In introductory and intermediate economics, firms are assumed to exist, and are characterized by production functions, cost curves, demand curves, etc.
One can imagine production w/o firms: individual traders exhanging capital and labor for payment, these being combined and marketed.
Organizations may seem to form "from a distance" -- cartel-types of trade made on a consistent basis to achieve some purpose, but we would probably not characterize these as firms.
We normally understand firms as embodying some kind of institutional structure.
Coordination of economic activity in these imaginary worlds would be via prices/bargaining.
Coase's observation: There are costs to using the price mechanism for coordinating economic activity. "transaction costs" or "marketing costs"
Given this, alternative institutional arrangements may coordinate economic activity at a lower cost. For example, it may be less costly for an individual to direct how resources should be used.
(imagine the costs of bargaining within a firm every time your boss tells you to do something upon which you have not previously agreed!)
Firms exist to economize on the cost of coordinating economic activity.
Firms are characterized by the absence of the price mechanism.
Sources of transaction costs:
This is a transaction-based theory. If it is more efficient for a transaction to be conducted under alternative institutions, price mechanism will not be used. Coordination by fiat.
This is an important insight that has been applied toward explaining many institutions other than firms. Institutions arise in order to economize on transaction cost (Williamson, etc.) For example, bank clearing houses, commodity markets, vertical integration, etc.
Scope of the Firm
Follows from above.
If it is more efficient for a transaction to take place within the firm than under some other institutional arrangement, then it will take place within the firm.
If not, then it will take place under some other institutional arrangement:
How would one form a Coaseian explanation for the Disney-ABC/Cap Cities merger?
The cost of coordinating the economic activity within Disney and ABC separately was higher than the cost of doing so together under the direction of Disney's management. Furthermore, it is less costly to do everything that Disney does managing by fiat than mediated through the price mechanism.
What is a similar explanation for GM's spinning off EDS?
The cost of coordinating economic activity of these firms separately is lower than the cost of doing so together under GM's direction.
What limits the scope of the firm?
So the scope of the firm is determined at the margin.
MC of organizing one more transaction within the firm equals the cost of using alternative institutional arrangements.
So, important questions to which Coase's theory provides a set of answers:
But even this theory leaves some gray areas...