Economics is the study of how people allocate scarce resources. One important way that people allocate resources is through commerce (the other major way is through government actions, such as taxes or subsidies). Many economists are interested in how people organize their commerce activities. One way people do this is to participate in markets.
Economists use a formal definition of market that includes two conditions: first, that the potential sellers of a good come into contact with potential buyers, and second, that a medium of exchange is available. This medium of exchange can be currency or barter.
Most economists agree that markets are strong and effective mechanisms for allocating scarce resources.
Thus, one would expect most business transactions to occur within markets. However, much business activity today occurs within large hierarchical business
organizations, which economists generally refer to as firms, or companies.
Most hierarchical organizations are headed by a top-level president or chief operating officer. Reporting to the president are a number of executives who, in turn, have a larger number of middle managers who report to them, and so on. An organization can have a relatively flat hierarchy, in which there are only a few levels of management, or it can have many reporting levels. In either case, the bottom level includes the largest number of employees and is usually made up of production workers or service providers.
Thus, the hierarchical organization always has a pyramid-shaped structure.
These large firms often conduct many different business activities entirely within the organizational structure of the firm and participate in markets only for purchasing raw materials and selling finished products. If markets are indeed highly effective mechanisms for allocating scarce resources, these large corporations should participate in markets at every stage of their production and value-generation processes.
Nobel laureate Ronald Coase wrote an essay in 1937 in which he questioned why individuals who engaged in commerce often created firms to organize their activities. He was particularly interested in the hierarchical structure of these business organizations. Coase concluded that transaction costs were the main motivation for moving economic activity from markets to hierarchically structured firms.