Firm-Specific Learning and the Nature of the Firm: Why Transaction Cost Theory May Provide an Incomplete Explanation

This article discusses the limits of the transaction cost explanation of the existence of the firm. It develops three simple models that compare the profitability of firms and markets, two without transaction costs related to market trading. In both firms and markets it is assumed that skills increase due to a static specialisation effect. In addition, in the first two models, firms benefit from firm-specific capabilities referring to skill-enhancement due to the learning environment of the firm. On the other hand, organisation by the firm requires costly monitoring. In the first model, organisation by the market is more profitable unless monitoring costs are countered by the existence of firm-specific capabilities. The second odel introduces dynamic learning effects, in which case some firms may, irrespective of monitoring costs, always turn out to be more profitable than the comparable market organisation. The third model involves a preliminary attempt to establish an empirical methodology for comparing the relative importance of transaction cost and capabilities explanations for the existence of the firm. There is no a priori reason to assume the supremacy of one type of explanation over the other. It is argued that a conjoint research program, encompassing both transaction cost and competence-based approaches, must be developed and tested empirically.