The Nature of the Firm

“The Nature of the Firm” authored by British economist Ronald Coase in 1973 introduced the concept of transaction costs as an explanation for why firms exist and how they operate. The impact of this paper, along with Coase’s “The Problem of Social Cost,” earned him the Nobel Prize in Economics in 1991. Having been introduced to Coase through a Natural Resource Economics course last quarter, I wanted to dive in to his seminal contribution to Economics and one of its subfields, the theory of the firm.

In writing “The Nature of the Firm,” Ronald Coase aimed to provide a realistic definition of a “firm” and to answer the question of why firms exist given that if the allocation of production inputs is purely determined by prices, then production could be done outside of an organization. Which is to say that according to basic economic principles of the time, there should be no reason for companies to exist — it should be cheaper to contract out work that is necessary for producing something to specialists in the economy.

By the time of the paper’s publishing, economists did recognize that prices could not wholly account for the way firms allocate resources, but Coase was the first to present an intuitive explanation based in economic principles for why people choose to allocate resources in firms.

In his essay, Coase describes production outside of a firm as being determined by price movements from market transactions, whereas inside of a firm, production is directed by an “entrepreneur coordinator” (think “founder” or a group of executives).The link between production factors being allocated by a firm through a price mechanism versus an entrepreneur coordinator would be found in the reason firms develop in the first place.

Classically in economics, when people do something that does not make sense according to prevailing principles or understandings of a market, it means that the established alternative must, in reality, have costs associated with it that makes it less rational of a choice.

Thus, Coase theorized that there must be costs associated with using a price mechanism, including the cost of learning relevant prices and establishing long-term contracts, as well as costs placed on market transactions (like sales tax) by regulatory bodies. It would therefore be more profitable to establish a firm where resources can be allocated by a central authority, where production may come at a lower cost than the alternative of engaging in multiple costly market transactions.

As such, Coase defined a firm as being “…the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.”

Under Coase’s theory, transactions could similarly provide a way of understanding the size of firms, with a firm becoming larger or smaller depending on the number of transactions its entrepreneur coordinator organized. All other things being equal, Coase finds that a firm would be larger given (i) low costs of organizing production and such costs emerging slowly with increased transactions, (ii) a low chance of the entrepreneur coordinator making mistakes and those mistakes increasing slowly with greater transactions, and (iii) larger firms in the market having a lower supply of factors of production than the given firm.

Thus, through “The Nature of the Firm,” Ronald Coase established a new lens for understanding firms through the concept of transaction costs, paving the way for further inquiries in to the theory of the firm and modern-day industrial organization.

Abhishek Joshi is an Economics and Informatics student at the University of Washington — Seattle.

Cover image originally from Rutgers University.