Ronald Coase on the Nature of the Firm: Are economists clueless, or what?

Ronald Coase

Ronald H. Coase who died on September 3rd at the age of 102, won the Nobel Prize for economics partly in recognition of his 1937 paper, The Nature of the Firm. In that paper, Coase, in a series of long shapeless paragraphs, claims to answer the question why, in a market economy where the factors of production are supposed to be allocated between different uses by the price mechanism, are there firms within which the allocation of resources is determined by management fiat, something equivalent, in a limited sphere, to the central planning of which the Soviets made such a catastrophic disaster.

Specifically, Coase asks, why does a firm emerge at all in a market economy?

It's a good question to which there seems a rather simple answer, but the rather simple answer is not the one that Coase gives. 

So what is Coase's answer?

The main reason, he says, why it is profitable to establish a firm "would seem to be that there is a cost of using the price mechanism. The most obvious cost of of 'organising' production through the price mechanism is that of discovering what the relevant prices are. The cost of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account."

But within a firm, says Coase: "A factor of production (or owner thereof) does not have to make a series of contracts with the factors with whom it is co-operating within the firm, as would be necessary, of course, if this co-operation were a direct result of the working of the price mechanism."

So there you have it: according to Coase, firms exist because they allow planned allocation of economic resources, which eliminates the transaction costs of the free market.

Coase wrote his paper on the nature of the firm in 1937 when many British intellectuals saw the Soviet system as the wave of the future, which raises the question whether Coase's ideas had a political coloring. But whether or not that is the case, a weakness of his theory is that it suggests no obvious reason for the failure of the Soviet planned economy, or the deadly consequences of Mao's experiments in top-down allocation of economic resources.

Before proceeding, we might therefore ask, why is it that firms or entrepreneurs are supposed to be able to organize economic resources successfully outside the market system, whereas states cannot? To which the answer is that, in fact, not all firms can, as the bankruptcy of many confirms. Moreover, it is incorrect to assume that states cannot, since that is what all states attempt with, at times, apparent success (consider state pension, unemployment, healthcare, and educational benefits, or the success of Russia's Soviet era space program).

So the question that Coase might have usefully considered is this: why are some firms and some states successful in organizing the factors of production, whereas others are not. And the answer to that can be stated without acres of turgid prose. To put it shortly, the answer is that it's a matter of knowledge intelligently applied. Some managers possess relevant knowledge, others do not. Some managers apply knowledge intelligently, others do not. And there's also luck. Thus, organization of economic resources without adequate information or sufficient intelligence generally means failure, whereas sound information intelligently applied often results in success.

Trouble is, the application of intelligence and information is not automatic, either within a firm or by a government. In a diversified economy without monopolies, failure of firms is not catastrophic since it clears the way for the greater success of firms that allocate resources effectively. But all states are monopolies. Therefore, state planning always runs the risk of state-wide economic failure as happened in Communist China and the Soviet Union.

Upon reflection, it will be seen that beyond the simplest tasks, little can be achieved without planning, which in turn requires the education of a workforce to perform the various aspects of the overall project. Such deployment of knowledge is not possible within a pure market system, where all work must be contracted to freelance individuals at liberty to pursue other opportunities at a moment's notice. This is made apparent by considering as a prototype of the firm, the artisan and his assistant:

The cobbler has more orders that he can fulfill. He can raise his prices, thus raising his profit while keeping demand in line with his unaided supply, but that would mean some citizens going bare-foot and it would earn him a reputation as a price gouger. He could contract out the work to an unskilled person ready to accept a low wage, but then the work would be poorly done if not totally botched. Or he could contract the work to the cobbler in a neighboring town, but then the extra supply would cost as much as he could reasonably sell it for, while adding considerably to the aggravation of his business.

But there is a third option, which is to hire an assistant and delegate to him some part of the work to be done under the cobbler's instruction and close supervision. In return for performing this lowly function, the assistant would receive benefits equal to less than the extra income the cobbler earns by virtue of the extra output made possible by the labor of his assistant. In time, the assistant may learn all parts of the cobbler's trade in which case he may become a full partner with the cobbler or set out on his own and in competition with his erstwhile employer. Until then, however, the cobbler earns a profit from the application of his knowledge to the close direction of the labor of another.

That, in essence, and ignoring the role of the firm in the deployment of capital, is why firms exist. Firms that embody valuable information deployed with genius, for example Apple under the direction of Steve Jobs, or Tesla with Elon Musk,* tend to generate large profits. When the genius that creates a successful firm quits, dies or loses their way, the firm fails and ceases to exist. Firms are thus a key feature of any market economy, and it is the market that establishes which firms live and which die.

Possibly, I have misrepresented Coase's theory of the firm, but if so, I have to say his manner of presentation is so obscure that the message is unintelligible to me even though, for more than 25 years I successfully managed a firm, the product formulas for which have now been acquired by other firms and continue, so it appears, to yield income.

There are two lessons to be learned from the theory that firms exists to allow the intelligent deployment of special information by talented entrepreneurs. First, that monopolism, whether state or private, risks failure of part or all of an economic system, from which it follows that the long-term viability of an economy depends on a competitive free market in which natural selection ensures the survival of only the more productive firms. Second, firms that are taken over by financiers and bean-counters are almost surely doomed as the absence of intelligence applied to the productive process will result in a failure to adapt in an evolving marketplace.

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* With hindsight, the choice of Elon Musk and Tesla as an example of a potentially profitable firm may have been mistaken.