Coase’s Explanation of the Existence of Firms.
The problem of the existence of the firms has been a very important issue for many years due to its influence on the development of economic thought. There were many economists studying this question but for a long time, the issue of the existence of the firms wasn’t investigated to the full extend. The ideas of Ronald Coase were revolutionary in many ways in the development of the theory of the firms.
According to Coase’s theory, “in a regime of zero transaction costs, an assumption of standard economic theory, negotiations between the parties would lead to those arrangements being made which would maximize wealth and this irrespective of the initial assignment of rights”[1]. The author makes a very important discovery in comparison with the theories which were introduced before him. Coase starts regarding a firm as a plan. By that statement the economist means that everything in the firm, all of its activities have to be planned very carefully and organized according to the wish of the entrepreneur.
As long as the planning and coordination process in the firm are done on the high level, it is functioning efficiently. However, Coase also states that there is a reason why firms are being organized. As an example he gives a possibility of having just one large company which would be engaged in al the operations in the market. By his assumptions, he destroys this possibility. Coase comes to the conclusion that as long as it will be more profitable for the companies to function in separate units, the entrepreneurs will keep organizing companies instead of working in one large company. Coase states that if the transactions costs are higher within the firm than within the separate units in the market, the price mechanism will be making sure the firm decreases in size. The firm is gong to expand if it is more profitable for it to produce those units within the firm itself.
In his theory, Coase also regards firms as the special islands in the ocean of the market. The islands have their own boundaries which separate them from the ocean. However, with the help of the price mechanism, the islands either become smaller or increase in size. Coase also pays some attention to the problem of entrepreneurs and employees. According to him, the price mechanism does not always work to its fullest when it comes to this point. Some people will never want to be entrepreneurs even f they know that they are going to get much more money for that. If people were not created to be entrepreneurs, they will not be forced to become entrepreneurs no matter how much money they could get. The same thing happens when people change the place of wok- in some situations, they do that not because of the price mechanism but because of some other reasons, for example when they are forced to do that.
1. To what extent does Coase in his 1937 article merely deploy the conventional tools and categories of economics to address a long neglected issue?
In his work “The Nature of the Firm” Coase did lots of work on deploying the conventional tools and categories of economics to address the nature of the firm. One of the economists whose theory he studied very carefully, was Joan Robinson (1932). According to her, the economists could make those assumptions which were, on one hand, “manageable” and on the other hand “realistic”. When Coase started considering the question of defining the nature of the firm, he did his best to come up with the definition which had both of those features. Coase does lots of research on the nature of the firm which was suggested by economists for many years. The conventional theory states that the economic system works by itself, so all the choices which are made in such an economic system are only influenced by the direction of the prices in the market.
In order to destroy this point of view, Coase regards an economic system not only as a combination of price mechanism but also of planning which exists in the firms. Some research on that point was already done in the past. For example, “A. Marshall introduced organization as a fourth production factor and, in the 1920’s, J. B. Clark and Knight emphasized the coordinating function of the entrepreneur or manager, respectively. D. H. Robertson (1923), described firms in the market environment as “islands of conscious power in this ocean of unconscious co-operation” or, even more metaphorically, as “lumps of butter coagulating in a pail of buttermilk”[2]. However, the explanation of why those islands existed was only done by Coase.
The author also devoted lots of attention to the problem of why a company appears in a market economy, which was neglected by many economists in the past. There have certainly been some points of view of other economists on this matter but they were all not supported by grounds. The research has showed to Coase that “the essential reason for firms to emerge in the cost of using the price mechanism: that of discovering what the relevant prices are, that of negotiating and concluding a separate contract for each exchange transaction, and that of specifying longer period contracts (especially in the case of services).”[3] Those costs were given the name of at fist marketing costs and later transactions costs, and this term is being used widely now. Coase did lots of research on the way how the government can influence the size of firms and their existence through such mechanisms as taxes, donations.
There were many economists the readings of whose works were important for Coase to base his theory on and as well deploy some assumptions created by them. For example, Adam Smith, Alfred Marshall, Arthur Salter, Joan Robinson, Friedrich von Hayek were all considered very carefully by Coase and he was doing his best to build the concept of the firm based on the research provided by those economists. “According to Coase, classical market-based economics was not able to answer why industries were organized in different ways. Coase intuitively felt this idea to be incompatible with the factual diversity of organization throughout industries.”[4] One more issue which Coase studied very carefully, was Russia’s phenomenon. The way Lenin organized the economic system of his country was close to a large plant, and Coase was investigating this question in order to make contributions to his theory. He also had a good chance to implement his theory for the times of Great Depression in which he was leaving because that crisis in the economy offered him a very good base for the research.
2. What limitations do you associate with Coase’s analysis of the nature of the firm?
There are some limitations connected with the theory, which Coase has suggested. One of the most important limitations, which have been noticed by many writers, is the way Coase describes the nature of the firm. According to him, as well as some other economists who were supporting his point of view, a firm represents a “nexus of contracts”. This point can be supported by the statement of Coase himself, that “a firm… consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.”[5]. With this statement, Coase means that the firm is created by concluding different agreements according to the wish of the entrepreneur and his way of conducting business. Coase does not talk about other important features which have a great influence on the activity of the firm, for example a psychological factor, relationships between the employees and the manager of the company, between the employees themselves or with their customers. Those factors are not less important than the contracts which are signed while the firm is functioning.
Another piece of evidence, which proves Coase’s view on the firm as the “nexus of contracts”, can as well be found in his works: “A firm becomes larger as additional transactions (which could be exchange transactions co-ordinated through the price mechanism) are organized by the entrepreneur and becomes smaller as he (sic) abandons the organization of such transactions”[6]. According to Coase, the firm starts expanding and employing more people in the case when it begins to perform more transactions or transactions of a much larger volume. On the contrary, the firm gets smaller in the situation when the entrepreneur considers it more efficient to decrease the number of operations and deploy some people. The mechanism which regulates those actions which the entrepreneur takes is the price mechanism, according to Coase. Therefore, in his explanation of firms, the firm’s size is influenced by the number of the contracts which the firm is engaged in.
As we have seen, this model has some limitations, which need to be eliminated for the model of the firm to be more complete. In order to make up for the limitations which Coase’s theory suggests, other economists have been trying to take into consideration those aspects and create theories which did not bear those limitations. For example, Sosino argues that instead of being a nexus of contracts, a firm represents a “nexus of conversations”. According to Sosino, “Ronald Coase’s classic paper on the nature of the firm as a bundle or nexus of contracts spawned a series of papers in the 1970s and through the 1990s in which the firm was regularly construed as a nexus of contracts. Taking the language turn in organization theory (Alvesson and Kärreman, 2000) many people have progressed their thinking to the point where actually a theory of the organization as ‘a nexus of conversations’ more accurately reflects their worldview.”[7] Another economist who supported Sosino’s point of view was Foss. According to him, ‘the modern economics of organization … neglects those determinants of economic organization that are not related to incentive conflicts, such as information processing and organizational ‘codes’, ‘languages’ etc.”[8]
At present, many economists tend to be against Coase’s theory because of a large number of its limitations but nevertheless, they all agree that in the functioning of the firm, transaction costs play a very important role. However, there are many points of view which expand Coase’s theory. For example, Alchian and Demsetz (1972), as well as Jensen and Meckling (1976) were looking at the firm as the complex of relations among different individuals, the major role in which is being played by the shareholders and managers. The relations between managers and shareholders are very important because to a large extend, those relations define the profitability of the company. In some situations, the conflict of interests between shareholders and managers can lead to the problems in the company. Casson and Wadeson (1998) “proposed ‘conversations as a rational response to communication costs’. In practice firms often engage their suppliers, for instance, in a dialogue or conversation, and this idea can be extended, they suggested, to model all the forms of dialogue involved in the process of coordination, both within and between firms.”[9]
All of the ideas stated in Coase’s The Nature of the Firm had a very deep influence on the development of the economic thought in the middle of 20th century. Even though some of the parts of Coase’s theory are argued nowadays by many economists, the approach which was used by the author became a very solid base for the investigations of the concept of the firm many years after the work was published. Coase’s concept of transaction costs is still being used in the economic theory, and many conclusions he made were brilliant for his time.
Bibliography.
Berle, Adolf A. Jr., and Gardiner C. Means (1932): The Modern Corporation and Private Property. New York: Macmillan; reprint New Brunswick, NJ: Transaction Publishers, 1991.
Bolton, Patrick and David S. Scharfstein (1998): ‘Corporate Finance, the Theory of the Firm, and Organizations’, Journal of Economic Perspectives. Vol. 12, Fall 1998, pp. 95-114.
Coase, Ronald H. (1937): ‘The Nature of the Firm’, Economica. November 1937, pp. 386-405. Reprinted in Williamson, Oliver E. and Sidney G. Winter /eds./ (1991): The Nature of the Firm – Origins, Evolution, and Development. Oxford University Press, pp. 18-33.
Coase, Ronald H. (1960): ‘The Problem of Social Cost’, Journal of Law and Economics, October 1960, pp. 1-44. Reprinted in Coase, Ronald H. (1988): The Firm, the Market, and the Law. The University of Chicago Press, pp. 95-156.
Felder, Joseph (2001): ‘Coase Theorems 1-2-3’, American Economist. Spring 2001, Vol. 45, Issue 1, pp. 54-61.
Foss, Nicolai J. (1999) ‘Research in the strategic theory of the firm: “isolationism” and “integrationism”’ Journal of Management Studies 36(6): 725-755 Oxford: Blackwell
Ondrej Vychodil. Transaction Costs in Ronald Coase’s works. December 2001.
Robinson, Joan (1932): Economics is a Serious Subject.
Steven Sonsino. Recasting Coase: a Theory of the Organization as a Nexus of Conversations. Centre for Management Development. London Business School. February 2002.
Williamson, Oliver E. and Sidney G. Winter /eds./ (1991): The Nature of the Firm –Origins, Evolution and Development. Oxford University Press.
[1] Coase 1991, p. 199
[2] Ondrej Vychodil, 2001, p.2.
[3] Coase 1991, p. 205
[4] Ondrej Vychodil, 2001, p.3.
[5] Coase, 1937, p.391
[6] Coase, 1937, p.390
[7] Sosino, 2002, p.1
[8] Foss, 1999, p.12.
[9] Sosino, 2001, p.4.
