Why can't a large firm do everything that a collection of small firms can do and more? That is a variant of a question asked many times before for which an adequate answer has never been devised – to wit, what is responsible for limitations in firm size? Yet another way of putting the same issue is this: Why not organize everything in one large firm?

The trade-off model in Chapter 4 [of Williamson (1985)] offers two reasons why a firm would eschew integration: economies of scale and scope may be sacrificed if the firm attempts to make for itself what it can procure in the market, and the governance costs of internal organization exceed those of market organization where asset specificity is slight. … The first is not a thoroughly comparative explanation. If economies of scale are realized by the outside supplier, then the same economies can be preserved upon merger by instructing the supplier to service the market in the future just as it has in the past. The fundamental limitation to firm size thus must turn on the governance cost disabilities of internal organization where asset specificity is insubstantial. But wherein do the firm's comparative disabilities in those governance cost … respects reside?…

A chronic puzzle

Frank Knight made early reference to the limitations to firm size puzzle when, in 1921, he observed that the “diminishing returns to management is a subject often referred to in economic literature, but in regard to which there is a dearth of scientific discussion” (1965, p. 286, n. 1).