The Nature of the Firm

"The Nature of the Firm" (1937) is an 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. The author was awarded the Nobel Memorial Prize
in Economic Sciences in 1991 in part due to this paper. Despite the honor, the paper was written
when Coase was an undergraduate and he described it later in life as "little more than an
undergraduate essay."[1]

The article argues that firms emerge because they are better equipped to deal with the transaction
costs inherent in production and exchange than individuals are.[2][3] Economists such as Oliver
Williamson,[4] Douglass North,[5] Oliver Hart, Bengt Holmström, Arman Alchian and Harold Demsetz
expanded on Coase's work on firms, transaction costs and contracts.[2] Economists and political
scientists have used insights from Coase's work to explain the functioning of organizations in
general, not just firms.[3][4] Coase's work strongly influenced the New Economics of Organization
(New Institutional Economics).[3]

Coase's article distinguished between markets as a coordination mechanism and firms as a

coordination mechanism.[6]

Summary

Given that production could be carried on without any organization, Coase asks, 'Why and under
what conditions should we expect firms to emerge?'[7] 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.[8]

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.[8]

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.[8]

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.[8]

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 (ceteris paribus), 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.[8]

Coase does not consider non-contractual relationships, as between friends or family.[8]

Reactions

In 1991, Coase was awarded the Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in
Memory of Alfred Nobel. His paper provided a breakthrough on the significance of transaction costs
and property rights for the institutional structure and functioning of the economy.[9]
The paper has 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. According to Google Scholar,
the paper has been cited more than 40,000 times as of March 2019.

This article was famously referred by Yochai Benkler in his article "Coase's Penguin, or, Linux and
The Nature of the Firm",[10] where he links Coase's essay to the emergence of commons-based peer
production communities using the Internet. In particular, Benkler considers the commons-based
peer production a third alternative coordination mechanism for economic transactions besides the
dichotomy composed of markets and hierarchies. In the article's title, ‘penguin’ refers to the logo of
the Linux operating system, invoking the challenge it poses to Coase's work by working through
different mechanisms than those present in markets and firms. Resolving this challenge, according
to Benkler, lies in substituting the role of transaction costs in Coase's work with the concept of
information opportunity costs when explaining the emergence of commons-based peer production.

The World Bank's 2019 World Development Report on The Changing Nature of Work[11] suggests that
firms and production processes become less vertically integrated as technology makes it cheaper
to resort to the open market to complete portions of the production process.

See also

Economic analysis of law Business and

Economics portal
"The Problem of Social Cost"

Theory of the firm

Notes

Coase, Ronald (1937). "The Nature of the Firm". Economica. 4 (16). Blackwell Publishing: 386–
405. doi:10.1111/j.1468-0335.1937.tb00002.x (https://doi.org/10.1111%2Fj.1468-0335.1937.tb00
002.x) . JSTOR 2626876 (https://www.jstor.org/stable/2626876) .

References

1. Levi, Edward H. "Ronald Coase still stirs debate at 101" (https://www.uchicago.edu/features/20

120423_coase/) . The University of Chicago. Retrieved 2020-10-26.
 2. "Coase's theory of the firm" (https://www.economist.com/schools-brief/2017/07/29/coases-th
eory-of-the-firm) . The Economist. ISSN 0013-0613 (https://www.worldcat.org/issn/0013-061
3) . Retrieved 2020-09-12.

3. Moe, Terry M. (1984). "The New Economics of Organization" (https://dx.doi.org/10.2307/21109

97) . American Journal of Political Science. 28 (4): 739–777. doi:10.2307/2110997 (https://do
i.org/10.2307%2F2110997) . ISSN 0092-5853 (https://www.worldcat.org/issn/0092-5853) .
JSTOR 2110997 (https://www.jstor.org/stable/2110997) .

4. Williamson, Oliver E. (1981). "The Economics of Organization: The Transaction Cost Approach"
(https://dx.doi.org/10.1086/227496) . American Journal of Sociology. 87 (3): 548–577.
doi:10.1086/227496 (https://doi.org/10.1086%2F227496) . ISSN 0002-9602 (https://www.wor
ldcat.org/issn/0002-9602) . S2CID 154070008 (https://api.semanticscholar.org/CorpusID:154
070008) .

5. North Douglas C. (1982). Structure & change in economic history (http://worldcat.org/oclc/6789

02839) . W.W. Norton. ISBN 0-393-95241-X. OCLC 678902839 (https://www.worldcat.org/ocl
c/678902839) .

6. Powell, Walter W. (1990). Research in organizational behaviour : an annual series of analytical

essays and critical reviews (http://worldcat.org/oclc/23188932) . JAI Press. pp. 295–336.
ISBN 1-55938-029-2. OCLC 23188932 (https://www.worldcat.org/oclc/23188932) .

7. R. H. Coase; Economica, New Series, Vol 4, Issue 16 (Nov., 1937), 386-405. is the actual quote
from pp. 388 "if production is regulated by price movements, production could be carried on
without any organisation at all, well might we ask, why is there any organisation?" but the
paraphrase in the wiki article is far more lucid and should be kept.

8. "Summary of Coase: The nature of the firm -- Adam Brown, BYU Political Science" (https://ada
mbrown.info/p/notes/coase_the_nature_of_the_firm) . adambrown.info. Retrieved
2020-04-07.

9. "Nobel Prizes and Laureates" (https://www.nobelprize.org/nobel_prizes/economic-sciences/la

ureates/1991/press.html) . Press Release. Nobel Media. 15 October 1991. Retrieved 2 July
2018.

10. Benkler, Yochai (2002). "Coase's Penguin, or, Linux and "The Nature of the Firm" ". The Yale Law
Journal. 112 (3): 369–446. arXiv:cs/0109077 (https://arxiv.org/abs/cs/0109077) .
doi:10.2307/1562247 (https://doi.org/10.2307%2F1562247) . JSTOR 1562247 (https://www.j
stor.org/stable/1562247) . S2CID 16684329 (https://api.semanticscholar.org/CorpusID:1668
4329) .
11. World Bank World Development Report 2019: The Changing Nature of Work. (http://document
s.worldbank.org/curated/en/816281518818814423/pdf/2019-WDR-Report.pdf)

External links

The Legal Structure of the Firm, Accounting, Economics, and Law (https://web.archive.org/web/2
0111122061936/http://www.bepress.com/ael/vol1/iss1/5/) , Vol. 1 : Iss. 1, Article 5, by Jean-
Philippe Robé, 2011 Jean-Philippe Robé
Oliver Williamson Biography - The Library of Economics and Liberty (https://www.econlib.org/libra
ry/Enc/bios/Williamson.html) by David R. Henderson