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Ronald Coase the Nature of Firms and Their Costs

Ronald Coase the Nature of Firms and Their Costs

Economic Insights

FEDERAL RESERVE BANK OF DALLAS VOLUME 8, NUMBER 3 The Nature of Firms and Their Costs

One of my favorite philosophers—Yogi Ronald Harry Coase was born in a Berra—once said “You can observe a lot just London suburb in 1910. He was edu- cated at the London School of Eco- by watching.” Economist Ronald Coase did nomics from 1929 through 1932, study- just that, and it earned him a . ing industrial with the intention of becoming a . But that changed Coase has always asked economists to be keen after his exposure to Professor of Com- observers, trying to understand why things merce Arnold Plant, who came to the London School of from a operate as they do, rather than pure theoreti- position in Cape Town, South Africa, in cians, wondering why the world doesn’t con- 1930. Plant’s influence put Coase firmly on the road to becoming an economist form to their theoretical models of reality. And and also shaped his attitude that eco- he led the way by observing industrial orga- nomic theory is fine as long as it’s grounded in reality. nizations and structures up close before theo- During 1931–32, Coase traveled to News Office rizing about them. the United States on a scholarship to study the structure of American indus- Ronald Coase said philosophy had ex- try. This study became the basis for Firm,” published in (1937). In plained the world and now it was necessary to Coase’s lifetime fascination with indus- and his later work on “,” Coase ex- change it. Coase’s writings imply that this ap- the nature of firms and their costs. plained that firms exist because they re- duce the transaction costs that emerge proach is backwards. First observe the world, After leaving the London School of Economics, Coase held a series of teach- during production and exchange, cap- he says, and then explain it. Having done so, ing positions: at the Dundee School of turing efficiencies that individuals cannot. Coase was heavily influenced by we learn that in many cases it is not necessary Economics and Commerce (1932–34), the (1934–35) ’s monumental Risk, Uncer- to change it. expressed this fun- and the London School of Economics tainty, and and Philip Wick- steed’s The Common Sense of Political damental insight about existing institutions (1935–51). Immigrating to the United States in 1951, Coase taught first at the Economy. The former inspired his in- and structures with his famous University of Buffalo, then joined the terest in institutions and the structure of productive process. The latter led him metaphor of the . And no econ- faculty of the in 1959. He moved to the University of Chi- to study constrained optimization prob- omist has a better claim to having furthered cago in 1964, remaining there until 1982. lems, that is, choices that are con- strained by costs, information, market this key lesson than the one we recognize with He was awarded the Nobel Memorial Prize in Economic Sciences in 1991. prices and uncertainty.1 this edition of Economic Insights, a man whose Coase’s central contributions to In his article about the Federal Com- observations changed economics forever. modern economic theory are recorded in munications Commission, Coase showed two seminal articles published in the economists the crucial importance of in- University of Chicago’s Journal of Law stitutional rights and how their — Bob McTeer and Economics—“The Federal Commu- presence or absence influences the effi- President Federal Reserve Bank of Dallas nications Commission” (1959) and “The cient allocation of scarce resources. In Problem of ” (1960)—as well that paper, Coase first put forward what as in an earlier article, “The Nature of the has come to be known as the Coase Why Do Firms Exist? What Determines the Outside the firm, price movements direct production, which is co-ordinated through a series of Size of the Firm? exchange transactions on the market. Within a firm, these market transactions are eliminated, and in Other things being equal, therefore, a firm place of the complicated with exchange transactions is substituted the entrepre- will tend to be larger: neur–co-ordinator, who directs production. It is clear that these are alternative methods of co-ordinat- (a) the less the costs of organizing ing production. Yet, having regard to the fact that if production is regulated by price movements, pro- and the slower these costs rise duction could be carried on without any organization at all, well might we ask, Why is there any with an increase in the transac- organization?… tions organized; In view of the fact that while economists treat the price mechanism as a co-ordinating instrument, (b) the less likely the entrepreneur is they also admit the co-ordinating function of the “entrepreneur,” it is surely important to inquire why to make mistakes and the smal- co-ordination is the work of the price mechanism in one case and of the entrepreneur in another. The ler the increase in mistakes with purpose of this paper is to bridge what appears to be a gap in economic theory between the assump- an increase in the transactions tion (made for some purposes) that resources are allocated by means of the price mechanism and the organized; assumption (made for other purposes) that this allocation is dependent on the entrepreneur–co-ordi- (c) the greater the lowering (or the nator. We have to explain the basis on which, in practice, this choice between alternatives is effected…. less the rise) in the supply price The main reason why it is profitable to establish a firm would seem to be that there is a cost of of factors of production to firms using the price mechanism. The most obvious cost of “organizing” production through the price mech- of larger size. anism is that of discovering what the relevant prices are. The cost may be reduced but it will not be Apart from variations in the supply price eliminated by the emergence of specialists who will sell this information. The costs of negotiating and of factors of production to firms of different concluding a separate for each exchange transaction which takes place on a market must also sizes, it would appear that the costs of organiz- be taken into account. Again, in certain markets, e.g., produce exchanges, a technique is devised for ing and the losses through mistakes will minimizing these contract costs; but they are not eliminated. It is true that are not eliminated increase with an increase in the spatial distrib- when there is a firm but they are greatly reduced. A factor of production (or the owner thereof) does ution of the transactions organized, in the dis- not have to make a series of contracts with the factors with whom he is co-operating within the firm, similarity of the transactions, and in the proba- as would be necessary, of course, if this co-operation were a direct result of the working of the price bility of changes in the relevant prices. As more mechanism…. transactions are organized by an entrepreneur, We may sum up this section of the argument by saying that the operation of a market costs some- it would appear that the transactions would thing and by forming an organization and allowing some authority (an “entrepreneur”) to direct the tend to be either different in kind or in different resources, certain marketing costs are saved. The entrepreneur has to carry out his function at less places. This furnishes an additional reason why cost, taking into account the fact that he may get factors of production at a lower price than the mar- efficiency will tend to decrease as the firm gets ket transactions which he supersedes, because it is always possible to revert to the open market if he larger. Inventions which tend to bring factors of fails to do this. ■ production nearer together, by lessening spa- tial distribution, tend to increase the size of the —“The Nature of the Firm,” 388–92 firm. Changes like the telephone and the tele- graph which tend to reduce the cost of orga- Theorem, the idea that in the absence essential point. That point was system- nizing spatially will tend to increase the size of of transaction costs, any initial property atically reiterated in one of the most- the firm. All changes which improve manager- ial technique will tend to increase the size of the rights arrangement leads to an eco- cited economics articles ever published, firm. ■ nomically efficient outcome. “The Problem of Social Cost” (1960). This stance was so counterintuitive Using examples from English com- —“The Nature of the Firm,” 396–97 that the journal editors asked Coase to mon law, Coase methodically demon- retract or modify it. Coase refused to strates that regulatory interventions can, In the Pigouvian case, party A harms modify the article but did agree to de- under certain conditions, lead to less party B by engaging in trades with party fend himself at a history-making meet- economically efficient outcomes than C (and/or D …n). It is a clear case of ing at journal editor ’s markets alone would create. This con- black and white hats, for party B is seen home in Chicago. Also present and trasts with the contention A. C. Pigou as an innocent bystander who is suffer- ready to question Coase were Rueben first put forth in The Economics of Wel- ing a negative (cost) from Kessel, , Martin Bailey, fare (1920)—that government regula- party A’s action(s). For Coase, a Arnold Harberger, Gregg Lewis, John tion enhances efficiency by correcting occurs only because there are conflicts McGee, and , for claimed imperfections, which Pigou over resource use and all parties can as formidably skeptical an audience as called market failures. harm each other. Thus, to stop party A any economic theorist has probably Coase gets his results with an as- from harming party B is akin to harm- ever faced. At the end of that evening, sumption of zero transaction costs, but ing party A. In this Coasian world, the not only was Coase still standing, but his analysis rests also on a particular assignment of property rights does not the participants had conceded his view of quite different from Pigou’s. matter in terms of the efficient eco- A New Approach to Understanding Social Costs

This paper is concerned with those actions inevitable that some cattle will stray, an increase in far…. of firms which have harmful effects on the supply of meat can only be obtained at the It is my belief that the failure of economists others. The standard example is that of a factory, expense of a decrease in the supply of crops. The to reach correct conclusions about the treatment the smoke from which has harmful effects on those nature of the choice is clear: meat or crops. What of harmful effects cannot be ascribed simply to a occupying neighboring . The economic answer should be given is, of course, not clear un- few slips in analysis. It stems from basic defects analysis of such a situation has usually proceed- less we know the of what is obtained as well in the current approach to problems of welfare ed in terms of a divergence between the private as the value of what is sacrificed to obtain it…. economics. What is needed is a change of and social product of the factory, in which econ- The problem which we face in dealing with approach. Analysis in terms of divergences omists have largely followed the treatment of actions which have harmful effects is not simply between private and social products concen- Pigou in The Economics of Welfare. The conclusions one of restraining those responsible for them. What trates attention on particular deficiencies in the to which this kind of analysis seems to have led has to be decided is whether the gain from prevent- system and tends to nourish the belief that any most economists is that it would be desirable to ing the harm is greater than the loss which would measure which will remove the deficiency is nec- make the owner of the factory liable for damage be suffered elsewhere as a result of stopping the essarily desirable. It diverts attention from those caused to those injured by the smoke; or to place action which produced the harm. In a world in other changes in the system which are inevitably a on the factory owner varying with the which there are costs of rearranging the rights es- associated with the corrective measure, changes amount of smoke produced and equivalent in tablished by the legal system, the , in cases which may well produce more harm than the terms to the damage it would cause; or, relating to nuisance, are, in effect, making a deci- original deficiency…. finally, to exclude the factory from residential sion on the economic problem and determining It would clearly be desirable if the only districts (and presumably from other areas in how resources are to be employed. It was argued actions performed were those in which what was which the emission of smoke would have harm- that the courts are conscious of this and that they gained was worth more than what was lost. But ful effects on others). It is my contention that the often make, although not always in a very explicit in choosing among social arrangements within suggested courses of action are inappropriate in fashion, a comparison between what would be the context of which individual decisions are that they lead to results which are not necessar- gained and what lost by preventing actions which made, we have to bear in mind that a change in ily, or even usually, desirable. have harmful effects. But the delimitation of rights the existing system which will lead to an The traditional approach has tended to ob- is also the result of statutory enactments. Here we improvement in some decisions may well lead to scure the nature of the choice that has to be also find of an appreciation of the recip- a worsening in others. Furthermore, we have to made. The question is commonly thought of as rocal nature of the problem. While statutory enact- take into account the costs involved in operating one in which A inflicts harm on B and what has ments add to the list of nuisances, action is also the various social arrangements (whether it be to be decided is, How should we restrain A? But taken to legalize what would otherwise be nui- the working of a market or of a governmental this is wrong. We are dealing with a problem of sances under the . The kind of situa- department) as well as the costs involved in a reciprocal nature. To avoid the harm to B would tion which economists are prone to consider as re- moving to a new system. In devising and choos- be to inflict harm on A. The real question that has quiring corrective governmental action is, in fact, ing among social arrangements we should have to be decided is, Should A be allowed to harm B often the result of governmental action. Such action regard for the total effect. This, above all, is the or should B be allowed to harm A? The problem is not necessarily unwise. But there is a real dan- change in approach which I am advocating. ■ is to avoid the more serious harm…(An) exam- ger that extensive governmental intervention in the —“The Problem of Social Cost,” ple is afforded by the problem of straying cattle economic system may lead to the protection of those 95–96, 132–33, 153, 155–56 which destroy crops on neighboring land. If it is responsible for harmful effects being carried too nomic outcome because the parties created a strong pro-market bias in cases remains Clifton R. Musser Professor will bargain their way to the same out- where prior theorists—most notably Emeritus at Chicago’s law school. come regardless of how property rights Pigou—had crafted regulatory respon- Coase’s study of positive transac- are assigned, that is, regardless of who ses to perceived examples of market tion costs in economic exchange led gets to sue whom. (See the box titled failure. him, and by extension the entire eco- “A New Approach to Understanding After his successful presentation to nomics field, to a remarkable conclu- Social Cost.”) Chicago’s top social theorists, Coase was sion: Coase’s analysis of the theory and offered a position at the University of I explained in “The Problem of Social history of torts, combined with his as- Chicago, where he edited the Journal Cost” that what are traded on the mark- sumptions about what the legal system of from 1964 to et are not, as is often supposed by eco- ought to do in cases of conflict over 1982. Under his editorship, the journal nomists, physical entities but the rights resource use—maximize economic effi- became one of the economics profes- to perform certain actions, and the ciency and thus societal wealth rather sion’s most influential forums. He was rights which individuals possess are 2 than punish specific conduct—created the first president of the International established by the legal system. a huge boost for the then-young field Society for New Institutional Econom- For our understanding of why firms we now call law and economics. It also ics, which was founded in 1996, and he exist, why institutions have evolved as How Much Government Intervention is Appropriate? Theories and Reality: What is the general view that I will be completely beyond the reach of government reg- Making the Data Talk examining? It is that, in the market for goods, ulation…. Economists, or at any rate enough of government is desirable whereas, in My argument is that we should use the them, do not wait to discover whether a the- the market for ideas, government regulation is same approach for all markets when deciding on ory’s predictions are accurate before making undesirable and should be strictly limited. In the public policy. In fact, if we do this and use for the up their minds. Given that this is so, what part market for goods, the government is commonly market for ideas the same approach which has does testing a theory’s predictions play in eco- regarded as competent to regulate and properly commended itself to economists for the market nomics? First of all, it very often plays either motivated. Consumers lack the ability to make for goods, it is apparent that the case for gov- no part or a very minor part…. the appropriate choices. Producers often exercise ernment intervention in the market for ideas is I remarked earlier on the tendency of monopolistic power and, in any case, without much stronger than it is, in general, in the mar- economists to get the result their theory tells some form of government intervention, would not ket for goods…. them to expect. In a talk I gave at the University act in a way which promotes the public interest. [C]onsider the question of consumer ig- of Virginia in the early 1960s, … I said that if In the market for ideas, the position is very dif- norance which is commonly thought to be a jus- you torture that data enough, nature will ferent. The government, if it attempted to regu- tification for government intervention. It is hard to always confess, a saying which, in a somewhat late, would be inefficient and its motives would, believe that the general public is in a better posi- altered form, has taken its place in the statisti- in general, be bad, so that, even if it were suc- tion to evaluate competing views on economic and cessful in achieving what it wanted to accomplish, social policy than to choose between different cal literature. Kuhn puts the point more ele- the results would be undesirable. Consumers, on kinds of food. Yet there is support for regulation in gantly and makes the process sound more like the other hand, if left free, exercise a fine dis- the one case but not in the other. Or consider the a seduction: “nature undoubtedly responds to crimination in choosing between the alternative question of preventing fraud, for which govern- the theoretical predispositions with which she views placed before them, while producers, ment intervention is commonly advocated. It is approached by the measuring scientist.” ■ whether economically powerful or weak, who are would be difficult to deny that newspaper articles —“How Should Economists Choose?” found to be so unscrupulous in their behavior in and the speeches of politicians contain a large 72, 74 other markets, can be trusted to act in the public number of false and misleading statements—in- interest, whether they publish or work for the New , sometimes they seem to consist of little York Times, the Chicago Tribune or the Columbia else. Government action to control false and mis- ——— (1988), “The Problem of Social Cost,” Broadcasting System. Politicians, whose actions leading advertising is considered highly desir- in The Firm, the Market, and the Law sometimes pain us, are in their utterances beyond able. Yet a proposal to set up a Federal Press (Chicago: University of Chicago Press), 5–156, reproach. It is an odd feature of this attitude that Commission or a Federal Political Commission commercial advertising, which is often merely an modeled on the Federal Trade Commission orig. pub. 1960. expression of opinion and might, therefore, be would be dismissed out of hand. ■ thought to be protected by the First Amendment, ——— (1991), “The Institutional Structure of is considered to be part of the market for goods. —“The Economics of the First Amendment: Production,” Nobel Prize Lecture to the The result is that government action is regarded The Market for Goods and Memory of Alfred Nobel, December 9, 1991, as desirable to regulate (or even suppress) the the Market for Ideas,” www.nobel.se/economics/laureates/1991/ expression of an opinion in an advertisement 384–85, 389–90 coase-lecture.html which, if expressed in a book or article, would be

——— (1994), Essays on Economics and they have and how this shapes public Coase, Ronald H. (1937), “The Nature of the Economists (Chicago: University of Chicago policy, we owe a large debt to Ronald Firm,” Economica 4 (November): 386–405. Press). Coase. ■ ——— (1959), “The Federal Communications — Robert L. Formaini Commission,” Journal of Law and Economics 2 Thomas F. Siems (October): 1–40. Senior Economists ——— (1974), “The Economics of the First Economic Insights is a publication of the Federal Reserve Bank of Dallas. The views Notes Amendment: The Market for Goods and the 1 expressed are those of the authors and should Cheung (1987). Market for Ideas,” 2 not be attributed to the Federal Reserve System. Coase (1991). 64 (May): 384–91. Please address all correspondence to Sources and Suggested Reading ——— (1988), “How Should Economists Economic Insights Public Affairs Department Cheung, Steven N. S. (1987), “Ronald Harry Choose?” in Ideas, Their Origins, and Their Federal Reserve Bank of Dallas Coase,” in The New Palgrave: A Dictionary of Consequences: Lectures to Commemorate the P.O. Box 655906 Economics, vol. 1, ed. John Eatwell, Murray Life and Work of G. Warren Nutter Dallas, TX 75265-5906 Milgate and Peter Newman (New York: Stockton (Washington, D.C.: American Enterprise Visit our web site at www.dallasfed.org. Press), 455–57. Institute for Public Policy Research) 57–79.

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