THE NATURE OF THE FIRMThe Nature of the Firm was a brief but highly influential essay in which Coase tries to explain why the economy is populated by a number of business firms, instead of consisting exclusively of a multitude of independent, self-employed people who contract with one another. Coase asks, why and under what conditions should we expect firms to emerge knowing that productions could be carried on without any organization or firm?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.

Coase explained that firms exist because they reduce the transaction costs that emerge during production and exchange, capturing efficiencies that individuals cannot. Firms are like centrally planned economies, he wrote, they are formed because of people’s voluntary choices. But why do people make these choices? The answer, wrote Coase, is “marketing costs.” (Economists now use the term “transaction costs.”) If markets were costless to use, firms would not exist. Because markets are costly to use, the most efficient production process often takes place in a firm.

For clearer understanding, take for example a broken car. If you are the owner of the car and decided not to bring it to a mechanic shop (which is a firm) it will take you “marketing cost” to fix it by yourself. You need to buy those parts which need to be repair, tools to be used in repairing, fare in going to hardware stores, and effort and time to do the work. That is what Coase tries to explain on why firm exists. If you bring the car directly to the repair shop it won’t take you marketing cost in doing the repairing.

One useful way of thinking about the market is as a coordinating system. The price mechanism serves as a means for directing the flow of every resource to its highest valued use. Suppose that a hurricane hits New Orleans, and as a result the price of plywood increases. That increase in price performs an important coordinating function. As a Virginia resident, when I observe the price of plywood going up, I am induced to delay my plans to build a shed in my backyard. That is, I conserve plywood. This leaves more plywood available to go to New Orleans, where it is most needed. The price system is impersonal, meaning that I don’t even have to know or care about the people in New Orleans in order to behave in a way that is beneficial to them. We will talk much more about the role of prices in the next installment.

However, the market is only one of two main ways that resources are directed. The other mechanism is command and control. Within firms, the autonomous impersonal coordination of the price system is replaced by a conscious interpersonal coordination mechanism. The boss has to gauge or guess if employees are pulling their weight, and to figure out if there are enough computers and office space and coffee and so on. The whole purpose of a firm is to engage in production without the coordinating assistance of the market mechanism. Why should this be? Why would anyone want to avoid a system that sends resources to their highest valued use?

It must be the case that there are costs intrinsic to using the price system. These “transaction costs” include the cost of discovering what the relevant prices are and the cost of negotiating complete contracts that plan for all contingencies and eliminate opportunism. When an entrepreneur starts a firm, he is making a bet that he can direct resources within the firm with

enough efficiency so as to produce at a lower cost than the market could produce. That is, he is betting that he can economize on transaction costs. This, Coase argues, is the raison d’être of a firm.

Coase then asks, “[W]hy, if by organising one can eliminate certain costs and in fact reduce the cost of production, are there any market transactions at all? Why is not all production carried on by one big firm?” There must be some countervailing cost that increases with firm size that makes it uneconomical for firms to continue increasing their “insourcing” forever. The main answer that Coase gives is that it gets harder for the entrepreneur to direct resources as the number of resources increases. At some point, the firm is directing so many resources internally that the cost of directing one more resource is equal to the cost of just relying on the market to direct it, transactions costs and all.

The theory can now be used to discuss what affects firm size. Factors that decrease transaction costs or increase organizing costs will tend to make firms smaller. Factors that do the opposite will tend to make firms larger. One factor that increases transaction costs is taxes on market exchange. If it costs firms extra money in taxes to buy furniture, they may decide to make their own furniture in-house. A second factor is technology. As communications technology improves, it becomes cheaper to organize over a wider spatial area, increasing firm size. On the other hand, technology also reduces the cost of using the market, e.g. locating prices, and therefore would tend to reduce firm size. Coase also spends a fair bit of space contrasting his theory with Frank Knight’s theory of the firm. To sum up, using the price system is not free. The fact that there are transaction costs means that people will attempt to limit the number of their transactions to economize on these costs. This implies that they will seek alternative methods of directing resources, which we find in firms. The other method, command and control, does not scale well forever. Therefore, there are natural economic limits to the firm’s size.