Thursday, 26 September 2013

Misunderstanding Coase.

At the Forbes website Steve Denning asks Did Ronald Coase Get Economics Wrong? I would say not, but Denning does get Coase wrong.

Denning writes,
Coase’s 1937 essay set out to explain why firms exist. The article asked: given that “production could be carried on without any organization at all”, and given that “the price mechanism should give the most efficient result,” why do firms exist? Coase’s answer was that firms exist because they reduce transaction costs, such as search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs.
The expression
production could be carried on without any organization at all
appears at the end of a paragraph in Coase's paper which begins with the sentence,
It is convenient if, in searching for a definition of a firm, we first consider the economic system as it is normally treated by the economist.
And of course the way the economic system was normally treated by the economists at the time was, implicitly but importantly, as a zero transaction cost system. As to the second expression noted by Denning
the price mechanism should give the most efficient result
I can't find it in Coase's paper and so don't know its context and thus what to make of it.

Denning continues,
These arguments were widely accepted by economists in the 20th Century and are still accepted by many today. But let’s face it: at least one of the starting assumptions of Coase’s article was flat out wrong, even in 1937. Although it’s true for simple commodities that “production could be carried on without any organization at all”, it is simply untrue that complex products and services such as airliners, smart phones or multi-disciplinary professional services “could be carried on without any organization at all.”
Here he has lost the plot entirely with regard to Coase's argument. As I noted above the expression “production could be carried on without any organization at all” occurs in a discussion of the standard, zero transaction cost, approach to the study of the economic system. In such a world production can and would be carried out without organisations such as firms since such organisations would have no reason to exist. As I have noted before, Nicolai Foss summaries the situation as,
With perfect and costless contracting, it is hard to see room for anything resembling firms (even one-person firms), since consumers could contract directly with owners of factor services and wouldn’t need the services of the intermediaries known as firms.
The zero transaction cost world is a world of perfect and costless contracting, that is, a world within which complete contracts can be written. This means that firms serve no purpose, markets can do everything.

But it wasn't a starting assumption of Coase's theory. To quote Coase,
The world of zero transaction costs has often been described as a Coaseian world. Nothing could be further from the truth.It is the world of modern economic theory, one which I was hoping to persuade economists to leave.
The starting point of Coase's theory is assumption of positive transaction costs, it is only in such a world that firms make any sense at all for Coase. That was the basic point Coase was trying to make For 80 years he was saying positive transaction costs matter, let us leave the world of zero transaction costs, - blackboard economics, as he called it - behind and study the world as it really is, a world with positive transaction costs.

Denning goes on to say,
Those products and services [complex products and services such as airliners, smart phones or multi-disciplinary professional services] require collaboration for their very existence. The economic reason that such organizations exist is that they provide value to customers that could not be produced without an organization.
Such collaboration could occur across markets if transaction costs are low compared to the costs of carrying out the transaction in a firm. If transactions are high then Coase wold say that a firm would be formed.

Following this Denning notes,
Coase’s theory did help explain the spread of big hierarchical bureaucracies of the 20th Century built on economies of scale. In the 20th Century, firms could generally succeed by pushing products and services at customers with greater efficiency than smaller firm
If economics of scale result in lower costs of management compared to transaction costs then firms would tend to be larger. As Coase said,
Other things being equal, therefore, a firm will tend to be larger :
(c) the greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size.
However in a world of low transaction cost there is no reason that things like large fixed costs can not be handled across the market. With complete contracts organising large amounts of capital present no insurmountable problems.

Denning also states,
But even in narrow economic terms, Coase’s theory was just plain wrong.
When properly understood it becomes clear that Coase's theory is fine, its Dennings arguments that are wrong.

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