Review: “The Nature of the Firm” – by Ronald Coase (1937)

This review aims to summarize and capture the main contents of famous article “The Nature of the Firm” of Ronald Harry Coase, published in Economica in 1937. At that time, economists in building up a theory, have often omitted to examine the foundations on which it was erected. In this paper, Ronald Coase intended to give not only a clear definition of the word “firm”, but also its difference from a firm in the real world, the theory where its assumptions may be both manageable and realistic.

I – The normal economic system

In searching for a definition of a firm, Coase (1937) first consider the economic system “as being co-ordinated by the price mechanism” (p.387) or the market in other word. According to economists in that period, “the normal economic system works itself. For its current operation it is under no central control, it needs no central survey” (p.387). “… The allocation of factors of production between different uses is determined by the price mechanism” (p. 387). “…The economic system works itself; this does not mean that there is no planning by individuals” (p.387). Moreover, Coase pointed out that “… there is planning within our economic system which is quite different from the individual planning mentioned and which is akin to what is normally called economic planning” (p.388).

Outside the firm, price movements [or market] direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these markets transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur co-ordinator, who directs production” (p.388).

II – Why a firm emerges in a specialized exchange economy

According to Coase, “there is a cost of using the price mechanism. The most obvious cost of “organizing” production through the price mechanism is that of discovering what the relevant prices are. This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information. The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account” (p.390-391).

A firm […] consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur” (p.393). Coase (1937) argued “… that if one contract is made for a longer period, instead of several shorter ones, then certain costs of making each contract will be avoided” (p.391). So, “the distinguishing mark of the firm is the super-session of the price mechanism” (p.389). And he defines “… a firm is likely therefore to emerge in those cases where a very short-term contract would be unsatisfactory” (p.391).

Then, Coase (1937) discuss about the firm size that is larger or smaller. “A firm becomes larger as additional transactions (which could be exchange transactions co-ordinated through the price mechanism) are organized by the entrepreneur and becomes smaller as he abandons the organization of such transactions” (p.394).

He poses then a question: why is not all production carried on by one big firm? “First, as a firm gets larger, there may be decreasing returns to the entrepreneur function, that is, the costs of organizing additional transactions within the firm may rise”. “Secondly, it may be that as the transactions which are organized increase, the entrepreneur fails to place the factors of production in the uses where their value is greatest, that is, fails to make the best use of the factors of production” (p.394-395).

In fact, there is a market transaction where entrepreneurs can evaluate the costs of organizing certain transactions within the firm, that is greater or smaller than the costs of carrying out the exchange transactions in the open market. Then they decide to expand or not. So, “a firm will tend to expand until the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organizing in another firm” (p.395).

Coase concludes: “Other things being equal, therefore, a firm will tend to be larger:

  1. the less 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 (or the less the rise) in the supply price of factors of production to firms of larger size” (p.396-397).

III – Reasons for the emergence and the existence of a firm in a specialized exchange economy

The reason for the existence of a firm is to be found in the division of labor […]. The firm becomes “the result of an increasing complexity of the division of labour… The growth of this economic differentiation creates the need for some integrating force without which differentiation would collapse into chaos; and it is as the integrating force in a differentiated economy that industrial forms are chiefly significant”” (p.398).

However, “this fact of uncertainty brings about the two most important characteristics of social organization. In the first place, goods are produced for a market, on the basis of entirely impersonal prediction of wants, not for the satisfaction of the wants of the producers themselves. The producer takes the responsibility of forecasting the consumers’ wants. In the second place, the work of forecasting and at the same time a large part of the technological direction and control of production are still further concentrated upon a very narrow class of the producers, and we meet with a new economic functionary, the entrepreneur …” (p.399-400).

As more transactions are organized by an entrepreneur, it would appear that the transactions would tend to be either different in kind or in different places. This furnishes an additional reason why efficiency will tend to decrease as the firm gets larger. Inventions which tend to bring factors of production nearer together, by lessening spatial distribution, tend to increase the size of the firm. Changes like the telephone and the telegraph which tend to reduce the cost of organizing spatially will tend to increase the size of the firm. All changes which improve managerial technique will tend to increase the size of the firm” (p.398).

IV – The cost-curve of the firm

It has sometimes been assumed that a firm is limited in size under perfect competition if its cost curve slopes upward, while under imperfect competition, it is limited in size because it will not pay to produce more than the output at which marginal cost is equal to marginal revenue. But it is clear that a firm may produce more than one product and, therefore, there appears to be no prima facie reason why this upward slope of the cost curve in the case of perfect competition or the fact that marginal cost will not always be below marginal revenue in the case of imperfect competition should limit the size of the firm” (p.401-402).

To determine the size of the firm, [Coase (1937) indicates that] we have to consider the marketing costs (that is, the costs of using the price mechanism), and the costs of organizing the different entrepreneurs and then we can determine how many products will be produced by each firm and how much of each it will produce” (p.403).

V – Fitness of the concept of a firm in with that existing in the real world

Finally, Coase (1937) explains “… the concept of a firm which has been developed fits in with that existing in the real world” “by considering the legal relationship normally called that of “master and servant” or “employer and employee”” (p.403).

“[His] …. definition of firm is realistic. Is it manageable? This ought to be clear; When we are considering how large a firm will be the principle of marginalism works smoothly” (p.404). “Management proper merely reacts to price changes, rearranging the factors of production under its control” (p.405).

VI – Dicussions

In conclusion, this paper of Coase (1937) provided a breakthrough on the significance of transaction costs and property rights for the institutional structure and functioning of the economy. It 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.

For this paper, in 1991, Coase was awarded the Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel. And taken into March, 2019, this paper has been cited more than 40,000 times according to Google Scholar. It continues to inspire new areas of inquiry. For example, on its 80th anniversary, an homage was paid to it by extending its logic to the field of blockchains.

 

Source: Ronald Coase (1937), “The Nature of the Firm”, Economica, New Series, Vol. 4, No. 16, pp. 386-405. doi.org/10.1111/j.1468-0335.1937.tb00002.x

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