before we start - who wrote ‘the nature of the firm’?

Ronald Coase wrote this research paper published in Economica 1937, which won a nobel in 1991. He got inspiration for this paper when visited the US on a scholarship at the age of 21.

He spent the next year interviewing business leaders and touring facilities. Many of the people he spoke to would go on and on about the idea of an ‘invisible hand’. The invisible hand refers to the fact that the free market perfectly coordinates supply and demand and rather than explain what the hand is, people believed in this ‘hand’.

Coase did not like this explanation, rather you get the vibe that he knows there ought to be an actual reason, and the choice to overlook this makes traditional economists lazy. His counter is saying that if the market automatically allocates resources, then there is no reason for a company to exist.

Anywho now that you know his beef with lazy economists treating firms and the economy as a black box, the ‘human condition’, and the motivation to be thorough, we can start his paper.

Introduction

When studying the economy, it is EXTREMELY important to state your assumptions so decision-making is better. Coase describes why it is important, but I did not find anything significant to mention here.

ANY assumption in economics must be TRACTABLE and REALISTIC. but more often than not:

if a theory is realistic: it is not trackable
if a theory is tractable with math, then it relies on unrealistic assumption

Coases’ goal is create a definition for a firm that is both realistic and trackable.

I - in search of a definition of a firm

What do we currently believe?

We believe the economy works itself. It has no central control
The invisible hand automatically adjusts demand and consumption into a balance

What assumption does this theory make?

That the direction of resources (like any transaction) is completely dependent on price

BUT - this is not observed in the real world

Say we have the price of product A is higher in company X than in Y
So consumers would move from X to Y.
But products X and Y also represent departments within a firm. Here a boss can order someone to work on X. So he works on X, not because of price but because he’s being ordered to.

Analogy - think of the economy as ice cubes in a bucket of water

in the water (economy), the production is directed by complex system of price movements and exchanges
Inside the ice (firm), complex structure is replaced by strict entrepreneur-worker relationship who directs production. Here we have centralized planning. Coase says the firm ‘supersedes’ the complex open market with its own strict centralized control.

II - why firms emerge?

Firstly - What if firms exist just because people have an emotional preference for working in a hierarchy instead of on the open market?

It can’t be because of emotional reasons. Like some people like being bosses and some like being workers. but it does not tractably describes the firms existence

Lets first define the price mechanism

it refers the cost of using the open market, which we call transaction cost.
these transaction costs include costs accrued from searching, negotiating, and actually making exchange transactions.

firms deal with less transaction costs

since firms deal with less transaction costs -> they dont rely on price mechanism

example Imagine someone places long term order for product. But it is difficult to predict demand.

The longer the contract, the less possible it is for the customer to specify what the company is expected to do. So these details are specified later. You can’t get this on the open market.

Firms specifically emerge because the future is too unpredictable to rely on individual market contracts.

the opposing theory of why firms exist (professor knight’s theory)

Knight says firms exist because of uncertainty and people’s adverse reaction to risk. Argues that the paycheck structure (getting a guaranteed, fixed wage) is the entire reason a firm exists.

Coase: this is irrelevant. Aan independent freelancer on the open market can sign a contract for a fixed, guaranteed payment. You don’t need a boss for a steady paycheck.

Coase moves back to his question: Why do we stop using the open market and start letting bosses tell us what to do? (And his answer, as always, is transaction costs).

Another factor of why trandsaction costs are lower in firms?

there is less transaction cost WITHIN a firm. These encourage firms growth over the open market, but its not a reason for why firms exist

Ok. but Coase - can you tell us scientifically why its like that?

Knights’ definition of when a firm gets larger or smaller:

Firms size is determined by ‘personality and historical accident’ over actual principles
Firms don’t get infinitely big : there is an opposing force that makes them less efficient as they get bigger.

Coase: Knights’ theory is lazy and GARBAGE.

Coases’ on why the world isn’t one giant firm?

As firm gets larger, organising additional transactions may increase cost, up until it is = open market (diminishing returns)
As number of transactions increase, it is harder for entrepreneurs to make efficient (diminishing returns). Again increase until price = market

He describes this as: Firms limit because of diminishing returns to management and the rising costs of organizing internal transactions.

BUT, there is a paradox:

If 1 firm can’t get too big, then two firms can handle different parts of the supply chain still below market prices?

The Setup: Firm A and Firm B trade on the market because both currently operate below their maximum efficiency limits.

The Reality: Firm B handles multiple production stages; if Firm A wants to eliminate market fees entirely, it cannot just absorb one task—it must swallow Firm B’s entire complex operation.

The Decision: Firm A will only merge if the massive internal cost of managing all of B’s operations is cheaper than just paying the open market transaction fee

our major assumption:

we assumed transactions are homogenous.
note that transaction costs vary heavily: so the open market with ALWAYS exist alongside firms
BUT, transaction diversity does not explain why we have many firms

so how do firms grow?

Efficient Management (Lower Bureaucracy Costs): A firm will grow larger if it is simply cheaper to organize tasks internally
Better Decision Making: A firm can get much bigger if the entrepreneur is highly skilled at avoiding errors. [so improving management techniques = bigger firm]. also, bringing factors of produciton closer (lessen the chaotic distribution), helps firm grow (think of the invention of phone).
Scale advantage: firm get better deals on resources

we have 2 ways a firm can expand:

Combination is when a transaction organized by 2+ entrepreneurs is now organized by 1
This is integration when it involves organizing transactions previously carried out between entrepreneurs

III - disproving other explanations of why firms emerge

Usher and Dobb argue

Firms exist because of complexity of dividing labour. Firms act as the integrating force that keeps labour together

Coase calls them stupido:

He says the economy already has an integrating force - the ‘open market’ coordinates labour automatically
Economists already agree that as long as open market exists, division of labor does not lead to chaos

Professor Knight argues

In a perfect world where everyone knows the future, the economy would run without firms
But real life has a lot of uncertainty which splits people into two groups: the confident and venturesome (Entrepreneurs), and doubtful and timid (regular workers)

Brave people take financial risk and guarantee wages to workers in exchange for power

Coase: this theory does not explain why people choose firms over open market

You don’t need to be a firm to be brave and make good decisions (consulting)
Control is still taken even without guaranteed payments (consulting)

IV - relating this to ‘cost curve of the firm’

Defining the cost curve = graph that shows how much it costs a company to produce goods as it gets bigger. in theory people use the cost curve to predict how big a firm will get

Mainstream theory

Firm expands until the cost to make one extra item equal money they get from selling it (marginal revenue). Coase’s:
This theory assumed a company is only allowed to make 1 product
If product B’s cost curve gets too high, the firm expands to products A and C. it doesn’t stop growing

So the cost curve is not a good indicator of when a company will stop growing if it plans to make to products.

is our firm definition realistic?

Firstly: Employees vs independent contractors

Contractor (the market): you buy the fruits of their labour, do not tell how to do their job
Employee (firm): the boss has legal right to control the servant The difference is not how they get paid (fixed vs variable), but the freedom they have to approach the work The law says defining characteristics of employment relationship is control

Coase reaches same conclusion

Firm exists the moment when open market’s price is superseded by an entrepreneur’s direct command
This lines up perfectly with real-world definition

Is my definition manageable?

Yes. you can plug my theory in with math to calculate when a firm should stop growing

Business owners constantly experiment to find balance between internal and market costs - It is a moving equilibrium

business owners must always forecast the future by making contracts, and manage the existing team within the firm to always be efficient