The Size of Markets and the Scope of Firms

Abstract

We contrast transactions in markets with those in firms and characterize the optimal numbers in each. Governance structures appear as equilibria and are compared in terms of production costs -- determined by a tradeoff between specialization and adaptation, -- and bargaining costs. Under natural conditions, employment or local markets weakly dominate all other equilibria. As local markets become smaller, the parties are better adapted to each other, but bargaining costs make it inefficient to be very small. As firms become larger, gains from specialization come at the cost of increasingly poor adaptation, ultimately bounding their scope.