If free market is so great, why do “companies” exist?

One of the fundamental lessons of economics is that in a free market, prices determine what gets produced and by whom. If onions are in short supply somewhere, the prices of onions rise, then more farmers switch to planting onions and the supply problem is met. And this is one of the most efficient ways of organizing production of the world.

But obviously, this is now how things work within a company. You do what your boss tells you to do. If he wants TPS reports, he doesn’t announce this fact to all the employees and give the job to the one who quotes the lowest prices. He simply tells you to do it because “it is your job”.

So how does economic theory handle this apparent contradiction?

This essay tackles this problem. First the problem definition:

So, one day the boss has this crazy thought. He asks himself a question that has never occurred to him before: Why have any employees at all? Why have a building? Why not just sit home, wearing his jammies and bunny slippers, sipping a nice cup of tea, and outsource everything? He can write contracts to buy parts, he can pay workers to assemble the parts, and he can use shipping companies to box and transport the product.

The boss is elated. He never really liked these people anyway. Always asking questions, constantly looking for direction and expecting him to know the answers. He fires all his employees, effective one month from now, and takes bids on all the design, parts manufacture, assembly, and shipping that those people used to do.

On day 31, after all those wasteful employees are gone and the new contracting efficiency regime is in place, the boss has a nice breakfast, pours his tea, and puts his bunny-slippered feet up on his desk at home.

So what is wrong with this picture? Why aren’t all companies in the world structured this way?

If prices and competition do such a terrific job of directing resources (and they do!), then why are there firms? Why are there hierarchical organizations that are internally directed by command and control, rather than the price system? Why not outsource everything? Why don’t bosses sit home wearing bunny slippers?

The problem is the overheads introduced:

Each step, each break in the production process from one artisan to another, would require negotiations, a transaction, payment, and transportation of the product to the next step.

Obviously, that’s silly: no [company] could work that way. The cost savings from division of labor would be swamped by the increased cost of negotiating and carrying out transactions, and monitoring quality.

But that’s only a partial answer. The real question that needs to be answered is:

The task of the economist, then, is to explain two phenomena with just one theory. First, why are firms more efficient than markets at organizing some transactions? Second, if firms are so efficient, why are there any market transactions at all? What determines the margin where the firm stops organizing additional transactions internally, and buys goods or services instead through the market?

Will this mean the end of free-market theory? Will the author succeed in saving economic theory from imminent doom? For answers to this and all other questions, read the thrilling conslusion in the original essay.