Firms are intermediaries in the market for contracts. By coordinating contracts, firms create a “nexus of contracts.” The firm provides an alternative to direct exchange between consumers. There are many types of bilateral contracts including buyer-seller, principal-agent, borrower-lender, and investor-entrepreneur. Firms offer advantages over bilateral contracts through market making and coordination across multiple contracts. This chapter compares bilateral contracts between consumers with multilateral transactions managed by the firm. The discussion examines transaction costs associated with adverse selection, moral hazard, and contract hold-up.

Competition provides a major source of benefits from multilateral contracts. Buyers compete with each other to obtain the firm's goods. Sellers compete with each other to provide goods to the firm. The firm is able to manage competition between its customers and between its suppliers. This allows the firm to do much more than extract rents from its trading partners. By orchestrating competition, the firm can promote efficient behavior.

Competition between the firm's trading partners provides a number of useful incentives that are absent from bilateral contracts. Competition induces buyers and sellers to invest in increasing benefits or reducing costs, thereby mitigating the effects of hold-up observed in bilateral contracts. Competition allows the firm to use group incentives that aggregate information, thus alleviating moral hazard problems that are present in bilateral contracts. Competition also allows the firm to obtain economies of scale in monitoring performance, evaluating quality, or observing agent characteristics, thus reducing adverse selection problems that arise from asymmetric information in bilateral contracts.