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Ronald Coase the Nature of Firms and Their Costs

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Ronald Coase the Nature of Firms and Their Costs Economic Insights FEDERAL RESERVE BANK OF DALLAS VOLUME 8, NUMBER 3 Ronald Coase 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 Nobel Prize. ing industrial law with the intention of becoming a lawyer. 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 Economics 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 University of Chicago News Office rizing about them. the United States on a scholarship to study the structure of American indus- Ronald Coase Karl Marx said philosophy had ex- try. This study became the basis for Firm,” published in Economica (1937). In plained the world and now it was necessary to Coase’s lifetime fascination with indus- trial organization and his later work on “The Nature of the Firm,” 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 University of Liverpool (1934–35) Frank Knight’s monumental Risk, Uncer- to change it. Adam Smith expressed this fun- and the London School of Economics tainty, and Profit 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 market 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 invisible hand. And no econ- faculty of the University of Virginia 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 property 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 Social Cost” (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 market structure 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 contract 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 contracts 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 Aaron Director’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 externality (cost) from Kessel, Milton Friedman, Martin Bailey, fare (1920)—that government regula- party A’s action(s).
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