Question

If a firm can save on transaction costs by making internal decisions about resource allocation (instead of using the resource markets), then … is there a limit on how much a firm can save on transaction costs using this method?

Answer 1

This question goes to the heart of the economies and diseconomies of scale, which is a very important concept in economics. There are many enablers for a firm to take advantage of the economies of scale, one of which, probably the most important one, is the size of the firm. A large size allows the firm to have many specialized departments which can provide different types of resources to the firm and help avoid the transaction cost of buying these resources from the market. The flip side, though, is that unless a firm achieves a certain critical size threshold, it cannot create specialized departments within itself to take advantage of the transaction cost free internal allocation of resources.

On the other hand, when a firm becomes too big, specialization starts to hurt the firm's business due to multiple reasons, e.g., department heads start creating empires instead of being efficient.

Both of the above, being too small and being too big, are the limits on what a firm can save by way of transaction costs.