The Nature of the Firm

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"The Nature of the Firm" (1937) is an article by Ronald Coase. It offered an economic explanation of why individuals choose to form partnerships, companies, and other business entities rather than trading bilaterally through contracts on a market. The author was awarded the Nobel Memorial Prize in Economic Sciences in 1991 in part due to this paper. Despite the honor, the paper was written when Coase was an undergraduate and he described it later in life as "little more than an undergraduate essay." [1]

Contents

The article argues that firms emerge because they are better equipped to deal with the transaction costs inherent in production and exchange than individuals are. [2] [3] Economists such as Oliver Williamson, [4] Douglass North, [5] Oliver Hart, Bengt Holmström, Arman Alchian and Harold Demsetz expanded on Coase's work on firms, transaction costs and contracts. [2] Economists and political scientists have used insights from Coase's work to explain the functioning of organizations in general, not just firms. [3] [4] Coase's work strongly influenced the New Economics of Organization (New Institutional Economics). [3]

Coase's article distinguished between markets as a coordination mechanism and firms as a coordination mechanism. [6]

Summary

Given that production could be carried on without any organization, Coase asks, 'Why and under what conditions should we expect firms to emerge?' [7] Since modern firms can only emerge when an entrepreneur of some sort begins to hire people, Coase's analysis proceeds by considering the conditions under which it makes sense for an entrepreneur to seek hired help instead of contracting out for some particular task. [8]

The traditional economic theory of the time suggested that, because the market is "efficient" (that is, those who are best at providing each good or service most cheaply are already doing so), it should always be cheaper to contract out than to hire. [8]

Coase noted, however, that there are a number of transaction costs to using the market; the cost of obtaining a good or service via the market is actually more than just the price of the good. Other costs, including search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs, can all potentially add to the cost of procuring something via the market. This suggests that firms will arise when they can arrange to produce what they need internally, and somehow avoid these costs. [8]

There is a natural limit to what can be produced internally, however. Coase notices "decreasing returns to the entrepreneur function", including increasing overhead costs and increasing propensity for an overwhelmed manager to make mistakes in resource allocation. This is a countervailing cost to the use of the firm. [8]

Coase argues that the size of a firm (as measured by how many contractual relations are "internal" to the firm and how many "external") is a result of finding an optimal balance between the competing tendencies of the costs outlined above. In general, making the firm larger will initially be advantageous, but the decreasing returns indicated above will eventually kick in, preventing the firm from growing indefinitely.

Other things being equal (ceteris paribus), a firm will tend to be larger:

The first two costs will increase with the spatial distribution of the transactions organized and the dissimilarity of the transactions. This explains why firms tend to either be in different geographic locations or to perform different functions. Additionally, technology changes that mitigate the cost of organizing transactions across space will cause firms to be larger—the advent of the telephone and cheap air travel, for example, would be expected to increase the size of firms. On a related note the use of the internet and related modern information and communication technologies seem to lead to the existence of so-called virtual organizations. [8]

Coase does not consider non-contractual relationships, as between friends or family. [8]

Reactions

In 1991, Coase was awarded the Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel. His paper provided a breakthrough on the significance of transaction costs and property rights for the institutional structure and functioning of the economy. [9]

The paper has had an outsized impact on the field of microeconomics, particularly in essentially inventing the body of research that deals with the theory of the firm. According to Google Scholar, the paper has been cited more than 59,000 times as of September 2024.

This article was famously referred by Yochai Benkler in his article "Coase's Penguin, or, Linux and The Nature of the Firm", [10] where he links Coase's essay to the emergence of commons-based peer production communities using the Internet. In particular, Benkler considers the commons-based peer production a third alternative coordination mechanism for economic transactions besides the dichotomy composed of markets and hierarchies. In the article's title, ‘penguin’ refers to the logo of the Linux operating system, invoking the challenge it poses to Coase's work by working through different mechanisms than those present in markets and firms. Resolving this challenge, according to Benkler, lies in substituting the role of transaction costs in Coase's work with the concept of information opportunity costs when explaining the emergence of commons-based peer production.  

The World Bank's 2019 World Development Report on The Changing Nature of Work [11] suggests that firms and production processes become less vertically integrated as technology makes it cheaper to resort to the open market to complete portions of the production process.

See also

Notes

Related Research Articles

<span class="mw-page-title-main">Ronald Coase</span> British economist and Nobel laureate (1910–2013)

Ronald Harry Coase was a British economist and author. Coase was educated at the London School of Economics, where he was a member of the faculty until 1951. He was the Clifton R. Musser Professor of Economics at the University of Chicago Law School, where he arrived in 1964 and remained for the rest of his life. He received the Nobel Memorial Prize in Economic Sciences in 1991.

In economics, industrial organization is a field that builds on the theory of the firm by examining the structure of firms and markets. Industrial organization adds real-world complications to the perfectly competitive model, complications such as transaction costs, limited information, and barriers to entry of new firms that may be associated with imperfect competition. It analyzes determinants of firm and market organization and behavior on a continuum between competition and monopoly, including from government actions.

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<span class="mw-page-title-main">Externality</span> In economics, an imposed cost or benefit

In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's activity. Externalities can be considered as unpriced components that are involved in either consumer or producer market transactions. Air pollution from motor vehicles is one example. The cost of air pollution to society is not paid by either the producers or users of motorized transport to the rest of society. Water pollution from mills and factories is another example. All (water) consumers are made worse off by pollution but are not compensated by the market for this damage. A positive externality is when an individual's consumption in a market increases the well-being of others, but the individual does not charge the third party for the benefit. The third party is essentially getting a free product. An example of this might be the apartment above a bakery receiving some free heat in winter. The people who live in the apartment do not compensate the bakery for this benefit.

<span class="mw-page-title-main">Market failure</span> Concept in public goods economics

In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher Henry Sidgwick. Market failures are often associated with public goods, time-inconsistent preferences, information asymmetries, non-competitive markets, principal–agent problems, or externalities.

In economics, a transaction cost is a cost incurred when making an economic trade when participating in a market.

<span class="mw-page-title-main">Oliver E. Williamson</span> American economist (1932–2020)

Oliver Eaton Williamson was an American economist, a professor at the University of California, Berkeley, and recipient of the 2009 Nobel Memorial Prize in Economic Sciences, which he shared with Elinor Ostrom.

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From a legal point of view, a contract is an institutional arrangement for the way in which resources flow, which defines the various relationships between the parties to a transaction or limits the rights and obligations of the parties.

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A Pigouvian tax is a tax on any market activity that generates negative externalities. A Pigouvian tax is a method that tries to internalize negative externalities to achieve the Nash equilibrium and optimal Pareto efficiency. The tax is normally set by the government to correct an undesirable or inefficient market outcome and does so by being set equal to the external marginal cost of the negative externalities. In the presence of negative externalities, social cost includes private cost and external cost caused by negative externalities. This means the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. Often-cited examples of negative externalities are environmental pollution and increased public healthcare costs associated with tobacco and sugary drink consumption.

<span class="mw-page-title-main">Douglass North</span> American economist and Nobel laureate (1920–2015)

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Commons-based peer production (CBPP) is a term coined by Harvard Law School professor Yochai Benkler. It describes a model of socio-economic production in which large numbers of people work cooperatively; usually over the Internet. Commons-based projects generally have less rigid hierarchical structures than those under more traditional business models.

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References

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  2. 1 2 "Coase's theory of the firm". The Economist. ISSN   0013-0613 . Retrieved 2020-09-12.
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  4. 1 2 Williamson, Oliver E. (1981). "The Economics of Organization: The Transaction Cost Approach". American Journal of Sociology. 87 (3): 548–577. doi:10.1086/227496. ISSN   0002-9602. S2CID   154070008.
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  6. Powell, Walter W. (1990). Research in organizational behaviour : an annual series of analytical essays and critical reviews. JAI Press. pp. 295–336. ISBN   1-55938-029-2. OCLC   23188932.
  7. R. H. Coase; Economica, New Series, Vol 4, Issue 16 (Nov., 1937), 386-405. is the actual quote from pp. 388 "if production is regulated by price movements, production could be carried on without any organisation at all, well might we ask, why is there any organisation?" but the paraphrase in the wiki article is far more lucid and should be kept.
  8. 1 2 3 4 5 6 "Summary of Coase: The nature of the firm -- Adam Brown, BYU Political Science". adambrown.info. Retrieved 2020-04-07.
  9. "Nobel Prizes and Laureates". Press Release. Nobel Media. 15 October 1991. Retrieved 2 July 2018.
  10. Benkler, Yochai (2002). "Coase's Penguin, or, Linux and "The Nature of the Firm"". The Yale Law Journal. 112 (3): 369–446. arXiv: cs/0109077 . doi:10.2307/1562247. JSTOR   1562247. S2CID   16684329.
  11. World Bank World Development Report 2019: The Changing Nature of Work.