Why do firms exist? Theory Overview

In the contemporary business literaure you can find 4 main approached to the fundamental question: Why do firms exist? Below, I've put together an overview of main views that put pinpoint different market's and firm's characterisitcs and capabilities.

The Market Power Approach

According to this approach firm should exist in the industries with high overall profitability. Porter's Five Forces Model is the best example of the market power approach. It determines the competitive intensity and therefore attractiveness of a market. It is worth noting that the overall industry attractiveness doesn’t imply that every firm in the industry will have the same returns.


The Transaction Costs Approach

Coase (1937) stated that “the essence of the firm is that it displaces market organization”. It means that they have a domain for organizing activity in non-market fashion. The main reason why do firms exist is that they can lower the cost of using markets, i.e. firms can organize some economic activity more efficiently

The Resource-Based View

Resource-Based View focuses on firm’s resources to explain its performance. It is based on an assumption that superior resources and capabilities create competitive advantage. RBV has its foundation in early work of Edith Penrose (1959). She stated that the growth of the firm is an outcome of the way it deploys its resources.

Competitive advantage derives from valuable specialized resources that yield extra profit in the long run. Sustainability of competitive advantage depends on difficulty for other firms to obtain the specific resource. According to Barney (1991) "sources of sustained competitive advantage are valuable, rare, non-imitable, non-substitutable resources". Growth takes place around the key resources.

The Knowledge-Based View

According to Kogut and Zander (1992) firms exist because they create conditions under which individuals integrate their specialized knowledge. Knowledge-Based View argues that knowledge is the most strategically significant resource of the firm. The performance and growth of a firm are rooted in heterogeneous knowledge bases and capabilities, being difficult to imitate and socially complex. It is the employees of the firm, its routines, culture and policies that carry organizational knowledge. Therefore it is not possible to separate knowledge from the social setting within which it is produced. Knowledge is path dependent because it is accumulated through experience – therefore firms are different. Being taught of the functional skills of how to do something is different than being taught how to create it.