

and scope, average costs decline at higher levels of output. This offers a first expla-

nation for large firm size. Of course, the increase in scale makes the business of

transforming inputs into outputs much more complicated. No longer can a sin-

gle owner-manager take on all management and decision-making responsibilities.

The modern firm distributes information and management responsibilities among

a wide group of inside managers. Today’s firm is an organization based on a set of

agreements and contracts, both explicit and implicit.

594 Chapter 14 Asymmetric Information and Organizational Design

(^14) R. Coase, “The Nature of the Firm,” Econometrica (1939): 386–405.
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