Coases Theory of the Firm - Essay Example

COASE’S THEORY OF THE FIRM Coase’s Theory of the Firm In 1937, Coase put the theory of the firm forward, in which he emphasized on transaction cost economies in his famous article.1 The transaction cost economies led to the appreciation of the existence of the firm, based on thinking, planning and contracting costs that are associated with any transaction. These costs had been ignored by the neoclassical paradigm. Coase’s argument was that transaction costs are lower when the transaction is carried out within a firm rather than in the market. This essay critically reviews Coase’s theory of the firm and evaluates the effectiveness of authority and monitoring as ways of promoting productivity. Economists hold a universal view pertaining to the economic system. In this view, it is presumed that normally, the economic system is supposed to work itself. This means that prices are to be determined by demand and supply, as influenced by free market condition. Therefore, in an economic system, there should be no central control or central survey to influence prices or supply and demand.2 This means that supply will be adjusted to demand while production is adjusted to consumption to meet market requirements. For instance, if the demand is high, prices will increase and vice versa. In addition, whenever consumption rates increase, firms will increase their production while they will reduce their output, if the contrary case is witnessed. In an economic system, the process of adjustment is set to be automatic and elastic, as well as responsive. Therefore, society is regarded as an organism and not an organisation. This does not rule out the fact that individuals within the economic system carry out planning. Actually, individuals plan by exercising foresight and choosing between alternatives that are available within the economic system.3 It is also presumed that resources are directed based on price mechanism within the economic system. However, according to Coase, this description does not fit the firm. The premise that in the economic system, resources and factors are allocated on the basis of price mechanisms does not hold true as far as the theory of the firm is concerned. Instead, resources within the firm are allocated through the use of some authority, which is bestowed in the entrepreneur. Consequently, this leads to supersession of the price mechanism.4 For instance, in the firm, a worker may be transferred from a department to another, not because of a change in relative prices, but because of a directive from whoever who is charge of control of an organisation or the firm.5 The entrepreneur represents that factor of production, which executes authority and monitoring within the firm. An entrepreneur carries out coordination and management of resources.6 It should be noted that i the firm, it is the entrepreneur who directs production through coordination functions while outside the firm, production is supposed to be controlled by price movements such that when prices are more output is expected in the market. As output increases, prices will tend to reduce, thus removing the incentives to produce more by firms. These price movements are coordinated by a series of market exchange transactions. Production cannot be carried out without organisation, as it presumed because every firm has its organisation. If the contrary is the case, then production can be carried out with no organisation and no control or authority in the firm. In such a case, it is presumed that it would be automatic for a firm to produce in response to market movements in terms of prices, depending on demand and supply.7 The theory of firm provides a rational claim that authority and monitoring are necessary in the firm to enhance production. An ideal example is a department store where allocation of different sections and various locations within the building will have to be done by the controlling authority. However, the allocation may be as a result of competitive price bidding for the space. Naturally, it is rare that the latter is the case. Normally, the former is the case, as far as the firm is concerned. The theory of the firm truly asserts that those people who want to direct others would like to pay them more so that they can have authority over them and direct them. In this case, more payment refers to payment of more wages than what the price mechanism can offer.8 Similarly, those who would like to be controlled will have to accept less money and work under others. This is the basis under which the firm is formed. The only pitfall with this assumption is that those who pay more to be able to control others are not paid to direct because that is a very rare occurrence in real life. It is imperative to note that internal coordination of factors of production within the firm is never influenced by price mechanism in the market. For instance, one can rent a business space and pay for electricty and can obtain inventory on credit, but these activities are done without the intervention of the price mechanism.9 This assertion is applicable in the real economic situation. Within a firm, vertical integration, which represents authority, surpasses the price mechanism forces. There could be a relationship with the outside network of relative prices and costs, but these relative prices and costs do not control or influence the vertical integration within the firm.10 Instead, the vertical integration within the firm is influenced by authority and control or monitoring. The theory of the firm recognises that the entrepreneur represents the firm, which continues to produce in relation to the nature of the economic system. Division of labour is carried out within the firm, but when the outside economic system is considered, the firm becomes one specialized unit.11 Therefore, coordination by the entrepreneur within the firm determines prices. This is because allocation of resources within the firm is never dependent on the economic system or price mechanism, but rather on the entrepreneur’s coordinator role.12 The cost of meeting the requirements of the price mechanism fuels the reason of establishing a firm’s profitably. For instance, there are costs involved when information has to be obtained, given that production can be organized by discovering relevant prices. It should be noted that the cost of organising may be reduced, but it cannot be eliminated. What the firm is capable of doing is enhancing reduction of contract costs, but it cannot eliminate the costs. The need for authority and control or monitoring motivates an entrepreneur to make contracts with other factors of production within a firm. This is aimed at promoting productivity. If production was to be controlled through price mechanisms in the market, then there would be no need for these contracts by the entrepreneur.13 However, since production has to be controlled within the firm by the entrepreneur through authority, these contracts have to be entered into. Factors of production are controlled and monitored by the entrepreneur, once he she or he has entered into contract with the factors. A firm emerges in situations where a very short term contract with the factors of production is unsatisfactory. The operation of a market has some costs. Therefore, it is only through the formation of an organisation and allowing of some authority and monitoring to direct resources, that certain marketing costs can be saved.14 In consideration of regulatory factors such as sales tax, imposed by governments, the firm, through the entrepreneur, has to monitor production through control and authority to meet a desired requirement. Therefore, the proposed theory of the firm regards a firm as a product of the system of relationships that emerges when the entrepreneur exercises authority and monitoring powers over the direction of resources. It is impossible to have an economic context, where production flows smoothly by workers doing exactly the right thing at the right time in a pre-established harmony with the work of others.15 Monitoring and authority has to be present in the form of managers and superintendents, who should be coordinating the activities of individuals. This increases productivity within the firm, and even within the economic system. Naturally, man has to own some power of directing his work, if productivity is to be increased. For instance, contractors perform because of the authority and monitoring that guides them. They ought to perform as per the requirements of those who award them contracts in order to be paid as per the terms. To enhance production, there has to be a servant-master relationship within any firm such that the servant should be in a position of performing duty to others on behalf of the master. In addition, the master should be able to control the servant’s work, either personally or by another servant or agent. This is effective because control and interference explains when he or she is required to work and what he or she should or should not do, as well as how she or he should do it.16 The contractual perspective emphasizes the cost of making and monitoring transactions.17 These are the costs that a firm has to evade or minimise and specialize in its own production to achieve high productivity. Given that the use of the price mechanism is associated with some costs, firms find it advantageous to and efficient to evade the direct use of the market system. In addition, it is effective for firms when they segregate some associations within the firm. There has to be administering, directing, and negotiating and monitoring teams’ performance. This contributes to productivity increase.18 It should be noted that the firm can exercise power through authority and monitoring to enhance productivity. Therefore, productive specialization is promoted, in light of the anticipated changes in market rewards, leading to marginal productivity. There has to be an organisation, most probably the firm, to enhance this achievement. It facilitates the allocation of rewards to resources in accordance with their productivity.19 It has been established that the theory of the firm, as developed by Coase deals with management and allocation of resources within the firm, without much consideration of the economic system. This means that a firm cannot function automatically in response to price mechanisms, without guidance and control of an entrepreneur. The role of an entrepreneur is to manage and allocate resources, as well as exercise authority and monitoring to ensure satisfactory productivity levels. These roles are carried out without consideration of the mechanisms of the economic system. The theory of the firm recognises a servant-master relationship, which should be embraced by any firm that seeks high levels of productivity. In such a case, the entrepreneur should be willing to pay the worker or employee more than what the price mechanisms can offer so as t achieve authority over the employee. Consequently, the employer will be able to monitor and control activities of the worker and attain desired levels of productivity. It should be noted that this can only happen, if the employee or worker accepts o be paid by the entrepreneur, as determined by the latter. Authority and monitoring can be exercised directly by the entrepreneur or by an agent such as a supervisor, manager or any other person appointed for that role. It has also been established that authority and monitoring enhance productivity within the firm. Supervisors and senior agents, appointed by the entrepreneur or the entrepreneur can monitor the work of employees to ensure that productivity of the firm is at a desirable level. Bibliography Alchian A and Demsetz H, ‘Production,Information Costs, and Economic Organization’, , 1972, (accessed 10 April 2015). Coase, R H, ‘The Nature of the Firm’, Economica, New Series, Vol. 4, issue, 16, 1937, pp. 386-405. Foss, N J, The Theory of the Firm: Critical Perspectives on Business and Management, Volume 1, Taylor & Francis Press, London, 2000. Hodgson, G M, ‘Competence and Contract in the Theory of the Firm’, Journal of Economic Behavior & Organization, Vol. 35, 1998, pp. 179-201. Sautet, F E, An Entrepreneurial Theory of the Firm, Routledge Publications, London, 2000. Williamson, O E and Winter, S G, The Nature of the Firm: Origins, Evolution, and Development, Oxford University Press, New York, 1991. Read More