“Coase’s view of neoclassical theory’s theory of the firm, expressed quite early in his career, is simple enough – it has no theory of the firm. His claim is that neoclassical theory offers no explanation for why firms exist or why they are organized as they are; it cannot explain the firm because it is preoccupied with understanding an economic system in which owners of scarce resources are guided by prices, not by central planners or managers who instruct them how to behave” (Demsetz 2011: S8)In Coase’s view, as the neoclassical model is, implicitly, a zero transaction costs model there is no need for firms since all production can take place via market transactions. In effect, consumers can contract directly with owners of factor services to bring about production, and thus there is no need for firms to act as intermediates. Demsetz take a very different view.
“Neoclassical economics does offer a definition of the firm and a rationalisation for its existence, but these must be “teased” out of theory. Neoclassical economists were not much concerned about a firms structure or its managerial methods. The firm in their theory is identified by its function. To them, the firm is a conceptual institution or entity that produces goods and services for purchase by persons who, in the main, are not involved in the production of what they buy. The function it serves in their theory is to create a complex coordination problem whose solution is sought in the price system” (Demsetz 2011: S8-S9)The coordination problems arises because firms and households are seen as different conceptual entities, firms supplying goods and demanding resources and households purchasing goods and supplying resources. The price system coordinates the decisions of the two groups. Firms exist because specialisation and exchange produces greater wealth than self-sufficiency. For Demsetz (1995: First commentary) as transaction costs fall, the costs to specialisation fall as the use of the market becomes cheaper and more specialisation takes place, and thus more firms are created. As transaction costs increase, the use of the market becomes more expensive and thus it is used less, self-sufficiency becomes more common and the number of firms falls. Demsetz sums up the ‘specialisation theory of the firm’ as,
“[t]he bottom line of specialization theory is that firms exist because producing for others, as compared to self-sufficiency, is efficient; this efficiency is due to economies of scale, to specialized activity, and to the prevalence of low, not high, transaction costs” (Demsetz 1995: 11; emphasis in the original)So in the Coaseian literature markets and firms are seen as substitutes, in that as transaction costs fall, the market is used more and firms do less. In the limit, as transaction costs go to zero the firm ceases to exist and all activities take place via markets. In the Demsetz framework, the relationship between firms and markets is complementary. The number of firms grows as the cost of using the market falls and the number of firms falls as use of the market becomes more expensive.
But what of the boundaries and internal organisation of the firm? The Demsetz firm could be just one person organising production via market transactions. There is no need for a hierarchy or employment relationships. Also, as soon as you integrate in any way, do you not start producing for yourself and thus stop being a firm in Demsetz’s terms? Demsetz's version of the firm lacks important features of real-world firms.
- Demsetz, Harold (1995). The Economics of the Business Firm: Seven Critical Commentaries, Cambridge: Cambridge University Press.
- Demsetz, Harold (2011). ‘R. H. Coase and the Neoclassical Model of the Economic System’, Journal of Law and Economics, 54(4), Markets, Firms, and Property Rights: A Celebration of the Research of Ronald Coase, November: S7-S13.
