A basic tenet of modern economics is the proposition that prices allocate resources efficiently: The invisible hand is a system of prices that contain information, without each market participant having to bear the full cost of producing that information. But, when a firm forms, a market closes; resources that were previously allocated via the invisible hand of the price system are now allocated by the visible hand of managerial authority within the firm. Such "centrally planned" internal firm economies can be very large. Table 1 shows that General Motors has an internal economy roughly the size of a small, developed, capitalist country. The existence of these planned economics poses the question: What advantages do firm managers have over markets in allocating resources?
Providing a satisfactory answer to this question requires explaining the essential features of the modern corporation. Since it is managers, not owners, who allocate resources inside corporations, we must have a model in which there is a separation of ownership and control. It is difficult to envision General Motors as corresponding to a large number of entrepreneurs who have handed together to form a "firm". Of course, such "firms" exist, as partnerships. But, for a firm to have internal economy the size of a large company like General Motors requires that there be agents of the firm who are directed by someone who may be the owner, or an agent of the owner, and who, in any case, has the authority or right to direct how resources are to be allocated.
With separate firms, trade of inputs involves prices that, presumably, are valuable in the allocation of the resources. If production is organized in a single firm, losing the information from the price and creating a moral hazard in them problem, what is the countervailing benefit? We answer this by developing a notion of managerial authority.
We develop the price formation process in a series of steps to clarify how principal may obtain some information that they do not pay for from the price. We then explore which organizational form is socially efficient and which is privately efficient from the viewpoint of the agents and from the viewpoint of the principals. Finally, we ask why is it not possible to replicate the information in market prices through internally generated "transfer" prices? The answer is related to property rights and limited liability. On the other hand, internal trade involves no transfer of property rights.
There are several ways that inefficiency can creep into the market.
First, markets may not be perfectly competitive. There is a paradox of the market theory: the role of competition is the premise of the market mechanism, but the market competition often leads to the accumulation and centralization, which will Monopoly will have negative influence on competition and efficiency. Because it leads to price distortions and output distortions, which not only resulte in ineffective allocation of resources, but also inhibit competition and reduce the total social welfare. In such a situation, prices are not be determined by supply and demand, and outputs deviate from the perfectly competitive norm.
Second, "externality" problem exists. In economics, an externality or spillover of an economic transaction is an impact on a party that is not directly involved in the transaction and in such a case, prices do not reflect the full costs or benefits in production or consumption of a product or service. For example, the harvesting by one fishing company in the ocean depletes the stock of available fish for other companies and overdfishing may be the result. The benefits of other companies are affected but they can not get the compensation from the market.
Third, Neo-classical economic theory assumed that the information is symmetric,but it is not true, information is always asymmetric and incomplete. Information economics, which developed on the basis of uncertainty research, showed that incomplete and asymmetric information are one of the important reasons which make the market economy can not work perfectly. One important prerequisite of the optimal allocation of resources is that the decision-makers have full, accurate, comprehensive and timely information. But in fact, as other economic goods, information is a scarce resource. You must pay to obtain information and the cost is usually high. Therefore, the existence of asymmetric and incomplete information is very common.
Nevertheless, the perfectly competitive economy stands as an ideal in which rational self-interest leads to an efficient allocation of resources - a remarkable modern reflection of Adam Smith's founding insight.