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Ronald Coase and the Nature of the Firm 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. 2 Draft notes for Bob Wayland’s Economics of Business S1600 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.
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