ABSTRACT
If the firm is a contractual joining of certain factor owners, and all contracts exist because of uncertainty, and all uncertainties addressed by contracts are of the two types just mentioned, then the provisions of the contract defining a firm must concern one or both of these two kinds of uncertainty: uncertainty about the future behavior of the parties to the contract, and uncertainty about future states of nature, events beyond the control of the parties of the contract. Each uncertainty gives rise to a different sort of contract, and a different rationale for the existence of firms. Capital owners can optimally absorb all of the risks of demand shocks facing a firm, because they can effectively "buy insurance" in the capital market against the risks facing the firm. The seller becomes the monitor and residual claimant policing the contract by voice, the weaver receives a fixed wage and polices the contract by the threat of exit.
