The Nature of the Firm
Encyclopedia
'The Nature of the Firm' (1937) 4(16) Economica
386–405, is an influential 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 contract
s on a market.
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.
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.
Coase noted, however, that there are a number of transaction cost
s 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 secret
s, 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.
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.
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, 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 organization
s.
Coase does not consider non-contractual relationships, as between friends or family.
Economica
Economica is a peer-reviewed academic journal of economics published on behalf of the London School of Economics by Wiley-Blackwell. It was established in 1934...
386–405, is an influential article by Ronald Coase
Ronald Coase
Ronald Harry Coase is a British-born, American-based economist and the Clifton R. Musser Professor Emeritus of Economics at the University of Chicago Law School. After studying with the University of London External Programme in 1927–29, Coase entered the London School of Economics, where he took...
. It offered an economic explanation of why individuals choose to form partnerships, companies and other business entities rather than trading bilaterally through contract
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
s on a market.
Summary
Given that "production could be carried on without any organization that is, firms at all", Coase asks, why and under what conditions should we expect firms to emerge? Since modern firms can only emerge when an entrepreneurEntrepreneur
An entrepreneur is an owner or manager of a business enterprise who makes money through risk and initiative.The term was originally a loanword from French and was first defined by the Irish-French economist Richard Cantillon. Entrepreneur in English is a term applied to a person who is willing to...
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.
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.
Coase noted, however, that there are a number of transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...
s 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 secret
Trade secret
A trade secret is a formula, practice, process, design, instrument, pattern, or compilation of information which is not generally known or reasonably ascertainable, by which a business can obtain an economic advantage over competitors or customers...
s, 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.
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.
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, 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
Internet
The Internet is a global system of interconnected computer networks that use the standard Internet protocol suite to serve billions of users worldwide...
and related modern information and communication technologies seem to lead to the existence of so called virtual organization
Virtual organization
Several unrelated things are named virtual organization:* In business an organization that can take one of the following forms:** a business which operates primarily via electronic means; see virtual business...
s.
Coase does not consider non-contractual relationships, as between friends or family.