Welcome to the first installment of our series of discussions of the Most Insightful Articles in economics. Today we are discussing Ronald Coase’s 1937 article The Nature of the Firm.
Ronald Coase wrote only a handful of academic journal articles—nearly every one is a blockbuster. He won the Nobel Prize in 1991 “for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.” He is still alive at the ripe old age of 99; if you do the math, that means he wrote the article we are discussing today when he was 26. This gives me the sneaking suspicion that I am “behind.”
One useful way of thinking about the market is as a coordinating system. The price mechanism serves as a means for directing the flow of every resource to its highest valued use. Suppose that a hurricane hits New Orleans, and as a result the price of plywood increases. That increase in price performs an important coordinating function. As a Virginia resident, when I observe the price of plywood going up, I am induced to delay my plans to build a shed in my backyard. That is, I conserve plywood. This leaves more plywood available to go to New Orleans, where it is most needed. The price system is impersonal, meaning that I don’t even have to know or care about the people in New Orleans in order to behave in a way that is beneficial to them. We will talk much more about the role of prices in the next installment.
However, the market is only one of two main ways that resources are directed. The other mechanism is command and control. Within firms, the autonomous impersonal coordination of the price system is replaced by a conscious interpersonal coordination mechanism. The boss has to gauge or guess if employees are pulling their weight, and to figure out if there are enough computers and office space and coffee and so on. The whole purpose of a firm is to engage in production without the coordinating assistance of the market mechanism. Why should this be? Why would anyone want to avoid a system that sends resources to their highest valued use?
It must be the case that there are costs intrinsic to using the price system. These “transaction costs” include the cost of discovering what the relevant prices are and the cost of negotiating complete contracts that plan for all contingencies and eliminate opportunism. When an entrepreneur starts a firm, she is making a bet that she can direct resources within the firm with enough efficiency so as to produce at a lower cost than the market could produce. That is, she is betting that she can economize on transaction costs. This, Coase argues, is the raison d’être of a firm.
Coase then asks, “[W]hy, if by organising one can eliminate certain costs and in fact reduce the cost of production, are there any market transactions at all? Why is not all production carried on by one big firm?” There must be some countervailing cost that increases with firm size that makes it uneconomical for firms to continue increasing their “insourcing” forever. The main answer that Coase gives is that it gets harder for the entrepreneur to direct resources as the number of resources increases. At some point, the firm is directing so many resources internally that the cost of directing one more resource is equal to the cost of just relying on the market to direct it, transactions costs and all.
The theory can now be used to discuss what affects firm size. Factors that decrease transaction costs or increase organizing costs will tend to make firms smaller. Factors that do the opposite will tend to make firms larger. One factor that increases transaction costs is taxes on market exchange. If it costs firms extra money in taxes to buy furniture, they may decide to make their own furniture in-house. (For discussion: how does the income tax affect the household’s decision to have a second partner go to work or stay home? Hint: households are firms!) A second factor is technology. As communications technology improves, it becomes cheaper to organize over a wider spatial area, increasing firm size. On the other hand, technology also reduces the cost of using the market, e.g. locating prices, and therefore would tend to reduce firm size.
We can keep going with this. Here are some issues that Coase did not discuss. Another factor is bankruptcy and contract law. The fact that there are default rules for contracts lowers the costs of creating contracts (assuming the law is reasonably efficient). Fewer contingencies need to be specified in advance. This makes the cost of using the market lower, decreasing firm size. Next, consider employment regulations. These tend to make it more expensive to direct resources (at least human resources) internally, and therefore firms will be smaller when there is extensive employment regulation. Finally, what if there is a complete breakdown in law and order? This will tend to increase transaction costs, making markets less attractive. Firms will increase in size, and in fact, humans might revert to a tribal existence (tribes are firms!). Law and order, and markets generally, are what enable us to live our lives in a reasonably individualistic way.
Coase also spends a fair bit of space contrasting his theory with Frank Knight’s theory of the firm. I won’t spend a lot of time on this, but we can discuss it in the comments if people are interested. If you want food for thought on this, how plausible is Knight’s view if there are insurance markets and no transaction costs?
To sum up, using the price system is not free. The fact that there are transaction costs means that people will attempt to limit the number of their transactions to economize on these costs. This implies that they will seek alternative methods of directing resources, which we find in firms. The other method, command and control, does not scale well forever. Therefore, there are natural economic limits to the firm’s size.
I’ve raised a few questions above, but here are a few more. How does Coase’s notion of what it means for a firm to be large or small differ from our usual metrics? What is the role of market discipline (profits and losses) in ensuring that firms do not become inefficiently large? If you were an inventor with strong humanitarian impulses, would you want to invent a technology that lowers the cost of transactions or of organization? In a world with no transaction costs, would there still be unemployment? How does the existence of the concept of morality affect transaction costs?
The discussion is not limited to my questions, of course. Feel free to raise whatever issues in the paper you want to discuss. Our next article will be Friedrich Hayek’s 1945 piece The Use of Knowledge in Society. I will be in Las Vegas at a conference early next week, so our next discussion will not be until the latter part of the week. See you in the comments!
15 Comments
Eli points out that Coase was very young when this was published. I found this in the Concise Encyclopedia of Economics, which sheds a little light on how he came up with such an insightful idea. “He … came up with a puzzle: how could economists say that Lenin was wrong in thinking that the Russian economy could be run like one big factory, when some big firms in the United States seemed to be run very well? In answering his own question, Coase came up with a fundamental insight about why firms exist.” – A helpful anecdote for those of us looking for research questions.
Put in that light you can definitely see the similarities between Coase’s transactions costs and Mises’s calculation costs. Through a Coase lens the economic calculation argument against socialism essentially says that the centrally planned economy is a firm that has expanded far beyond the natural economics limits to the firm’s size. As to Eli’s question about market discipline, if the costs of organizing (or likelihood of mistakes, or greater rise in supply price of factors of production) are too great, managers will stay in business by responding (downsizing). When these signals are distorted (like for instance in some dystopian future where the government bails out large, failing firms….) you get a lot of organizations that are inefficiently large.
Zero transaction costs would eliminate unemployment. Induced unemployment (eg, from wage floors) could still exist but the justifications for policy that induces unemployment would largely go away in a world without transaction costs. Or I might even say that public policy is another type of transaction cost: I am willing to pay someone $5/hr, he is willing to work for that, breaking the law and paying him under the table costs me an equivalent of $3/hr extra due to the risk (a transaction cost), he remains unemployed.
Eli asks a good question about morality and social norms’ relation to transaction costs. Without a concept of fairness and the value of reputation, transactions cost would be much higher, it could be argued they would be so high as to cripple or destroy the enter economic system. Good paper on this here: Karayiannis, Anastassios and Hatzis, Aristides N., Morality, Social Norms and Rule of Law as Transaction Cost-Saving Devices: The Case of Ancient Athens (July 2007). Available at SSRN: http://ssrn.com/abstract=1000749
Alchian and Demsetz (1972) provide the most meaningful expansion on Coase’s theory in my estimation, although I have probably not read as much as some of you. What do you think are the most important works on the theory of the firm after Coase?
Have fun at the APEE conference, Eli.
I’m most interested in your question about a humanitarian inventor. Is it more humanitarian to lower transactions costs or organizational costs? According to Coase, lowering transactions costs will provide greater opportunities for people to use the market to produce and exchange. Lowering organizational costs will provide a greater incentive to use a firm to produce, and firms will exchange. I can’t convince myself that either option is more humanitarian, though, because reducing either cost gives people a greater opportunity to be productive and exchange their output with others (who are also more productive), so that everyone’s real wealth increases.
I keep going back and forth but cannot convince myself that one technological change would be more welfare-enhancing than the other. Can anyone help?
Great summary of Coase, Eli, and I look forward to the rest of your series.
Zac,
I agree that Alchian and Demsetz provide the best contributions to the theory of the firm after Coase.
I can’t speak to specific papers but I believe that the whole New Institutionalist school are the best heirs of Coase’s line of thought when it comes to the larger implications of the theory of the firm. Notably, Oliver Wiliamson has probably pushed the ideas in The Nature of the Firm farther than any other individual.
Pete,
My personal bias would be to say that lowering transactions costs would be more humanitarian, because it not only increases wealth but it also increases the ability of people to operate autonomously in the marketplace rather than in the hierarchical structure of a firm. Not to say that firms are bad, of course, just that, all things equal, it would be preferable to not have to subject oneself to someone else’s authority in order to make a living.
Eli,
first kudos for doing this. Great idea.
I’m quoting below a paragraph from an unpublished “essay” of mine on “division of labor” from a few years ago. Unfortunately, it’s pretty condensed due to a word limit the essay was subject to, but I wonder if there’s something there.
“Is it enough to fragment tasks and services in ever increasing degree? No. The phrase “division of labor” subsumes a coordination process that arises when people specialize. The innovation consists in recombining these new focused tasks in the most efficient way. As Ronald Coase later demonstrated the coordination of specialized tasks can rely on the price mechanism of free markets or can happen within firms of varying sizes. These forms of organization are in perpetual mutation subject to an analysis of costs and benefits. The price mechanism, as Hayek pointed out, is superior in harnessing the precious human knowledge that is dispersed among individual workers and individual firms. However, there are transaction costs that limit the benefits of relying on prices. For instance, searching for the best bidder takes time and energy. Firms reduce the costs of creating markets for each task, but forgo the efficiency that derives from more adapted knowledge. It would be a mistake, however, to equate firms with central-planning. The external pressures of direct or would-be competitors and the internal need to maximize profits pushes firms to continually reorganize, farm out, delegate, branch out, merge, acquire other firms, set up internal price-like mechanisms, etc…Likewise, competition among workers leads them to try to differentiate from one another, to acquire new skills, learn new techniques, specialize even further, etc…So division of labor is a dynamic process and is the result of myriads trials and errors and relies on the fact that human labor and the spirit of enterprise are highly flexible and malleable.”
On the humanitarian inventor issue, I think reducing transaction costs would be far more welfare enhancing. Zero transaction costs would make a lot of forms of organization moot. Almost all that differentiates the real world from the idealized world of perfect efficiency in the market can be explained in terms of transaction costs. What a different sort of world that would be!
Pietro, that’s a good answer to my market discipline question.
Zac and Adam hit on some ideas I had about the humanitarian inventor. But the other idea I had was that organizing technology can be used for evil as well as good, i.e. to enslave the human race. It’s difficult (or is it?) to imagine lower transaction costs leading to such an outcome.
Eli,
A very good point. My belief is that the last century+ is evidence of that; that industrial era technology made it much easier for a minority (the Communist Party of the USSR, for example) to maintain an iron grip on the majority. But the very end of the century saw the technological balance go the other way–digital technology and the internet make it extremely difficult for any regime to control the flow of information.
A world without transactions costs would certainly reduce unemployment, but it is not obvious to me that it would completely eliminate it. Zero transactions costs would allow resources greater freedom of movement, but how does that solve temporary periods of under-utilization?
An example if I’m unclear: Suppose a firm dies, and the workers are able to costless-ly seek new employment. Are we assuming that existing businesses have the capacity to take the new workers on, or, that a new firm opens to employ them? I’m seeing a potential lag between start-ups and bankruptcies even in the zero transactions costs world.
Am I wrong here? This is a bit of a reply to Zac, but anyone feel free to straighten me out.
Jake, if there were no transaction costs, then according to Coase there wouldn’t be any firms at all. Everyone would be essentially an independent contractor. So, at a minimum, unemployment would look very different. You certainly wouldn’t have sticky wages, for instance.
To Zac, Adam, and Eli,
I like the comments but want to continue to play devil’s advocate. How do you view innovation in, say, pharmaceuticals in a world of zero transactions costs where every individual operates as an individual contractor? After all, if the research doesn’t ultimately yield results, that person will have no recourse for earning a living. A firm functions to aggregate the risk and reward of research that leads to innovation, and I’m not sure independent contractors could mimic this.
I suppose they could organize and agree to share profits of fruitful research (and bear losses together). At this point, aren’t they a de facto firm though?
I think another part of the reason I want to push this argument is I don’t view every individual as happiest in an entrepreneurial role. In a zero transactions cost world, individuals would basically be entrepreneurs. I think many people are happy to work a 9-5 and “leave work at work”, and I’m not convinced being put in a position where they bear more risk of success and failure would be better for these people.
The point about slavery is well taken. Ultimately, I think the worst thing that happens in a zero-transactions cost world is that people are unable or unwilling to use their freedom to maximize their welfare. This is a far cry from slavery, though it’s probably a scary idea for some.
Eli,
I read it and in large part I think I understood it. I even agree with it in part, but there are bits where I get a bit of heartburn. One question not answered is, “Why, left to their own devices, do markets tend toward monopolies?” Since we are dealing here with a large number of independent actors, their individual motivations and morals should not matter. His answer seems to be that transaction costs and market efficiencies push them into combination, thus we get “firms.” OK, I can see that. And if you make the transaction costs high enough, then they do all get pushed into one firm, a monopoly. (Tell me I’ve got this right?)
Now, you say, “if there were no transaction costs, then according to Coase there wouldn’t be any firms at all.” and you might explain monopolies in traditional markets that way, but if you look at a real-world example of a market with transaction costs as close to zero as it is possible to get without violating the laws of thermodynamics, the internet, then you still see monopolies! Not only do you see them, but monopolies seem to me to be the internet’s base state! Whenever new concept is introduced (the spreadsheet, the word processor, the browser, the drawing program, etc. etc.) for a fairly short time there is a “Cambrian explosion” of variant designs, all freely available and usually at near-zero cost. Very quickly one design becomes dominant and “the standard.” The others die or wither. I’m not saying that this dominance is permanent, but even in the cases where one system has replaced another, the switch is fairly abrupt (Visicalc to Dbase to Excell) and total.
How do you/ how do you think Dr. Coase would explain this?
Eli,
That’s what I get for commenting before I refreshed myself with the article in question.
My question still remains even if we’re all independent contractors. It’s not clear to me that zero transactions costs completely eliminates unwanted periods of downtime.
Pete,
They’re a firm, in Coase’s world, if there’s one entity to which they all have a contract, rather than having contracts with one another. In a zero transactions costs world, scientists working on research could just all have contracts with one another; they would not be a firm but rather an association of independent contractors, and they could be working with others at the same time.
In a firm, there is a boss, who tells you what to work on and who to work with. You have a contract with the company and not with your coworkers.
The fact of the matter is that it isn’t very useful to think about a zero transactions cost world, any more than it is to think about a world without gravity or friction. But we can talk about reducing specific transaction costs, though they will never get to zero.
In fact I think the best way to understand what happens when you reduce one set of transaction costs is to consider the ones that remain unchanged that now are much higher, relative to the ones you just reduced. That wasn’t very articulate, but does that make sense? Sort of like how one of the biggest transaction costs to finding information has always been the time it took to look for it; and with the internet the costs of sharing specific content have dramatically reduced but that has only meant that the time cost of finding specific content may have increased, relative to the decrease in sharing costs.
Pete, if there were no transaction costs, then people could buy insurance to take on many different risk-return profiles. People who were relatively risk-tolerant would sell insurance to people who were relatively risk-averse, with contracts that fully eliminated moral hazard (because there are no transaction costs, remember?).
Apikoros, I think there can still be monopoly if there are no firms. Consider patents, for instance. If I have a patent, then I effectively have a monopoly in that innovation—I am the only seller, even if I am not a firm. And even if transaction costs were zero, some innovators would be first to market, and therefore have temporary market power. I don’t see this as a problem for the paper. All production would be organized by one firm if transaction costs were high enough, but that doesn’t rule out monopolies in smaller industries even with low transaction costs.