ABSTRACT
More than 60 years ago Nobel Laureate Ronald Coase (1937) posed the question, why do firms exist? Firms, not to mention giant corporations, are such a familiar part of the economic landscape, that this might seem like a silly question to ask. On the other hand, much of economics is concerned with describing and often celebrating the performance of markets as institutions for allocating goods and services, and thus one might wonder why markets cannot be relied upon as the only institutions for undertaking this task. Given the existence of competitive markets with all of their accompanying efficiencies, why are the large, bureaucratic organizations that we call firms or corporations needed? What economic role do they play in the production and allocation of goods and services? The answer that Coase gave has led to the development of a theory of the firm that views it as a contractual linking of the laborers, capital owners, managers, and the other suppliers of factor inputs. This theory is the subject of this chapter. We begin by exploring the fundamental characteristics of contracts.
