Why Firms Exist. Economic activity should occur within the firm when it represents a better way to coordinate and motivate than does the market. Even in the most market-oriented of economies, the vast bulk of economic activity occurs within formal, managed organizations rather than through market exchanges. In fact, John McMillan estimates that less than a third of all the transactions in the U.S. economy occur through markets, and instead over 70 percent are within firms.

Firms exist because sometimes markets simply do not work: There is “market failure.” It can happen that markets fail to exist, or are not competitive, or do not clear properly. In these circumstances, interdependencies among people will not be fully internalized—people’s self-interested behavior does not account for the costs borne and benefits received by others.

- John Roberts