Coase, The Nature of the Firm

– The purpose of paper to bridge gap in econ theory bet. Assumption that
resources allocated by means of price mech and the assumption that this
allocation is dependent on the entrepreneour –cordinator.
– Why individuals choose partnership, companies, and other business entities
rather than trading bilaterally through contracts in a market
– Why do firms exist at all.
– Traditional economic theory says 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 be always cheaper to contract out than to hire.
– But there are transaction costs to using the market. There are search
and information costs, bargaining cost, trading secrets, etc. policing and
enforcements costs. This suggests that firms will arise when they can
arrange to produce what they need internally and somehow avoid
these costs.
– Also, natural limit to what can be produced internally. Decrease returns
to the entrepreneur function. Overhead cost and increase propensity for
managerial error as transactions increase.
– Size of firm is result of optimal balance between competing tendencies of
the costs outlined above. Decreasing returns to making firm larger.
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– Firm gets larger if:
○ 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.
– Basically firms form tecause transactions are cheaper.

– Substitution at the margin

– An economist thinks of the econ sys as being co-ordinated by the price
mechanism and society becomes not an organization but an organisms
– Prevalaen theory is that the direction of resources is dependent directly on
the price mech
– Internally, within a firm, a workman who goes from dep x to y doesn’t’ go
because of a change in relative prices, but because he is ordered to do so.
– If coordination will be done by price mech, then why are orgs necessary? Why
do they exist?
– Within firm, market transcactinos elim and in place of complic
market structure with exchange transactions is substituted the
entrepreneur-co-ordinator who directsr production. These are
alternative methods coordinating production.
– The price mech (considered purely fro side of directin of resources)
might be superseded if the relationship which replaced it was
desired for its own sake.
– The main reason why it is profitable to establish a firm would seem to be that
there is a cost of using the price mechanism. For ex.. “discovering what the
relevant prices are” is most ovvous cost of organizing production through the
price mech.
– A firm is likely therefore to emerge in those cases where a very short term
contract would be unsatisfactory.
– Operation of a market costs something and by forming an org and allowing
some authority (an entrepreneur) to direct resources, certain marking costs
are saved. The entrepreneur has to carry out his function at leass cost taking
into accountth fact hat he may get factors of production at a lower price than
the market transactions which he supersedes, because it always possible to
revert to the open market if he fails to do this.
– A firm therefore consists of the system of relationships which comes
into existence when direction of resources is depnendent on
entreprenru.
– What determines size of firm?
– Costs of organizing additional transactions within the firm may rise… fails to
make best use of factors of production. Diminishing returns to
management
– The point has been made in the prev paragraph that a firm will tend to
expand until the costs of organizing an extra transaction with 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.
– Some argue that div of labor is reason firms exist.
– Economic differentiation creates need for integrating force without which
differentiation would collapse into chaos. But price mechanism is the
integrating force. What has to be explained is why one integrating force
(entrepreneur) should be substituted for another integrating force (price
mech)(
– Efficiency will decrease the firm size
– Result of uncertain is tha people have to forecast future wants (another
theory). Arg against is that people can sell advice or knowledge
– Certainty leads to no org and no market transactions. All automatic.