Summary - Coase (1937) the Nature of the Firm

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COASE, R. H. (1937) – The Nature of the Firm Economica, New Series, Volume 4, Issue 16, pp. 368-405 (revised 9/2013)

Summary: The author states that there is a chronic affliction of the economic theory, which is the inability to cope with its underlying assumptions. One of those fundamentals is the question of the locus of ‘control’ within an economic system. The economic system supposedly needs no central survey. It is assumed to ‘work itself’, as it fluidly reacts to changing conditions and maintains equilibrium in the long run. Many economists therefore claim that tinkering with the system is counterproductive as it upsets the equilibrium and inevitably brings about undesirable consequences. Such a claim, however, is a misconception, as there are processes akin to economic planning routinely present in any given economic system. One of such is the firm. The distinguishing mark of the organization of a firm is the supersession of the price mechanism. Instead, a firm is being placed under the control of an entrepreneur, who maintains an alternative means of organization. The undertaker still collaborates with the external market mechanisms and flexibly steers the working of the firm accordingly. Internal affairs, however, are being centrally governed. We could ask: What are the advantages of central government vis-à-vis the price-mechanism? There are some rather mundane motivations for the existence of a firm. As some people prefer to govern and some prefer to be governed, the hierarchical organization can simply be desired for its own sake. The corporate way of organizing can be also said to be advantageous thanks to different treatment from regulators. The actual reason that could explain the advent of the firm is to be sought, however, in costs of using the market mechanism, and those arise from the principle of uncertainty. If everyone were in possession of perfect knowledge of the situation and with ability to predict the future, such costs would not exist. No marketing transactions would be present; the flow of material and productive services would be entirely automatic. That is not the case. In a situation where uncertainty is present, forecasting of behaviour of the market is a crucial task and function of the entrepreneur. As long as there is a cost of using the price-mechanism, it is advantageous to organize within a firm and reduce uncertainty by making a promise of loyalty to a certain extent. Within a firm, an unsustainably large number of contracts is replaced by one. Certain number of contracts could hypothetically be replaced by a long term contract. Such a contract would lack the desired flexibility, though. Instead, employers and employees create hierarchical structures and subject themselves to a master-servant relationship. We made the case for the existence of the institution of firm. What remains to be explained is size. If this type of organization brings merit, why isn’t there one almighty firm, gradually consuming all markets? The fact that a firm stops growing at some point can be described by the law of diminishing returns to management: the cost of organizing rises with additional transactions due to inability to place resources effectively, and at some point surpasses the costs of carrying out the transaction in the open market. A firm therefore tends to be larger a) the less the cost of organizing is and the slower the cost grows with expansion, b) the less likely is the entrepreneur to make mistakes and the smaller the probability of being inefficient grows with accepting additional transactions and c) the less the supply price of factors of production rises as the firm grows larger.

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