The Nature of Firms
Fundamentally, Coase’s essay is an extension of the price theory put forward by Hayek:
“[Price Theory] assumes that the direction of resources is dependent directly on the price mechanism. Indeed, it is often considered to be an objection to economic planning that it merely tries to do what is already done by the price mechanism.”
“Yet in the real world, we find that there are many areas where this does not apply. If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so. Those who object to economic planning on the grounds that the problem is solved by price movements can be answered by pointing out that there is planning within our economic system which is quite different from the individual planning mentioned above and which is akin to what is normally called economic planning….”
“As D. H. Robertson points out, we find “islands of conscious power in this ocean of unconscious co‐operation like lumps of butter coagulating in a pail of buttermilk.”1 But in view of the fact that it is usually argued that co‐ordination will be done by the price mechanism, why is such organisation [firms] necessary?...”
“It can, I think, be assumed that the distinguishing mark of the firm is the supersession of the price mechanism.”
A firm, or any other kind of central organization, can only exist if it provides value to a system above what price provides on its own.
For a price to exist, there must be an exchange between two parties. Coase argues that this exchange, or transaction has a cost in and of itself:
“The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.”
These costs break down as:
Price discovery:
“The most obvious cost of “organising” production through the price mechanism is that of discovering what the relevant prices are.4 This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information.”
Contract:
“The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account.1 Again, in certain markets, e.g., produce exchanges, a technique is devised for minimising these contract costs; but they are not eliminated. “
Time risk:
“It may be desired to make a long‐term contract for the supply of some article or service. This may be due to the fact that if one contract is made for a longer period, instead of several shorter ones, then certain costs of making each contract will be avoided. Or, owing to the risk attitude of the people concerned, they may prefer to make a long rather than a short‐term contract. Now, owing to the difficulty of forecasting, the longer the period of the contract is for the supply of the commodity or service, the less possible, and indeed, the less desirable it is for the person purchasing to specify what the other contracting party is expected to do.”
Firms solve these problems in the following ways:
Contract → Employees / Partners:
”A factor of production (or the owner thereof) does not have to make a series of contracts with the factors with whom he is co‐operating within the firm, as would be necessary, of course, if this co‐operation were as a direct result of the working of the price mechanism. For this series of contracts is substituted one.”
Time → Broad employment contracts:
“Therefore, the service which is being provided is expressed in general terms, the exact details being left until a later date. All that is stated in the contract is the limits to what the persons supplying the commodity or service is expected to do. The details of what the supplier is expected to do is not stated in the contract but is decided later by the purchaser. When the direction of resources (within the limits of the contract) becomes dependent on the buyer in this way, that relationship which I term a “firm” may be obtained”
The higher the cost of transacting in the market through price, the higher the chance that a firm (or firms) will emerge. Generally speaking, the more service labor, or individual expertise from an “entrepreneur” is required, the higher transaction costs will be.
“A firm is likely therefore to emerge in those cases where a very short term contract would be unsatisfactory. It is obviously of more importance in the case of services—labour—than it is in the case of the buying of commodities. In the case of commodities, the main items can be stated in advance and the details which will be decided later will be of minor significance.”
“A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.”
Which is another way of saying, the more management decisions that must be made, the more likely firms are to exist.
But if firms reduce transaction costs, why are markets not dominated by massive firms that replace the role of price with something more efficient? Coase presents two factors that govern the proliferation of firms:
Decreasing returns with scale:
“First, as a firm gets larger, there may be decreasing returns to the entrepreneur function, that is, the costs of organising additional transactions within the firm may rise.3 Naturally, a point must be reached where the costs of organising an extra transaction within the firm are equal to the costs involved in carrying out the transaction in the open market”
As firms grow, price’s signal is lost and resource allocation becomes more inefficient:
“Secondly, it may be that as the transactions which are organised increase, the entrepreneur fails to place the factors of production in the uses where their value is greatest, that is, fails to make the best use of the factors of production.”
Collectively, these dynamics produce diminishing returns to management:
“The first two reasons given most probably correspond to the economists' phrase of “diminishing returns to management.”2”
Firms form and grow until the cost of organizing a transaction within the firm equals the cost of transacting on the open market through price alone, which is no different than any other MC = MR equilibrium.
The size of a firm is dictated by elements that impact this dynamic:
“Other things being equal, therefore, a firm will tend to be larger:
(a) the less the costs of organising and the slower these costs rise with an increase in the transactions organised.
(b) the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organised.
(c) the greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size.”
“Inventions which tend to bring factors of production nearer together, by lessening spatial distribution, tend to increase the size of the firm.2 Changes like the telephone and the telegraph which tend to reduce the cost of organising spatially will tend to increase the size of the firm. All changes which improve managerial technique will tend to increase the size of the firm.1”
“To determine the size of the firm, we have to consider the marketing costs (that is, the costs of using the price mechanism), and the costs of organising of different entrepreneurs and then we can determine how many products will be produced by each firm and how much of each it will produce.”