Thursday, 21 August 2014

Coase's view of the firm

An obituary of Ronald Coase appeared in the first issue of the new journal he helped set up, Man and the Economy. The piece is by Ning Wang, Coase's co-author of his last book "How China Became Capitalist". At one point Wang discusses Coase's 1937 paper "The Nature of the Firm". He notes that Coase asked a very simple question, if everything in a market economy is coordinated by the price mechanism, as claimed in standard economics textbooks, "Why does a firm emerge at all in a specialized exchange economy?" The answer we now know as transaction costs.
The answer was not that the firm performed some magic that the market could not. Rather, Coase found that using the market itself was not free. The costs of using the pricing mechanism, which have become known as transaction costs, give rise to the firm.
For his [Coase's] purpose, the discovery of transaction costs in the working of the market economy was sufficient as a novel explanation of the firm. For Coase, transaction costs were more an empirical finding than an analytical invention. Their nature and magnitude could only be unveiled through a cumulative interplay of empirical investigations and theoretical refinement. Attempts to elaborate the concept on purely analytical ground, without systematic empirical studies, would not bring much clarity.
A question that Coase's answer gave rise to is, what is the relationship between the market and the firm?
Coase’s explanation of the firm has led many to view the firm and the market as substitutes. Observing the ubiquity of firms in a market economy, Coase inferred that there must exist a cost of using the pricing mechanism. Otherwise, coordination among specialized agents could all be done through the market. From a static point of view, the firm and market present two competing mechanisms to organize business transactions, a choice later often referred to as "to make" versus "to buy" in the literature. In the real dynamic world, the firm and the market are the two main types of business organizations that make up the economy. They complement each other as well as substitute each other.
Seeing markets and firms as substitutes often results in economists seeing the creation of firms as an answer to market failure. But, I have often wondered, why is it we see market failure as giving rise to rises rather than "firm failure" giving rise to markets?
The rise of the firm in a market economy does not imply "market failure" or the triumph of "selective intervention" on the part of the firm. Selective intervention would require the firm (or its manager) to know ex ante its advantages relative to the market and to act accordingly. This information requirement is far too demanding to be met in reality even if the firm has the correct incentives to collect and act on the relevant information. Coase urged us to come to terms with the fact that no economic institution is perfect.
The impossibility of firms having the needed information for selective intervention has a Hayekian feel to it. Perhaps not too surprising given that Hayek as at the LSE during Coase's time there.

Also in the same issue of Man and the Economy is a two part interview between Wang and Coase. Part 1 having taken place on December 28 and 29, 2010 and Part 2 on May 4 and 5, 2013. Part 2 of the interview contains the following exchange:
Wang: Microeconomics is about demand and supply. Compared with classical economics, marginal analysis clearly offers a deeper understanding of consumer choice. But I don’t think it is equally powerful in explicating production, the supply side of the economy.

Coase: To understand production, we have to go back to Adam Smith’s division of labor. It serves well as a starting point, even though the modern economy today has become far more complicated.

Wang: This must be Smith’s most undeserving failure. Modern economics is built on Smith’s framework of the “invisible hand”. But it leaves no room for the division of labor.

Coase: Modern economics shows little interest in production. I am not sure production function tells us anything about production in the economy.

Wang: Adam Smith used the pin factory as an example to develop his analysis of the division of labor. Today, to investigate the division of labor, we can no longer afford to confine our focus to a single firm. Instead, we have to study the organizational structure of production.

Coase: That’s right. The firm remains the cell of the economy, but the intricate relations and constant interactions among the cells determine economic dynamism.
Coase and Wang (2011) also emphasises the importance of the division of labour,
Price theory is primarily concerned with resource allocation, with little to say about production and innovation. The study of the industrial structure of production offers a research program to bring the division of labor back to the center of economics, with direct implications for the study of innovation and entrepreneurship.
Interesting that even as late as 2013 Coase thought that standard economics still took little interest in the production side of the economy. Per Bylund made the same point a couple of years earlier,
[t]he theory of the firm has been a neglected area of study in mainstream economics. Despite Ronald Coase bringing the issue up for discussion in 1937, it was not on the research agenda until the 1970s. Even now, as both Coase and Oliver Williamson, the founder of and prominent scholar in the transaction cost-focusing analysis of firm organization, have received the Nobel Prize in economics, the area remains in the periphery of economic analysis (Bylund 2011: 189).
But the more interesting point is the emphasis Coase puts on the division of labour as the starting point of an analysis of production. The division of labour is often thought to be something Coase assumed to be of little importance to the theory of the firm. Clearly not.

  • Bylund, Per (2011). `Division of Labor and the Firm: An Austrian Attempt at Explaining the Firm in the Market', Quarterly Journal of Austrian Economics, 14(2): 188-215.
  • Coase, Ronald H. and Wang, Ning (2011) 'The Industrial Structure of Production: A Research Agenda for Innovation in an Entrepreneurial Economy', Entrepreneurship Research Journal, 1(2): Article 1.

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