Draft notes for Bob Wayland’s Economics of Business S1600

Class 1 Notes: Ronald Coase and the Nature of the Firm

Objectives. The objectives of the next several classes are to provide an understanding of the origin of the firm, its evolution, the roles and relationships of principals and agents within the firm and across firms, how decisions on output and investment affect the value of the firm. The Coase article that started much of the discussion about the nature of the firm and its boundaries is discussed below.

Required Readings. Coase 1937

The Firm

The modern business firm is the basis of our economy. By far most goods and services are produced within business firms and a huge majority of workers are employed by them. In 2004 the U.S. Census Bureau counted nearly 5.9 million firms employing about 115 million people, with receipts of something over $23 trillion, and payroll of about $4.3 trillion. Of these nearly six million firms, only about 11 per cent had more than twenty employees, less than two per cent had 100 or more employees and .3 per cent employed 500 people or more. These are the numbers people refer to when they discuss the importance of small and medium sized firms. But the behemoths, while a small percentage of the population, produce a disproportionate amount of the U.S. output. The 891 largest firms (by sales) accounted for 23 per cent of U.S. employment, almost 30 percent of payroll, and a whopping 42 percent of sales or receipts.1 On average over the past 20 years or so, about eight to nine percent of firms fail each year and are offset by the birth of new firms equal to about ten percent of the total firm population.

Over time, almost all firms fail or disappear. Many are absorbed into other firms. U.S. merger and acquisition activity in 2010 was valued at about $820 billion, about half that of worldwide M&A. The average acquisition premium, a measure of the acquiring company’s optimism, for U.S. deals was a little over 40 per cent, about ten points higher than the worldwide average.2

Economists didn’t give much thought to the phenomena of firms until the early 20th century. There were commercial censuses of businesses and some comment on the course of industry. J.H. Clapham reported in his 1926 book, An Economic History of Modern Britain, that the 1851 Census Commissioners counted 677 British “engine and machine makers,” 457 of which employed less than 10 men.3 But the formal study of the origin and evolution of firms was relatively neglected until Ronald Coase’s 1937 article. Since Coase, economists have asked and begun to find answers to important questions such as:

1 2004 U.S. Census Data, most recent available, http://www.census.gov/epcd/www/smallbus.html 2 These figures are still preliminary but are probably fairly accurate. See http://dealbook.nytimes.com/2011/01/03/confident-deal-makers-pulled-out-checkbooks-in-2010/ 3 Op cit. p 448

1 Draft notes for Bob Wayland’s Economics of Business S1600

• Why are there firms • What factors determine the scope of firms • What limits, if any, exist on the scale of firms • What are the efficient boundaries of firms • How do firms interact with other firms and the market

We can only address the major outlines of the economics of the firm in this course but that should enable students to approach many practical business problems and issues in a more critical manner.

Where Do Firms Come From?

Recall from our discussion of Adam Smith that specialization, trade and the market are means of creating wealth. Smith was clearly aware of firms but discussed them largely in terms of entrepreneurs, conflating the principal and the organization. The market’s invisible hand guided the decisions of entrepreneurs. But as anyone who has worked in a corporation knows, there are many visible hands directing resources within the walls of the firm. Society has many ways of organizing resources starting perhaps within families and clans and eventually markets and firms. As with any other “resource” economists seek to determine what are the optimal means of organizing resources and production and what factors bear on choices among competing organizational forms.

We take the existence of the firm for granted but the firm as we know it and its prominence in our lives is a fairly recent development in human history4 and it is not entirely obvious why it should be such an important factor in our economic lives. In the next few sections we will look at the work of five distinguished economists to gain insight into the factors that explain the origin and development of the firm. This provides a basis for analyzing and exploring the firm’s behavior, its boundaries, and the limits to its scale and scope. If we understand what really shapes a firm and the factors that govern its growth and survival we can better assess strategies and examine critically theories and prescriptions for success.

4 As we discussed in the previous section organized commercial activity has of course been around a long time. See for example, Karl Moore and David Lewis, Birth of the Multinational: 2000 Years of Ancient Business History--From Ashur to Augustus, Handelshojskolens Forlag, illustrated edition (September 1, 1999) which traces multinational activities back to Assyrian times and into the Roman Empire.

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Ronald H. Coase and the Nature of the Firm as an Alternative to the Market

Ronald H. Coase (1910-2013) was one of the greatest economists of his time. He was especially influential in the development of transactions cost economics, economics of property rights, and the intersection of economics and law. His most famous articles include this essay on the origin of firms and the classic, “The Problem of Social Cost,” which we will discuss in a future session. Coase was, as Peter Klein noted, extremely successful despite (or because of) not having a PhD in economics, eschewing math and statistics, and practicing for much of his career outside of an economics department (he was a faculty member of the Chicago Law School). Coase was the acknowledged founder of new institutional economics. He was working on a book on the emergence of China at the time of his death at 102.

Until Ronald H. Coase’s classic 1937 article, “The Nature of the Firm,”5 economists didn’t much discuss the inconsistency between their assumptions that some resource decisions were made more or less automatically by the price system and that others were made consciously and apart from the price system by people within firms. Coase grasped earlier than almost anyone else that the firm was an alternative to the market mechanism for organizing transactions. The dichotomy between firms and markets has a significant evolutionary implication. Once it is created a firm becomes a generator of variation in ways to satisfy the fitness requirements of the market. Those firms that generate the most fit solutions for customers are rewarded with profit and enabled to continue in the game. As we saw in the previous section, each year, hundreds of thousands of new firms are created. At the same time, hundreds of thousands of other firms are found wanting in meeting the fitness requirements of the market and fail.

Coase addressed two fundamental questions: why are there firms and what, if any, are the constraints on their size and scope of activity? In principle individuals could rely completely on the market and the price mechanism to direct resources. In fact many industries such as the putting out system in early fabric making were organized largely through market transactions among independent or semi-independent producers. But, in the evocative phrase of British economist Sir Dennis H. Robertson we find:

“… islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk.”

What causes the lumps? Coase’s most profound insight was that there are costs to using the price mechanism and that in some cases it is less costly to perform those transaction inside a firm rather than through the market.

Coase identified several costs of using the market. Most immediately, organizing activities through the market involves

5 Ronald H. Coase, “The Nature of the Firm,” Economica 1937

3 Draft notes for Bob Wayland’s Economics of Business S1600 discovering what the prices of relevant goods are. As George Stigler later showed in his work on the economics of information, the costs of price discovery are often significant and an important constraint on the market reach of firms.

The costs of price discovery do not disappear within firms although internally they are often called allocated expenses and overheads - the estimation and allocation of which employs legions of bookkeepers and accountants seemingly obsessed with obscuring their economic content. Other costs of using the market include negotiating, contracting and all the other expenses we lump together and call transactions costs today. (A bit confusingly, given current idiom, Coase used the term marketing costs to refer to the costs of using the price system or market.)

Coase held that the distinguishing feature of the firm was the “suppression of the price mechanism” and the use of hierarchy to direct resources. For Coase, the firm is an entity that performs those activities or transactions that can be conducted more efficiently internally (through hierarchy) than externally (through the market). The firm is thus an organism to acquire and organize resources and to use technological recipes, aka production functions, for converting those resources into more valuable goods and services.

Coase cites the flexibility of not having to develop continually contracts within a firm:

“A factor of production (or the owner thereof) does not have to make a series of contracts with the factors with whom he is cooperating within the firm, as would be necessary, of course, if this cooperation were as a direct result of the price mechanism. For this series of contracts is substituted one.”6

Clearly, it is often less costly for the entrepreneur to contact for a service, say labor, once rather than repeatedly. Matching the demand and supply of labor results in a spectrum of labor transactions from spot-market to long-term employment contracts. Firms or entrepreneurs may mix some spot labor purchased directly from the market, or temporary services purchased from an agency, with full time employees. In each case the costs of transactions must be considered. O.E. Williamson built on Coase’s insights and developed transaction cost economics (TCE) that considers not only the acquisition transaction but also the governance costs and contractual frameworks appropriate to various types of transactions and relationships.

Factors Bearing on Scale

If there are some activities or transactions that are best done by a firm, what is to prevent a firm from continuing to grow until it performed all of those activities? Why can’t a single large firm gather together and perform the transactions conducted by many small firms? Coase reasoned that the size of the firm was determined (constrained) by its ability

6 Op cit. p391

4 Draft notes for Bob Wayland’s Economics of Business S1600 to handle additional functions at costs superior to the market price plus the applicable transactions costs. At some point diminishing returns to management or entrepreneurial capability would set in and the firm would be unable to maintain its advantage relative to the market or other firms.

In his invocation of entrepreneurial capability as the limiting factor to long term firm growth, Coase echoed Nicholas Kaldor (1908-1986) who had argued in 1934 that, in the absence of some limiting factor of which the firm could possess one and only one, (and hence a truly fixed factor), the firm could simply acquire additional units of the limiting resource and go on growing. Kaldor noted that only entrepreneurial capacity met this requirement and therefore served as a fixed and limiting factor.

“It has been suggested that there is such a “fixed factor” for the individual firm even under long-run assumptions – namely, the factor alternatively termed “management” or “entrepreneurship.” As it follows from the nature of the entrepreneurial function that a firm cannot have two entrepreneurs, and as the ability of any one entrepreneur is limited, the costs of the individual firm must be rising owing to the diminishing returns to the other factors when applied in increasing amounts to the same unit of entrepreneurial ability. The fact that the firm is a productive combination under a single unit of control, explains, therefore, by itself why it cannot expand beyond a certain limit without encountering increasing costs.”7

Entrepreneurial capacity, as the uniquely and inherently fixed factor of production, is the ultimate limit to the firm’s long run size relative to its market. This is not intuitive and economists came relatively late to this insight. Many texts and courses do not stress the importance of this fact and often obscure it by devoting a great deal of attention to the classical derivation of long run marginal and average cost curves which suggest a uniform and optimal equilibrium firm size in a perfectly competitive industry subject to either constant or increasing long run average costs. (The case of long run decreasing costs is incompatible with competition and is usually finessed in introductory courses.) This analysis has artistic merit but few useful applications. Most people believe, understandably, given the standard pedagogy, that the ultimate limits to growth are imposed by cost or technical considerations. In fact, those factors do constrain output, but only in the short run. That’s what the short run is – the period over which some factors are fixed. And those factors are fixed in the short term due to previous entrepreneurial decisions.

Coase identified three specific limits to firm growth, two of which are managerial or entrepreneurial factors, the third a consequence of scale relative to supply markets:

7 Kaldor, Nicholas, “The Equilibrium of the Firm,” Economic Journal, March 1934, p 67. Coase cites this article but not as inspiration for his adoption of entrepreneurial capacity as a limiting factor. Rather, he notes and credits Kaldor with moving theory to the examination of firms directly rather than distilling their putative characteristics from a theoretical consideration of industrial equilibrium.

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“Other things being equal, therefore, a firm will tend to be larger: a) The less the costs of organizing and the slower these costs rise with an increase in the transactions organized. b) The less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organized. c) The greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size”

Coase noted also that technological change affects the potential scale and scope of firms. Technologies that increase management efficiency (or reduce what Armen Alchian and Harold Demsetz call metering costs) will tend to increase firm size. Technologies that reduce the costs of spatial separation will also tend to increase firm size. Of course as Coase notes, some technologies reduce both the costs of using the market and the operation of the firm. In these cases, there will usually be a net advantage in one direction or the other.

Coase also anticipates but does not develop the notion of smaller firms enjoying some sort of “other advantages” that offset the advantages of larger firms. Today, there is a great deal of discussion about the potential for small firms to out-hustle their larger rivals. This might be the case if at least some small firms enjoyed lower internal transaction costs that offset the lower external transaction costs (e.g. supply prices) enjoyed by larger firms. But, our earlier discussion of the relationship between the division of labor and the size of the market (external or internal) suggests that those functions susceptible to out- hustling are likely to display increasing costs and limited opportunities to achieve large scale. It is likely that large firms become slower and vulnerable to being outhustled because they expanded beyond the point where their internal transactions costs are lower than those in the market.

Measuring Relative Internal and External Efficiency

Even if the firm has an initial advantage over the market, conditions may change so the firm must be continually aware of the relative cost of the market option. Internal transfer prices and their relationship, if any, to external market prices are a major issue at many vertically integrated firms. Coase does not address this directly, leaving it to Hirshleifer in his “On the Economics of Transfer Prices” and others to explore the relationship of internal transfer prices and external or market prices. Many of the hybrid forms of corporate governance such as joint ventures are devised in large part to reduce external transactions costs and often fail when they don’t.

It follows from Coase that since the firm evolved as a substitute for the market, its value and efficiency should be measured against what the market can provide. He suggests as much by noting that firm-market borders will be found by management experimentation and trial-and-error – a process later given more formal shape by Oliver E. Williamson who worked out the conditions for determining whether transactions would be inside or outside the firm’s borders. In a sense, the firm makes it possible to ask the question

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“make or buy?” Today’s concept of managed supply chains involves closely related questions about the content and extent of the firm and its relationships with other firms.

In distinguishing between decisions made by an internal hierarchy (e.g. managers, executives, and owners) and external market forces, we encounter the question of how similar the decision criteria used by internal managers are or should be to those reflected in markets. Of course, suppressing the price mechanism totally makes it impossible to determine whether the firm does or continues to outperform the market. Firms spend a fair amount of time puzzling over this question and have developed elaborate internal transfer pricing schemes to guide internal resource use. Coase doesn’t say anything about the relative production costs, sans transactions costs, of market versus firm production. Williamson later corrects this omission.

Technological change affects the potential scale and scope of firms. Technologies that increase management efficiency (or reduce what Alchian and Demsetz call metering costs) will tend to increase firm size. Technologies that reduce the costs of spatial separation will also tend to increase firm size. Of course as Coase notes, some technologies reduce both the costs of using the market and the operation of the firm. In these cases, there will usually be a net advantage in one direction or the other.

Coase’s work was seminal but incomplete. He kicked the profession out of its torpor regarding the means of organizing production, founded the school of transactions cost economics (populated primarily by Oliver Williamson and acolytes), and stimulated a number of other leading economists to look more closely at the nature and role of the firm.

In our next session we’ll see that Alchian and Demsetz disputed Coase’s emphasis on the contrast between hierarchy and the price system or at least tempered it by emphasizing the importance of team-based cooperation as a rationale for establishing firms. The emphasis by Alchian and Demsetz on facilitating cooperation is broadly consistent with the stress placed on leadership by many executives and consultants.

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