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The Nature of the Firm

R.H. Coase (1937)

Sociology 224
February 9, 2010

Mary Carol Mazza


HBS
Introduction I. II. III. IV. V. Questions

Introduction
 Problem:
 Economists often fail to examine the foundations of
economic theory

 Coase proposes:
 to show a definition of the firm that both:
-corresponds to the real world meaning of the word
-tractable by tools of economic analysis (idea of the
margin and substitution)

-
I. The Economic System
as Treated by Economists
Introduction I. Economic System: Economists vs. Coase II. III. IV. V. Questions

Economists View of
Coases View of
Economic System
Economic System
 Price mechanism Outside the firm:
determines the allocation
Price movements direct
of the factors of
production, coordinated
production
through exchange
 The process is automatic, transactions on the market
responsive, and elastic: it
Within the firm:
adjusts supply to demand
The entrepreneur directs
and production to
consumption production
Introduction I. Economic System: Economists vs. Coase II. III. IV. V. Questions

Why is there an organization?


What is the distinguishing mark of the firm?

 Outside the firm: Price movements direct production


 Inside the firm: Entrepreneur directs production (because


there are no market transactions within the firm)

 **Mark of the Firm  the supersession of the price


mechanism (by some organizational director/person)
Introduction INTRO
I. Economic
STUDY
System:
1 STUDY
Economists
2 STUDY
vs. Coase
3 STUDY
II. 4 III.
DISCUSSION
IV. V. Questions

Purpose of the Paper


“bridg[ing] the apparent gap in economic theory
between the assumption that resources are
allocated by the price mechanisms for some
purposes and by the entrepreneur-co-ordinator for
others” (p.389)
II. Why does a firm emerge in a
specialized exchange economy
Introduction
INTRO
I. II. STUDY
Why a 1firm STUDY
emerges
2 in STUDY
specialized
3 STUDY
exchange
4 economy
DISCUSSION
III. IV. V.
Questions

Why does a firm emerge in a specialized


exchange economy?
**There is a cost to using the price mechanism
(“transaction costs” or “marketing costs”)

Finding out prices


Negotiating separate contracts
Difficulty creating long-term contracts

The firm: saves costs by allowing an entrepreneur


to direct resources
Introduction
INTRO
I. II. STUDY
Why a 1firm STUDY
emerges
2 in STUDY
specialized
3 STUDY
exchange
4 economy
DISCUSSION
III. IV. V.
Questions

Definition of the Firm


 A firm “consists of the system of relationships
which comes into existence when the direction of
resources is dependent on an entrepreneur” (p.393).

 This definition imparts scientific meaning to the
idea of a firm getting larger or smaller
Introduction
INTRO
I. II. STUDY
Why a 1firm STUDY
emerges
2 in STUDY
specialized
3 STUDY
exchange
4 economy
DISCUSSION
III. IV. V.
Questions

Can we treat the determinants of the size of


the firm scientifically?
 In response to Knight:
 If the firm, by definition, reduces marketing/production
costs, why are there any market transactions at all?
 Why not one big firm?

 Diminishing marginal returns (increasing marginal costs of
organizing more transactions within the firm)

 Decreasing returns of managerial ability (misallocation of
resources, knowledge, etc)

 Potential for rising supply prices
Introduction
INTRO
I. II. STUDY
Why a 1firm STUDY
emerges
2 in STUDY
specialized
3 STUDY
exchange
4 economy
DISCUSSION
III. IV. V.
Questions

Can we treat the determinants of the size of


the firm scientifically?
 A firm will tend to be larger:
1)The lower the costs of organizing and the slower
these costs rise with an increase in the
transactions organized
2)The less likely the entrepreneur is to make mistakes
and the smaller the increase in mistakes with an
increase in the transactions organized
3)The greater the lowering in the supply price of factors
of production to firms of larger size

III. Why the price mechanisms needs to
be substituted by the entrepreneur
Introduction INTRO
I. II. III.STUDY
Why 1
this explanation
STUDY 2 STUDY
of firm3emergence
STUDY 4is preferredIV.
DISCUSSION V. Questions

Why is Coase’s reason for the emergence of


the firm to be preferred over others?

 Others: Firm exists because of division of labor


 The firm integrates these various parts that
came about from economic differentiation

 …BUT

 Coase says: The price mechanism already existed


as an integrating force
Introduction I.
INTRO
II. III. STUDY
Why the
1 entrepreneur
STUDY 2 substitutes
STUDY 3 STUDY
for price
4 mechanism
DISCUSSION
IV. V. Questions

Why one integrating force (the entrepreneur)


Needs to substitute for another (price mechanism)

 Professor Knight: the firm exists because of Uncertainty!


 People have to forecast future wants (special class
arises who directs the activities and guarantees
wages)
 But they could just sell their advice

 It would be odd for one man to guarantee another a


result from the other’s work without being given
power over his work
 But that is what contracts are for
 But even without uncertainty, there would need to
be coordinators…never says why price mechanism
should be superseded
IV. The Cost Curve of the Firm
Introduction
INTRO I. STUDY
II. 1 III.
STUDY
IV. The
2 Cost
STUDYCurve
3 of
STUDY
the Firm
4 DISCUSSION
V. Questions

The Cost Curve of the Firm


 Prior discussion of firm size based on the simplifying


assumption that only one product will be produced.
 MC=MR
 The number of products produced by a firm is determined
by:
 A point where it’s less costly to organize the exchange
transactions of a new product than to organize further exchange
transactions of the old product (including marketing costs & costs of
organizing different entrepreneurs)

V. The Firm:
Realistic and Manageable?
Introduction I. II. III. IV. V. Concept fit with real world and manageable? Questions

Is this concept of the firm realistic and


is it manageable
 Examining the relationship of servant/master
(employer/employee):
1)The servant must render personal services to the
master/on his behalf
2)The master must have the right to control the
servant’s work
  Agent vs Servant: the freedom with which an agent
carries out his employment
Introduction I. II. III. IV. V. Concept fit with real world and manageable? Questions

Is this concept of the firm realistic and


is it manageable

Scope of the firm is determined at the margin


Marginal Cost of organizing an additional


transaction within the firm equals the cost of
alternative institutional arrangements (ie: another
firm or the market)
Introduction
Introduction
I. II. I. II.III. III. IV.
IV. V. Questions
V. Questions

Questions…

 So Coase’s definition of a firm might have worked


for 1937 (and maybe into the 1970s when other’s built
on his work), but in 2010, how relevant is Coase?

 If Coase were to revise his “Theory of the Firm” for


today’s world, what would he change?
Introduction I. Summary
II. III. IV. V. Questions


Give a clear definition of what is meant by a
“firm” in economics that is both realistic
(corresponds to general usage) and manageable
for economic analysis. Bridge the gap in economic
theory between assumptions of allocation by price
mechanism and by fiat of the entrepreneur.
Under what conditions one or the other? Why do
firms emerge at all in a specialized economy? (if it is
a matter if information efficiency, independent
consultants and specialists could do just as well) A
firm consists of the system of relationships that
come into being when the direction of resources
is dependent on an entrepreneur. Distinguishing
mark of firm is the supersession of pure price
mechanism (i.e., pricing is not only thing that guides
the emergence of firms)
Introduction I. Summary
II. III. IV. V. Questions


The main reason why it is profitable to establish a firm
is that there is a cost of using the price mechanism
(transaction cost). a) the cost of price information, b)
the cost of making separate contracts for each
exchange transaction (Firms reduce these contracts to
one, the employee’s salary and range of duties), c) risk
attitudes, firms prefer long-term contracts, but
uncertainties involved require a vague contract, d)
external actions: sales tax on market exchange (but not
inside firm) , quotas, and rationing all would raise
transaction costs outside the firm. “The operation of a
market costs something and by forming an organization
and allowing some authority (an “entrepreneur”) to direct
the resources, certain marketing costs are saved.” (p.
392)
Introduction I. Summary
II. III. IV. V. Questions


You can also use these conceptions to
describe and predict changes in the size of
firms. Growth occurs when more (types or
volume of) transactions are organized by the
entrepreneur. Maximum size of firms
corresponds to the point at which it is no longer
cheaper to organize transactions “in house”
compared to the market. Two ways a firm can
expand: combination occurs when transaction
originally done by 2 or more entrepreneurs
become organized by one; integration occurs
when transactions between entrepreneurs on the
market become organized by one.
Introduction I. Summary
II. III. IV. V. Questions


So, all else equal, a firm will tend to be
larger if it faces a) decreased cost of organizing
and slower cost increase if transaction
organized b) decreased likelihood of
entrepreneur making mistakes c) increased
lowering of supply price factors of production.


 Influenced wlliamson

The End