Q. Show the example on transaction cost theory?

Coase begins from standpoint that markets could in theory carry out all production and that what needs to be illustrated is the existence of the firm with its 'distinguishing mark ... [of] the supersession of the price mechanism'. Coase reveals somereasons why firms might arise and dismisses each as unimportant:

• Ifa number of people prefer to work under direction and are prepared to pay for privilege (however this is unlikely)
• Ifa number of people prefer to direct others and are prepared to pay for this (however normally people are paid more to direct others)
• If purchasers prefer goods produced by firms

Coase contends that central reason to establish a firm is to evade some transaction costs of using the price mechanism. These involve discovering relevant prices (that can be decreased however not eliminated by purchasing this information through specialists), and the costs of negotiating and writing enforceable contracts for every transaction (that can be large if there is uncertainty). Furthermore, contracts in an uncertain world will essentially be incomplete and have to be often re-negotiated. Costs of haggling about division of surplus, specifically if there is asymmetric information and asset specificity, may be considerable.

If a firm operated internally under the market system, many contracts would be needed (for example, even for procuring a pen or delivering a presentation). In contrast, a real firm has very few (though much more complex) contracts, like defining a manager's power of direction over employees, in exchange for that employee is paid. These kinds of contracts are drawn up in circumstances of uncertainty, specifically for relationships that last long periods. Such a situation runs counter to neo-classical economic theory. Neo-classical market is instantaneous, forbidding the development of extended agent-principal (manager-employee) relationships, of planning and of trust. Coase determines that 'a firm is likely therefore to emerge in those cases where a very short-term contract would be unsatisfactory'. And that 'it seems improbable that a firm would emerge without existence of uncertainty'.

He notes that government measures relating to the market (sales taxes, price controls, rationing) tend to increase the size of firms, because firms internally won't be subject to such transaction costs. So Coase defines the firm as 'the system of relationships that comes into existence when the direction of resources is dependent on entrepreneur'. We can consequently think of a firm as getting smaller or larger based on whether the entrepreneur organises more or fewer transactions.

Though what determines the size of the firm; why does entrepreneur organise the transactions he does, why no more or less? Because, the reason for the firm's being is to have lower costs than market, upper limit on the firm's size is shaped by costsmounting to the point where internalising an extra transaction equals the cost of making that transaction in market. (At lower limit, firm's costs surpasses the market's costs and it doesn't come into existence.) In practice, diminishing returns to management, augments cost of organising a large firm, specifically in large firms with numerous differing internal transactions and different plants (like a conglomerate) or if relevant prices change repeatedly.

Coase concludes that size of the firm is reliant on the costs of using the price mechanism and on the costs of organisation of other entrepreneurs. These 2 factors collectively determine how many products a firm produces and how much of every product they produce.