Monday, 9 September 2013

Mises, Coase and central planning

One way to think of firms is that they are small centrally planned "economies". But if they are, Why do they work? After all Mises started the socialist calculation debate by arguing that central planning can't work and yet firms do work, and in some cases for very long periods of time. Perhaps the oldest still existing (multinational) firm is the Roman Catholic Church. Ekelund and Tollison  argue that ``[t]he longest-running institution in Western culture and arguably one that has had an enormous influence on Western civilization has been the Roman Catholic Church". Ekelund et al note that ``[t]he formal character of the Catholic Church, the single institution that come to embody Christianity in its official capacity, emerged as a result of the Edict of Milan in A.D. 313". In an endnote they explain that the edict meant that ``[ ... ] the Church became the recognized legal holder of property". Micklethwait and Wooldridge write ``[t]he oldest existing private-sector company in Europe is probably Stora Enso of Sweden, whose direct ancestor, a copper mine, began trading in 1288 and was issued with a royal charter in 1347". In Japan Kongo Gumi was founded by a Korean in Osaka in 578 and is a builder of Buddhist temples, Shinto shrines and castles—and now also offices, apartment buildings and private houses. It looks like it succumbed to excess debt and an unfavourable business climate in 2006. Not a bad run however.

So what is the relationship between Mises and Coase? A reading of Murray N. Rothbard's essay "Ludwig von Mises and Economic Calculation Under Socialism" suggests an answer. In this article Rothbard explains that Mises's argument about the impossibility of socialism can be applied to the problem of the size of firms. Rothbard argues that
There is one vital but neglected area where the Mises analysis of economic calculation needs to be expanded. For in a profound sense, the theory is not about socialism at all! Instead, it applies to any situation where one group has acquired control of the means of production over a large area - or, in a strict sense, throughout the world. On this particular aspect of socialism, it doesn't matter whether this unitary control has come about through the coercive expropriation brought about by socialism or by voluntary processes on the free market.
In other words it can apply to a firm.

Rothbard continues
[ ... ] Mises analysis also supplies us the answer to the age-old criticism leveled at the unhampered, unregulated free-market economy: what if all firms banded together into one big firm that would exercise a monopoly over the economy equivalent to socialism? The answer would be that such a firm could not calculate because of the absence of a market, and therefore that it would suffer grave losses and dislocations. Hence, while a Socialist Planning Board need not worry about losses that would be made up by the taxpayer, One Big Firm would soon find itself suffering severe losses and would therefore disintegrate under this pressure. We might extend this analysis even further. For it seems to follow that, as we approach One Big Firm on the market, as mergers begin to eliminate capital goods markets in industry after industry, these calculation problems will begin to appear, albeit not as catastrophically as under full monopoly. In the same way the Soviet Union suffers calculation problems, albeit not so severe as would be the case were the entire world to be absorbed into the Soviet Union with the disappearance of the world market. If, then, calculation problems begin to arise as markets disappear, this places a free-market limit, not simply on One Big Firm, but even on partial monopolies that eradicate markets. Hence, the free market contains within itself a built-in mechanism limiting the relative size of firms in order to preserve markets throughout the economy.
Rothbard then notes that this argument is related to Coase's argument about the size of firms.
This point also serves to extend the notable analysis of Professor Coase on the market determinants of the size of the firm, or of the relative extent of corporate planning within the firm as against the use of exchange and the price mechanism. Coase pointed out that there are diminishing benefits and increasing costs to each of these two alternatives, resulting, as he put it, in ah " 'optimum' amount of planning" in the free market system. Our thesis adds that the costs of internal corporate planning become prohibitive as soon as markets for capital goods begin to disappear, so that the free market optimum will always stop well short not only of One Big Firm throughout the world market but also of any disappearance of specific markets and hence of economic calculation in that product or resource. Coase stated that the important difference between planning under socialism and within business firms on the free market is that the former "is imposed on industry while firms arise voluntarily because they represent a more efficient method of organizing production." if our view is correct, then, this optimal free-market degree of planning also contains within itself a built-in safeguard against eliminating markets, which are so vital to economic calculation
While Rothbard makes a telling point about the limits of monopoly in free markets, the issue of the size of the firm that Coase was interested in, I would argue, was what determined the size of the firm well before the firm gets to the point where it takes over entire input markets.

Mises's argument (and Rothbard's) utilises the idea that under socialism, by definition, there are no markets for the factors of production and thus no prices and therefore economic calculation is not possible. But here we have a difference between Mises and Coase: Coase assumes there are markets for all factors of production, thus economic calculation is possible for firms. Such calculation may be costly, as there are transactions costs, but under socialism there are no markets and thus calculation isn't just difficult it is impossible. Thus in the Coaseian view of the firm we have "central planning" with markets, rather than the central planning without markets inherent in socialism.

What causes firms to stop expanding before they get to the Rothbard's point? For Coase there are costs to using the market - transaction costs as we now call them - and there are costs to using the firm. The size of the firm is determined when these two cost are equal. But this is probably the weakness part of Coase's argument since he does really make clearly exactly what the costs of management and transaction costs are. Oliver Williamson has argued that the reason for the limited use of Coases's ideas for nearly 40 years was the fact that transaction costs had not be made "operational". As to management costs we are told in a general way about decreasing returns to management and the "individualistic spirit of the smaller entrepreneurs [who] prefer to remain independent". These reasons haven't fully satisfied economists. As Oliver Hart has mentioned,
Coase’s questions about why firms and markets co-exist are brilliant, but his answers are less satisfactory.
Making transaction costs and management costs clearer and operational has driven much of the research on the theory of the firm since the 1970s. Two examples of this being the development of the transaction costs approach to the firm and the property rights approach.

Thus size does matter, at least when it comes to the possibility of planning. Planning works at the small scale but but fails at the large.

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