The firm is defined to be a transaction institution whose objectives differ from those of its owners. This separation is the key difference between the firm and direct exchange between consumers. Consumer organizations that generally fail to satisfy the separation criterion include groups of contracting individuals, clubs, workers' cooperatives, buyers' cooperatives, nonprofits, and basic partnerships. This chapter examines how separation provides the firm with capabilities that improve the efficiency of transactions in comparison to direct exchange.

The scope of the firm is the combination of the firm's market-making and organizational activities. The “intermediation hypothesis,” as set forth in the previous chapter, states that increases in consumer transaction costs relative to those of the firm lead to growth in the scope of the firm. This chapter examines in greater detail how firms address transaction costs through both markets and organizations. The major role that firms play in the contemporary economy suggests that firms possess substantial transaction cost advantages over direct exchange.

The discussion then reviews the “internalization hypothesis,” otherwise known as the “make-or-buy” choice, which suggests that firms address some types of transaction costs by vertical integration. This determines how the firm divides its scope between its market-making activities and organizational activities, and is complementary to the “intermediation hypothesis.”