2018-03-05 concepts

Coase's nature of the firm

Hey all -

Be forewarned: this one’s a bear, so there’s only one concept this time. But I think, if my interpretation is correct, this reading in particular can really change how we think about business and management.

+ what I learned or rediscovered recently #

* The nature of the firm

As an economics major, I always heard Ronald Coase’s “The Nature of the Firm” thrown around, but I never looked into it - it felt too abstract. Like, why do we have firms employing people, instead of contractors just providing services to each other? Don’t know… but don’t really care either when it’s presented like that.

Recently I was spontaneously motivated to the read the actual paper and I think I’ve found a better way to present it. It seems much more useful now.

We all know the economy is important. It has this kind of superpower, called “emergent order,”[1] where we get an orderly system for the production of goods and services when no one told it how much to produce. No one tells the bakery to stock up more bread - people simply demand more of it, pay more for it, and the bakery eventually starts supply more bread (or another bakery pops up which does). Through supply, demand and price, the economy produces just as much stuff as people want, and no more.

The key here is that all of these transactions are mediated through this all-powerful price mechanism. Want more of something? Pay more, so the price goes up. Don’t need it anymore? Then offer less for it, so the price goes down. How much society collectively wants of something all goes through this lever: price.

Now here’s something odd. We have this wonderful system - the market - which allocates resources (i.e. what people want and don’t want) exceptionally well using the price mechanism. And yet, there’s an entire system of production that doesn’t use prices at all: the firm!

Think about it. You, as an employee, go to work, and someone tells you what to do. In fact, your boss, and their boss, all the way up to the CEO, tells everyone what to do. There’s no emergent order here - this is central planning to the max.

Why don’t we just use prices here? Why don’t employees (but really let’s just think of them as freelancers) skip the firm entirely and provide their services through the all-powerful price mechanism? That’s what the market does, and that seems to work pretty well.

Now we’re getting somewhere. In investigating the nature of the firm, Ronald Coase wondered why we have firms at all. Why isn’t everybody just a freelancer setting prices?

Clearly we have two ways of coordinating production: the price mechanism, and then what Coase called the entrepreneur mechanism. That’s your boss telling you what to do.

Why would the entrepreneur mechanism ever be better than the price mechanism? This would explain why we see firms, because then entrepreneurs could coordinate production more cheaply by hiring people than by paying a bunch of freelancers.

Well, Coase pointed out, there are actually some costs to using the price mechanism. For example, you have to see if the price you’re paying for a particular service - say repairing your house - is a complete rip-off or not. So you have to spend some time researching prices and getting better information - these are called “search costs.” You may need several contracts with each contractor, and you may have to negotiate every little detail - what a hassle. And here’s a major one: you have to pay taxes! You have to pay sales tax on every single transaction you make using the market.

To summarize, some of the major frictions we see in the price mechanism are: search costs, negotiating costs, legal costs, keeping trade secrets, enforcement costs, taxes, and other regulatory intervention[2].

Now let’s imagine we have some entrepreneur. She hires a bunch of people for their labor and - voilà - no more taxes whenever you ask people to do something! You don’t have to sign a new contract for every request; you don’t have to worry about re-negotiating every time; and you don’t have to worry about “search costs” for finding a better price - you just tell them what to do!

Here we see that this central planner - this entrepreneur - may actually direct production better (i.e. at a lower cost) than that market system. Alas, we’ve justified the existence of a firm.

But Coase goes one step further: why don’t firms grow forever then? Why don’t firms just get so big until they hire everyone on the planet?

Well, in entrepreneur-land, all is not rainbows and unicorns. There are also costs of using the entrepreneur mechanism. To start, you have to coordinate all these people. In practice, this is really hard, so we see “decreasing [marginal] returns to the entrepreneur function” as the firm grows larger[3]. Beyond just coordination to get things done, the entrepreneur also has to perform the function of the market: namely, allocate resources efficiently to the right groups to produce the right things in the right amounts. This was done automatically through the price mechanism in the market - now the entrepreneur has to do it all manually.

If those costs of the entrepreneur mechanism are too high, then it actually makes sense to go use the price mechanism on the open market. Now we’ve answered our second question: firms will continue to grow until the cost of the entrepreneur mechanism exceeds the cost of the price mechanism.

What does this mean in less technical language? We have firms because some enterprising individuals are convinced they can direct the production of goods and services better than the market. Yes, there will be organizational inefficiencies and some resource misallocation, but overall, it’s still better than paying a bunch of contractors to get things done.

Now, to take this full-circle. A lot of people think management is just overhead. And a lot of it probably is. But look what good management has to do: they have to coordinate labor - for the production of goods and services - at a cheaper cost than the market. There’s no automatic price lever they can rely on here. They have to do it all manually.

This is not trivial. The market serves our everyday needs fairly well. And yet, because we see firms all around us, we know that the entrepreneur mechanism to some degree must produce goods and services even more efficiently than the price mechanism (which, to reiterate, is not cheap either).

Of course, this is only true if entrepreneurs coordinate labor and allocate resources well[4]. The takeaway: these must be core functions of the firm - in fact they justify its very existence.

So whenever you think of a business selling widgets or whatever, don’t just think of its core competency as selling widgets. You could sell widgets. The reason a firm is selling widgets is because the entrepreneur mechanism was cheaper than the price mechanism. And hopefully, if I’ve presented that correctly, it reveals just how important the functions of organizational efficiency, management and coordination within the firm are.

Thanks for reading,


[1] You can read more about this here.

[2] For example, maybe the government sets a price floor for the services of all carpenters, so now you have to pay more for that service.

[3] One way to reduce this organizational cost is to, as we see in practice, have some geographical proximity: most of your people work in the same city or headquarters.

[4] “All changes which improve managerial technique will tend to increase the size of the firm.”