"The Nature of the Firm" (1937), 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 contracts on a market.
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 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.
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 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.
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 and related modern information and communication technologies seem to lead to the existence of so called virtual organizations.
Coase does not consider non-contractual relationships, as between friends or family.
"Few other economists have been read and cited as often as R.H. Coase has been, even though, as he admits, ""most economists have a different way of looking at economic problems and do not share my conception of the nature of our subject."" Coase's particular interest has been that part of economic theory that deals with firms, industries, and markets—what is known as price theory or microeconomics.
He has always urged his fellow economists to examine the foundations on which their theory exists, and this volume collects some of his classic articles probing those very foundations. ""The Nature of the Firm"" (1937) introduced the then-revolutionary concept of transaction costs into economic theory. ""The Problem of Social Cost"" (1960) further developed this concept, emphasizing the effect of the law on the working of the economic system. The remaining papers and new introductory essay clarify and extend Coarse's arguments and address his critics.
"These essays bear rereading. Coase's careful attention to actual institutions not only offers deep insight into economics but also provides the best argument for Coase's methodological position. The clarity of the exposition and the elegance of the style also make them a pleasure to read and a model worthy of emulation."—
Lewis A. Kornhauser, Journal of Economic Literature
R. H. Coase
Ronald Harry Coase (born 29 December 1910) 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 Programmein 1927–29, Coase entered the London School of Economics, where he took courses with Arnold Plant. He received the Nobel Memorial Prize in Economics in 1991.
Coase is best known for two articles in particular: "The Nature of the Firm" (1937), which introduces the concept of transaction costs to explain the nature and limits of firms, and "The Problem of Social Cost" (1960), which suggests that well-defined property rights could overcome the problems of externalities. Coase is also often referred to as the "father" of reform in the policy for allocation of the electromagnetic spectrum, based on his article "The Federal Communications Commission" (1959), where he criticizes spectrum licensing, suggesting property rights as a more efficient method of allocating spectrum to users. Additionally, Coase's transaction costs approach is currently influential in modern organizational economics, where it was reintroduced by Oliver E. Williamson.
Another important contribution of Coase is the Coase Conjecture: an informal argument that durable-goods monopolists do not have market power because they are unable to commit to not lowering their prices in future periods.
Coase is research advisor to the Ronald Coase Institute, an organization that promotes research on the institutions - the laws, rules, customs, and norms - that govern real economic systems, with particular support for young scholars from developing and transitional countries.