Treaty Application for Companies in a Group (FM nr. 178) 2022/2.2.2:2.2.2 General aspects of the theory of the firm

Treaty Application for Companies in a Group (FM nr. 178) 2022/2.2.2

2.2.2 General aspects of the theory of the firm

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Group companies and independent entities are not equal. Group companies can benefit from synergy benefits, resulting in lower transaction costs within a group.1 This widely known theory of the firm is based on an article written by Coase.2 In this article, Coase aims to fill the gap in economic theory between the assumption that resources are allocated by the price mechanism and the assumption that this allocation depends upon entrepreneur co-ordination.3 In essence, the author aims to answer the question: why are some activities directed by market forces, while others are directed by firms? As there is a cost of using markets (i.e., the price mechanism), it may be more profitable to establish a firm.4 Costs of using markets are for example related to negotiation and concluding a separate contract for each transaction.5 If activities are carried on in a coordinated manner, transaction costs can be reduced.6 Firms are thus in essence a response to the high costs of using markets.

If firms can lead to a cost reduction, the question arises why there are market transactions to start with; why does not all production take place within one big firm? If firms get bigger, the costs of organizing additional intra-firm activities may rise. Additionally, a bigger firm might fail to use the production factors in the best possible manner. The supply price of production factors may rise, as ‘other advantages’ of a small firm exceed the advantages of a large firm.7 In other words, the benefits from economies of scale can be outweighed by the additional costs of bureaucracy. The optimal size of a firm is therefore determined by the most favourable combination of productivity and transaction costs.

Transaction cost economics8 stipulates that the level of transaction costs is influenced by three dimensions: (1) the degree of asset specificity, (2) the degree of uncertainty, and (3) the volume and frequency of transactions. Asset specificity concerns investments made specially for the transactions under review. The degree of uncertainty includes the extent to which the parties can foresee the future and the effect of the future on the relevant transactions. The volume and frequency of transactions is an indicator for how close the connection between the transacting parties is. If the degree of asset specificity, the degree of uncertainty, and the volume and frequency of the transactions are all high, the transactions will more likely take place within the firm.9

The main underlying assumption of the theory of the firm by Coase10 is that it is often more efficient to organize production within the firm, than through contracts with independent parties.11 The existence of multinational groups can thus be explained by the internalization theory: multinational companies can gain efficiency from economic integration.12 Profit is generated partially via internalizing transactions within the firm. The firm is seen as a single economic unit. Because multinational firms organize their global business activities in an integrated manner, they are able to produce above-normal investment returns.13 These ‘additional’ returns are referred to as economic rents: the additional investment return compared to the normal return on the production factors labour and capital.14

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