Why firms?

Why the firm? Ronald Coase, a Nobel economist who died last week at the age of 102, was among the first to ask the question, in a 1937 article on the nature of the firm . His starting point was to notice the discrepancy between the way economic systems were described in theory and the reality of the firm: “An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organization but an organism. The economic system ‘works itself.’” Of course, people calculate and make decisions but “this theory assumes that the direction of resources is dependent directly on the price mechanism.”

But “within a firm, the description does not fit at all.” Changes in prices don’t cause re-allocations of resources and energies. Rather, “in the real world” an employee moves from “department Y to department X” not because of prices but “because he is ordered to do so.” He quoted DH Robertson, who referred to firms as “islands of conscious power in this ocean of unsconsious co-operation,” comparing them to “lumps of butter coagulating in a pail of buttermilk.” Coase concluded that the “mark of the firm is the supersession of the price mechanism,” the intervention of economic planning between the price mechanism and the movement of resources and energy. He wanted to “bridge what appears to be a gap in economic theory between the assumption (made for some purposes) that resources are allocated by means of the price mechanism and the assumption (made for other purposes) that this allocation is dependent on the entrepreneur co-ordinator.” If the former were true, why would such coordination be necessary at all?

One answer might be that people supersede the price mechanism because they prefer the alternative, the organization of economic activity by a manager. Perhaps some people want “to work under the direction of some other person.” That doesn’t explain the firm, since it seems that many want to work on their own, be their own master.

The real answer, he argued, must be that “there is a cost of using the price mechanism.” One cost is the problem of discovering what the prices are. But there are other disadvantages to relying entirely on the price mechanism: “It may be desired to make a long-term contract for the supply of some article or service . . . . A firm is likely to emerge in those cases where a very short-term contract would be unsatisfactory.” Taxation and regulation may also make direct dependence on prices inefficient. As Andrew Wilson explains in a Weekly Standard profile of Coase, “Imagine the extraordinary difficulty that a Henry Ford or a William Boeing would have faced in trying to contract out for every part and every task going into the manufacturing and assembly of a car or airplane. Hence the need for the visible hand of management in coordinating the allocation of resources.” Companies exist to reduce what Coase called the “transaction costs” of pure individual economic activity and unmediated reliance on the fluctuation of prices.

Coase also recognized that the form of the firm might change under the impact of technological changes: “Most inventions will change both the costs of organizing and the costs of using the price mechanism. In such cases, whether the invention tends to make firms larger or smaller will depend upon the relative effect of these two sets of costs. For instance, if the telephony reduces the costs of using the price mechanism more than it reduces the costs of organizing, then it will have the effect of reducing the size of the firm.” Thus the information revolution has the effect of reducing the size of companies, changing the form of the firm. Many got caught in the middle of the transition, expecting large firms to remain large.