The Nature of the Firm

 

Ronald Coase

Economica, new series, Vol. 4, No. 16 (November 1937), pp. 386-405

 

                                                Summarized by xiaoyang

                                                           2007-12-17

I. Abstract

 

This paper is to illustrate that “a definition of a firm may be obtained which is not only realistic in that it corresponds to what is meant by a firm in the real world, but is tractable by two of the most powerful instruments of economic analysis developed by Marshall”. The purpose of this paper is to synthesize two assumptions in economic theory: the assumption that resources are allocated by means of the price mechanism and that this allocation is dependent on the entrepreneur-co-ordination. Firms are the connection between these two. The nature of the firms is saving the costs of using price mechanism, and the size of the firm is determined by the trade off between transaction costs and management costs.

 

II. Structure of this paper

 

This paper was divided into 6 sections.

Introduction proposes the method with which this paper employed: “the idea of the margin and that of substitution, together giving the idea of substitution at the margin”.

 

Section I proposes questions: “it is usually argued that co-ordination will be done by the price mechanism, why is such organization necessary?”

 

Section II is the most value part of this paper. This section majorly analyzes two questions: why a firm emerges and how the boundary of a firm is determined.

 

Section III comments other theories about the emergence of firms, mainly on Frank Knight’s idea about uncertainty.

 

Section IV investigates how the number of products produced by a firm is determined, while no theory which assumes that only one product is in fact produced can have very great practical significance.

 

Section V deals with whether the concept of a firm which has been developed fits in with that existing in the real world.

 

III. What Gap the Paper has Filled

 

   Coase uses the basic economic tool----marginal analysis----to explain the nature of the firm and the determinants of the size of market. What factors make this paper to be a canon? Introducing transaction costs into economic analysis is the most admiral creation.

 

IV. Main points of the paper

   

   

1. If the price mechanism can allocate resource perfectly, why there are various economic organizations exits? That’s a question of why the allocation of resources is not done directly by the price mechanism. There must be some costs in using price mechanism. Economic organizations, mainly firms, are set to reduce this kind of costs by using order or economic planning. The nature of the firm is substituting market transactions with the entrepreneur-co-ordination. Three reasons are given to prove it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.

 

(1) The most obvious one is that it is costly to discover what the relevant prices are. This kind of cost can be reduced but can not be eliminated. Within a firm, factors of production are allocated by the directions of an entrepreneur. Firm is a contract can decrease the cost of using price mechanism and market transaction (later was developed to be transaction) because the there is no such kind of direction.

 

(2) Long-term contract has some more advantages over long-term one which maybe unsatisfactory. Including avoiding the cost of repeat contracting; less risk bearing; incompleteness of contrasts;

 

(3) “…exchange transactions on a market and the same transactions organized within a firm are often treated differently by governments or other bodies with regulatory powers.”

 

2. A further problem rises naturally. Given entrepreneur-co-ordination is more efficient than exchange transaction in the market, why is not all production carried on by one big firm? They must be some constrains accompanied by the advantages of the institution of the firm. It’s a problem of trade-off. The marginal analysis on the advantages and constrains to explain the size of the firm makes sense. Another three reasons are given to show the disadvantages in the process of being larger.

 

(1) As a firm expands, it’s becoming more difficult for the entrepreneur to direct producing. There may be decreasing returns to the entrepreneur function. Therefore, the costs of organizing additional transactions within a firm may rise. The main reason for the emergence of a firm is weakening in that process.

 

(2) As the transactions within a firm increase, the entrepreneur may fail to make the optimal allocation. (‘Diminishing returns to management’ together with (1))

 

(3) The supply price of factors of production may rise when a firm becoming larger.

 

3. Equilibrium----the boundary of a firm

 

According the principle of minimizing the costs, the optimal size of a firm can be determined. When the cost of organizing an extra (marginal) transaction within the firm equals to the costs of making such kind of transaction under price mechanism in the open market or in other firms, the firm cease expanding.

 

V. Characteristic of the model and the skills used

 

Coase is a representative of such kind of economists that insist observation rather than formal model. Not too many skills special in the analysis other than marginal analysis. But how to find appropriate trade-off related the issue is really skill-intensive.

 

VI. Comments on this paper

 

    Two questions discussed in this paper are seminal and arouse long-term echoes. On the emergence and nature of the firm, William proposed that assets specificity is the main reason for the existence of firms, when the transaction frequency of specified assets increases, it’s better to make a firm and exchange within in. Cheung (1983) also discussed the nature of firm by making comparison between market and firms with contract theory----the nature of a firm is a contract or a set of contracts of the transaction of factors of production. The main conception integrates those firm theories is the transaction cost. Although Coase didn’t use this term in this paper directly, no matter the nature or the size of a firm is a problem of reducing or substitute costs in using price mechanism. Transaction theory is the core of later contract theory and property right theory. Following Coase (1937) and Cheung (1983), New Classical Economics (ch.8, X. Yang, 2003) views the institution of the firm is a kind of (substitutive) division of labour---- when the transaction cost coefficient of labour is small than that of product, the firm is used to substitute product transaction with labour transaction. BUT the advantages of firms are explained mainly with the roundabout method of production which has economies to specialization (Young, 1928).