The Nature of the FirmR.H. Coase (1937)

Sociology 224February 9, 2010

Mary Carol MazzaHBS

Introduction

Problem:

Economists often fail to examine the foundations of economic theory

Coase proposes:

to show a definition of the firm that both:-corresponds to the real world meaning of the word-tractable by tools of economic analysis (idea of the margin and substitution)

Introduction I. II. III. IV. V.Questions

Introduction I. II. III. IV. V.Questions

I. The Economic System as Treated by Economists

• Price mechanism

determines the allocation of

the factors of production

• The process is automatic,

responsive, and elastic: it

adjusts supply to demand

and production to

consumption

Economists View of Economic System

Coases View of Economic System

Outside the firm:

• Price movements direct

production, coordinated

through exchange

transactions on the market

Within the firm:

• The entrepreneur directs

production

Introduction I. Economic System: Economists vs. Coase II. III. IV. V. Questions

Introduction I. Economic System: Economists vs. Coase II. III. IV. V. Questions

Outside the firm: Price movements direct production

Inside the firm: Entrepreneur directs production (because there are no market transactions within the firm)

**Mark of the Firm the supersession of the price mechanism (by some organizational director/person)

Why is there an organization? What is the distinguishing mark of the firm?

Introduction I. Economic System: Economists vs. Coase II. III. IV. V. Questions

Introduction I. Economic System: Economists vs. Coase II. III. IV. V. Questions

“bridg[ing] the apparent gap in economic theory between the assumption that resources are allocated by the price mechanisms for some purposes and by the entrepreneur-co-ordinator for others” (p.389)

INTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSIONINTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSION

Purpose of the Paper

Introduction I. Economic System: Economists vs. Coase II. III. IV. V. Questions

Introduction I. Economic System: Economists vs. Coase II. III. IV. V. Questions

II. Why does a firm emerge in a specialized exchange economy

**There is a cost to using the price mechanism (“transaction costs” or “marketing costs”)

• Finding out prices

• Negotiating separate contracts

• Difficulty creating long-term contracts

The firm: saves costs by allowing an entrepreneur to direct resources

INTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSIONINTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSION

Why does a firm emerge in a specialized exchange economy?

Introduction I. II. Why a firm emerges in specialized exchange economy III. IV. V. Questions

Introduction I. II. Why a firm emerges in specialized exchange economy III. IV. V. Questions

A firm “consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur” (p.393).

This definition imparts scientific meaning to the idea of a firm getting larger or smaller

INTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSIONINTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSION

Definition of the Firm

Introduction I. II. Why a firm emerges in specialized exchange economy III. IV. V. Questions

Introduction I. II. Why a firm emerges in specialized exchange economy III. IV. V. Questions

In response to Knight:

If the firm, by definition, reduces marketing/production costs, why are there any market transactions at all?

Why not one big firm?

•Diminishing marginal returns (increasing marginal costs of organizing more transactions within the firm)

•Decreasing returns of managerial ability (misallocation of resources, knowledge, etc)

•Potential for rising supply prices

INTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSIONINTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSION

Can we treat the determinants of the size of the firm scientifically?

Introduction I. II. Why a firm emerges in specialized exchange economy III. IV. V. Questions

Introduction I. II. Why a firm emerges in specialized exchange economy III. IV. V. Questions

A firm will tend to be larger:

1) The lower the costs of organizing and the slower these costs rise with an increase in the transactions organized

2) The less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organized

3) The greater the lowering in the supply price of factors of production to firms of larger size

INTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSIONINTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSION

Can we treat the determinants of the size of the firm scientifically?

Introduction I. II. Why a firm emerges in specialized exchange economy III. IV. V. Questions

Introduction I. II. Why a firm emerges in specialized exchange economy III. IV. V. Questions

III. Why the price mechanisms needs to be substituted by the entrepreneur

Others: Firm exists because of division of labor

The firm integrates these various parts that came about from economic differentiation

…BUT

Coase says: The price mechanism already existed as an integrating force

INTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSIONINTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSION

Why is Coase’s reason for the emergence of the firm to be preferred over others?

Introduction I. II. III. Why this explanation of firm emergence is preferred IV. V. Questions

Introduction I. II. III. Why this explanation of firm emergence is preferred IV. V. Questions

Professor Knight: the firm exists because of Uncertainty!• People have to forecast future wants (special class

arises who directs the activities and guarantees wages)• But they could just sell their advice

• It would be odd for one man to guarantee another a result from the other’s work without being given power over his work

• But that is what contracts are for

But even without uncertainty, there would need to be coordinators…never says why price mechanism should be superseded

INTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSIONINTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSION

Why one integrating force (the entrepreneur) Needs to substitute for another (price mechanism)

Introduction I. II. III. Why the entrepreneur substitutes for price mechanism IV. V. Questions

Introduction I. II. III. Why the entrepreneur substitutes for price mechanism IV. V. Questions

IV. The Cost Curve of the Firm

Prior discussion of firm size based on the simplifying assumption that only one product will be produced.

MC=MR

The number of products produced by a firm is determined by:A point where it’s less costly to organize the exchange transactions of a new product than to organize further exchange transactions of the old product (including marketing costs & costs of organizing different entrepreneurs)

INTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSIONINTRO STUDY 1 STUDY 2 STUDY 3 STUDY 4 DISCUSSION

The Cost Curve of the Firm

Introduction I. II. III. IV. The Cost Curve of the Firm V. Questions

Introduction I. II. III. IV. The Cost Curve of the Firm V. Questions

V. The Firm: Realistic and Manageable?

Examining the relationship of servant/master (employer/employee):

1) The servant must render personal services to the master/on his behalf

2) The master must have the right to control the servant’s work

Agent vs Servant: the freedom with which an agent carries out his employment

Is this concept of the firm realistic and is it manageable

Introduction I. II. III. IV. V. Concept fit with real world and manageable? Questions

Introduction I. II. III. IV. V. Concept fit with real world and manageable? Questions

Scope of the firm is determined at the margin• Marginal Cost of organizing an additional transaction within the firm equals the cost of alternative institutional arrangements (ie: another firm or the market)

Is this concept of the firm realistic and is it manageable

Introduction I. II. III. IV. V. Concept fit with real world and manageable? Questions

Introduction I. II. III. IV. V. Concept fit with real world and manageable? Questions

So Coase’s definition of a firm might have worked for 1937 (and maybe into the 1970s when other’s built on his work), but in 2010, how relevant is Coase?

If Coase were to revise his “Theory of the Firm” for today’s world, what would he change?

Questions…

Introduction I. II. III. IV. V. QuestionsIntroduction I. II. III. IV. V. QuestionsIntroduction I. II. III. IV. V.Questions

Introduction I. II. III. IV. V.Questions

Give a clear definition of what is meant by a “firm” in economics that is both realistic (corresponds to general usage) and manageable for economic analysis. Bridge the gap in economic theory between assumptions of allocation by price mechanism and by fiat of the entrepreneur. Under what conditions one or the other? Why do firms emerge at all in a specialized economy? (if it is a matter if information efficiency, independent consultants and specialists could do just as well) A firm consists of the system of relationships that come into being when the direction of resources is dependent on an entrepreneur. Distinguishing mark of firm is the supersession of pure price mechanism (i.e., pricing is not only thing that guides the emergence of firms)

•  

Introduction I. II. III. IV. V. QuestionsIntroduction I. II. III. IV. V. QuestionsSummarySummary

The main reason why it is profitable to establish a firm is that there is a cost of using the price mechanism (transaction cost). a) the cost of price information, b) the cost of making separate contracts for each exchange transaction (Firms reduce these contracts to one, the employee’s salary and range of duties), c) risk attitudes, firms prefer long-term contracts, but uncertainties involved require a vague contract, d) external actions: sales tax on market exchange (but not inside firm) , quotas, and rationing all would raise transaction costs outside the firm. “The operation of a market costs something and by forming an organization and allowing some authority (an “entrepreneur”) to direct the resources, certain marketing costs are saved.” (p. 392)

Introduction I. II. III. IV. V. QuestionsIntroduction I. II. III. IV. V. QuestionsSummarySummary

You can also use these conceptions to describe and predict changes in the size of firms. Growth occurs when more (types or volume of) transactions are organized by the entrepreneur. Maximum size of firms corresponds to the point at which it is no longer cheaper to organize transactions “in house” compared to the market. Two ways a firm can expand: combination occurs when transaction originally done by 2 or more entrepreneurs become organized by one; integration occurs when transactions between entrepreneurs on the market become organized by one.

Introduction I. II. III. IV. V. QuestionsIntroduction I. II. III. IV. V. QuestionsSummarySummary

So, all else equal, a firm will tend to be larger if it faces a) decreased cost of organizing and slower cost increase if transaction organized b) decreased likelihood of entrepreneur making mistakes c) increased lowering of supply price factors of production.

Influenced wlliamson

Introduction I. II. III. IV. V. QuestionsIntroduction I. II. III. IV. V. QuestionsSummarySummary

The End