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The Nature of the Firm

December 18, 2023

"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]

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 edit

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 less the costs of organizing and the slower these costs rise with an increase in the transactions organized.
  • the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organized.
  • the greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size.

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 edit

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 40,000 times as of March 2019.

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 edit

Notes edit

  • Coase, Ronald (1937). "The Nature of the Firm". Economica. Blackwell Publishing. 4 (16): 386–405. doi:10.1111/j.1468-0335.1937.tb00002.x. JSTOR 2626876.

References edit

  1. ^ Levi, Edward H. "Ronald Coase still stirs debate at 101". The University of Chicago. Retrieved 2020-10-26.
  2. ^ a b "Coase's theory of the firm". The Economist. ISSN 0013-0613. Retrieved 2020-09-12.
  3. ^ a b c Moe, Terry M. (1984). "The New Economics of Organization". American Journal of Political Science. 28 (4): 739–777. doi:10.2307/2110997. ISSN 0092-5853. JSTOR 2110997.
  4. ^ a b 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.
  5. ^ North Douglas C. (1982). Structure & change in economic history. W.W. Norton. ISBN 0-393-95241-X. OCLC 678902839.
  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. ^ a b c d e f "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.

External links edit

  • , Vol. 1 : Iss. 1, Article 5, by Jean-Philippe Robé, 2011 Jean-Philippe Robé
  • Oliver Williamson Biography - The Library of Economics and Liberty by David R. Henderson

December 18, 2023
nature, firm, 1937, article, ronald, coase, offered, economic, explanation, individuals, choose, form, partnerships, companies, other, business, entities, rather, than, trading, bilaterally, through, contracts, market, author, awarded, nobel, memorial, prize, . 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 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 Holmstrom 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 Contents 1 Summary 2 Reactions 3 See also 4 Notes 5 References 6 External linksSummary editGiven 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 less the costs of organizing and the slower these costs rise with an increase in the transactions organized the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organized the greater the lowering or the less the rise in the supply price of factors of production to firms of larger size 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 editIn 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 40 000 times as of March 2019 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 edit nbsp Business and Economics portalEconomic analysis of law The Problem of Social Cost Theory of the firmNotes editCoase Ronald 1937 The Nature of the Firm Economica Blackwell Publishing 4 16 386 405 doi 10 1111 j 1468 0335 1937 tb00002 x JSTOR 2626876 References edit Levi Edward H Ronald Coase still stirs debate at 101 The University of Chicago Retrieved 2020 10 26 a b Coase s theory of the firm The Economist ISSN 0013 0613 Retrieved 2020 09 12 a b c Moe Terry M 1984 The New Economics of Organization American Journal of Political Science 28 4 739 777 doi 10 2307 2110997 ISSN 0092 5853 JSTOR 2110997 a b 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 North Douglas C 1982 Structure amp change in economic history W W Norton ISBN 0 393 95241 X OCLC 678902839 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 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 a b c d e f Summary of Coase The nature of the firm Adam Brown BYU Political Science adambrown info Retrieved 2020 04 07 Nobel Prizes and Laureates Press Release Nobel Media 15 October 1991 Retrieved 2 July 2018 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 World Bank World Development Report 2019 The Changing Nature of Work External links editThe Legal Structure of the Firm Accounting Economics and Law Vol 1 Iss 1 Article 5 by Jean Philippe Robe 2011 Jean Philippe RobeOliver Williamson Biography The Library of Economics and Liberty by David R Henderson Retrieved from https en wikipedia org w index php title The Nature of the Firm amp oldid 1183553920, wikipedia, wiki, book, books, library,

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