Why Corporations Exist

Markets are powerful.

But they are not free.

Firms exist because using the market has costs.

Those costs determine the boundary of the corporation.

The Question

If markets allocate resources efficiently, why do we see large hierarchies?

Why not contract for everything?

Why do corporations internalise transactions instead of buying them?

The answer is simple.

Markets have transaction costs.

When those costs are high, hierarchy emerges.

Transaction Costs, Explicitly

Transaction costs are often referenced vaguely.

They should not be.

They can be decomposed.

At minimum:

1. Search costs
2. Matching costs
3. Contracting costs
4. Monitoring costs
5. Enforcement costs
6. Managerial bandwidth costs

Each of these affects the make-or-buy decision.

Each has a different economic structure.

1. Search Costs

Markets require discovery.

• Who can perform the task?
• At what quality?
• At what price?
• With what reliability?

Search is not free.

Information is dispersed.

When search costs are high, firms internalise labour and capability.

Internal labour markets reduce repeated search.

2. Matching Costs

Finding someone is not the same as aligning with them.

Matching requires:

• Skill fit
• Cultural fit
• Timing coordination
• Information symmetry

Mismatches destroy value.

Firms reduce matching variance by stabilising relationships.

Internal teams reduce uncertainty.

3. Contracting Costs

Every external transaction requires specification.

What exactly is being delivered?

Under what conditions?

With what contingencies?

Contracts are incomplete.

The more complex the task, the more incomplete the contract.

Hierarchies substitute authority for contractual completeness.

Inside a firm:

• Not every contingency is specified.
• Authority resolves ambiguity.

4. Monitoring Costs

Once a contract is signed, performance must be monitored.

• Is the task executed?
• Is quality maintained?
• Is effort aligned?

Monitoring external agents is costly.

Monitoring internal employees is also costly.

But internal monitoring benefits from:

• Repeated interaction
• Embedded oversight
• Information visibility

Monitoring intensity determines organisational scale limits.

5. Enforcement Costs

When things go wrong, enforcement begins.

Litigation is expensive.

Renegotiation is slow.

Reputation mechanisms are imperfect.

Firms reduce enforcement frequency by embedding repeated interaction.

Hierarchy substitutes for formal legal enforcement in many cases.

Authority lowers enforcement cost per transaction.

6. Managerial Bandwidth Costs

This is often ignored.

Managers are not free.

Each additional coordination edge consumes attention.

Managerial span of control is finite.

As firms grow:

• Communication paths increase.
• Monitoring load rises.
• Decision latency increases.

This produces diseconomies of scale.

Transaction cost economics must include managerial bandwidth explicitly.

The Make-or-Buy Boundary

The firm exists where:

Internal Coordination Cost < Market Transaction Cost

More formally:

TC_market = Search + Matching + Contracting + Monitoring + Enforcement

TC_internal = Managerial Bandwidth + Internal Monitoring + Agency Costs

The boundary of the firm is defined where:

TC_market = TC_internal

To the left of this boundary, hierarchy dominates.

To the right, market contracting dominates.

The boundary shifts when any cost component changes.

Technology shifts boundaries.

Institutions shift boundaries.

AI will shift boundaries.

But the mechanism must be understood first.

Firms as Institutional Solutions

A corporation is not merely a legal shell.

It is an institutional solution to coordination under friction.

It performs three core functions:

• Reduces transaction costs
• Aggregates capital
• Concentrates authority

Without transaction costs, firms would shrink toward zero.

With high transaction costs, firms expand.

The existence of the firm is not ideological.

It is structural.

What This Means for the Series

Before asking what AI does to firms, we must understand:

• Which transaction costs it reduces
• Which remain structural
• Which new ones it introduces

The rest of this series builds from this decomposition.

For scale dynamics, see The Rise of the Managerial Corporation.

For digital boundary shifts, see The Boundary of the Firm in a Digital Age.

References & Intellectual Lineage

Coase, R. (1937). The Nature of the Firm.

Williamson, O. (1985). The Economic Institutions of Capitalism.

North, D. (1990). Institutions, Institutional Change and Economic Performance.

Alchian, A., & Demsetz, H. (1972). Production, Information Costs, and Economic Organization.

Jensen, M., & Meckling, W. (1976). Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.