AI and the Nature of the Firm

We are witnessing a remarkable trend: billion-dollar companies powered by AI are achieving revenues ranging from tens of millions to over a hundred million dollars with small teams. For instance, Cursor has 30 employees, and Midjourney has 40 employees. This is driven both by the rapid adoption of AI by customers and the efficiency with which teams can build, market, sell, and support customers using AI tools.

This trend is expected to accelerate, and it is explained by Ronald Coase's influential 1937 essay, "The Nature of the Firm," where he introduced the concept of "transaction costs." According to Coase, firms exist because they lower the costs of transactions—such as finding partners, negotiating agreements, ensuring quality, and enforcing contracts—by internalizing these functions. Historically, this led to large, vertically integrated corporations because managing tasks internally was more efficient than external contracting.

This essay is particularly instructive in understanding how companies have become smaller over the past few decades and how they will continue to shrink with advances in AI, robotics, and automation. Companies have progressively become smaller due to advancements in IT, communications, and automation. Consider manufacturing giants like Nike and Apple, which outsourced production to specialized external partners. This transition was possible because advancements in communication technology, digital logistics systems, standardized contracts, and global supply chain infrastructure drastically reduced external transaction costs. Companies no longer needed massive in-house manufacturing teams, enabling them to focus instead on innovation, branding, and customer engagement.

Now, AI is pushing this boundary even further. AI-driven tools significantly reduce internal transaction costs by automating tasks that previously required large teams or costly external consultants. Consider legal services: traditionally, larger companies maintained substantial internal legal departments to handle compliance, contracts, and risk management. Today, AI-powered platforms streamline these tasks efficiently, drastically reducing the need for internal staff and simplifying external engagements.

This revolution has two profound implications. Large companies will continue shrinking their employee bases, managing sophisticated internal functions via autonomous AI-driven agents. At the same time, smaller businesses can now grow their revenue to a scale previously unimaginable with only a few employees, as they can now effortlessly access advanced legal, accounting, marketing, and operational expertise—once available only to larger enterprises—empowering them to operate with capabilities once unimaginable at their scale.

Ultimately, AI will not just make firms smaller—it will also allow smaller firms to operate as though they were much larger. This paradigm shift, rooted deeply in Coase's insights on transaction costs, will redefine the very nature of how companies organize, compete, and succeed.