Thus the standard approach to explaining firms starts with the Transaction Cost theory (typically attributed to Coase). Whenever the cost of a market-based mechanism is higher than a firm-based mechanism, a firm will end up coordinating production. Of course, to anyone who has ever started a new firm or worked any length of time at a large one, this explanation is not terribly satisfying. How do you know the relative costs in the first place and then explain the apparently wasted resources at large companies?Yes the transaction cost approach is due to Coase, Coase (1937): The Nature of the Firm, to be exact. How do you know the relative costs? The same way you know any costs, you look and see what others are doing and what there costs are and make a judgement as to what you think the relative costs are. This one of the important activities that an entrepreneur undertakes. Second once you have made your decision you put it to the test by actually producing and the market will tell you, via profits or losses, whether your judgement was right. As to the resources wasted in companies, the waste may be more apparent than real but the really important question is one about relative waste. Companies may waste resources but to survive they just have to waste less than the alternative. That is, they just have to be more efficient than either another firm or a market transaction.
The other point I found strange was this:
Typically, economic theory defines a firm in terms of its production function.Well no.
Ever since the aforementioned Coase (1937) paper the whole point of the theory of the firm is that a firm isn't just a production function. To see a firm as a production function is to suffer from what Oliver Williamson calls "technological determinism", that is, technology is assumed to be uniquely determinative of economic organization. As Williamson (1993: 4) has noted the boundaries of the firm is an issue of
[ . . . ] make-or-buy. What is it that determines which transactions are executed how? That posed a deep puzzle for which the firm-as-production function approach had little to contribute.As Oliver Hart points out
[t]o put it in stark terms . . . neoclassical theory [production function theory] is consistent with there being one huge firm in the world, with every existing firm . . . being a division of this firm. It is also consistent with every plant and division of an existing firm becoming a separate and independent firm. (Hart 1995: 17).Thus the production function tells us little about the boundaries of a firm and so the modern theory of the firm sees the firm as more than just a production function.