The Visible Hand, The Invisible Hand and Efficiency

When a firm forms a market closes. Resources that were previously allocated via the price system are allocated by managerial authority within the firm. We explore this choice of organizational form using a model of price formation in which agents negotiate prices on behalf of their principals when there is trade in a market. Principals motivate agents to make efforts and form prices by writing contracts contingent on the prices that the agents themselves negotiate. Admitting agency issues into price formation introduces a need for a principal to have the authority to coordinate economic activity. This can be achieved by closing a market and forming a firm, thereby contracting directly with both agents, and centrally directing trade. Closing a market, however, results in a loss of information from market prices, information that can be used to reduce the cost of contracting. This information cannot be replicated by internally generated “transfer prices.” Hence, when the market is internalized within the firm, information from market prices is lost. Choice of organizational form, a market or a firm, is then determined by the relative value of central authority over agents (the “visible” hand) versus information from market prices (the “invisible” hand). * We thank Franklin Allen, John Core, Phil Dybvig, Gerald Garvey, Armando Gomes, Bruce Grundy, Rich Kihlstrom, Hong Liu, Steve Matthews, John Morgan, David Musto, David Scharfstein, Bilge Yilmaz and seminar participants at Cornell, INSEAD, the New York Federal Reserve Bank, North Carolina, Washington University-St. Louis, and the Wharton School for helpful comments and suggestions. This paper was previously titled: "Markets versus Firms: The Tradeoff Between Informative Prices and Authority ".