Managerial Economics - Essay Example

Managerial Economics Introduction The Coarse theorem is a theorem associated with a Nobel Prize Laureate, Robert Coarse, who sought to describe the economic efficiency of economic allocations or outcomes while faced with externalities. This theory states that if trade in an externality is feasible and that no transaction costs are witnessed or exhibited, then, bargaining will lead to well-organized outcomes in spite of the original allocation of material goods rights. However, if there are any obstacles to bargaining, then they might prevent Coasian bargaining. Basically, Ronald Coarse concentrated on analyzing the role of transaction costs in a firm set up. In another paper - The Nature of the Firm - Coarse argues about the effects of real-world transaction costs and states that they are rarely low enough to consent to efficient bargaining and so this theorem is almost inappropriate in economic reality. However, despite all these, the Coarse’s theory is viewed as an essential basis for the analyses of most modern economic cases including government regulations in the case of externalities (Samuelson & Nordhaus, 1985). Likewise, this theory has been used by legal experts and jurists to analyze and make resolves to legal and economic disputes. In general, the Coarse theory is a legal and economic theory which affirms that, where complete competitive markets with no transaction costs are, an efficient set of outputs and inputs from and to the production-optimal distribution will be selected. This is without paying regard to how property rights are being divided. The parties involved can negotiate or bargain terms beneficial to them than an outcome of a property rights assigned to them (Mankiw, 2007). This is to say that they are not completely obliged by the property rights to trade for as long as they are able to trade and produce an outcome that is mutually advantageous to all of them. For this to exclusively occur, then the cost of bargaining or any cost associated with it such as cost of meetings must be extremely costless as any cost at all will influence the outcome of the bargain. However, no exact definition of the Coarse theorem has been established (Sloman & Sutcliffe, 2003). Theory of the Firm Economically, a firm is referred to as a legally organized and recognized organization that is designed with the main purpose of providing goods and services to the consumers. Coarse in establishing his theory, used applications based on the activities of the firm and related the same to the planning capability of a firm’s management. This might be metaphorically perceived as the firm being an island of planning in a sea of markets. When firms make decisions regarding production of the goods or services they produce, they do so guided by certain principles and which are as described by this theory proposed by Ronald Coarse (Rasmusen, 2007). This theory of the firm consists of several economic theories that seek to describe, explain and predict the nature of a firm. It seeks to answer questions about the existence of the firm, its behaviors and structures, their organization, the boundaries of firms and the heterogeneity of the performance of the firms. In reality, most firms are known to exist as alternative systems to the market-price mechanism if it can produce efficiently in a non-market environment. Consider an example of the labor market: it can be very costly for firms to produce efficiently if they have to hire and fire their employees based on the demand and supply conditions. Similarly, a shift by employees from one company to another everyday may be seen as costly or when companies shift each day in search of new suppliers (Williamson et al, 1991). This is because any action involves costs in it hence, the essence of firms’ transactions costs. The safest modality for the firm in such scenarios is to engage in long term contracts with either their workers or suppliers so as to be able to minimize on costs and at the same time maximize on the property rights. In studying this theory, one should recognize that consumers always seek to maximize on utility while firms or businesses seek to maximize on their profits. Considering this, firms will always produce output at levels where their marginal revenues equals their marginal costs. Any effect including that from the government probably by lowering the price of a particular input will have an effect on the price of the product. According to this theory of the firm, if such a thing happens, then it may not necessarily result in the firms lowering of the price of the product to the consumers. Instead, it may be raised. Transaction Cost Theory In the development of his theorem, Coarse acknowledged the effects of the transaction cost theory. Taking a transaction cost approach to the theory of the firm is essential in the analysis of Coarse’s theory. The costs of providing for some particular good or service through the market and not from within the firm is what is known as the transaction costs. Coarse while describing these costs, classified them into three categories: information and search costs, decisions and bargaining costs, and the enforcement and policing costs. According to his theorem, without one properly understanding these transaction costs and taking them into account, then it might be extremely impossible to properly understand how the economic system works or even have a sound basis for establishing the a firm’s economic policies. He went ahead to observe that the market prices only govern the relationship between firms and not within a particular firm. Hence, within the firm, the decisions are made on a totally different basis of the maximizing of profits. On the contrary, the firm’s decisions are made basing on the entrepreneurial coordination of the firm. The transaction cost theory as set up by Ronald Coarse was one of the first neo-classical attempts to theoretically define the firm in relation to the market in which it operates. This aspect lies with the manner in which he explains the firm’s consistency with constant returns to scale and not relying on the increasing returns to scale basis. According to him, it is only the existence of a firm that needs to be explained with a distinguishing mark of suppressing the price mechanism. In this line, Coarse theorem provides for a reasoning as to why most people would want to establish firms, which is, to avoid some of the transaction costs of the price mechanism. To achieve this, firms need to discover relevant prices that can be reduced and not eliminated and as well, discover the costs of negotiations and writing of contracts which are enforceable for each of the transactions. However, this cost can be extremely large in cases of any uncertainties. For example, if a firm decides to operate under the market system, i.e. internally, then it will have to contend with many contracts that will be required of it, if it chooses to operate as a real firm though it will be faced with more contracts that are complex. The kinds of contracts that it will draw under this situation will be those made with a long term view. When analyzed, it is revealed that such will run in contrast to the neo-classical views that assumes the market to be instantaneous and which forbids the development of the principal-agent relationship. From these, the Coarse theorem makes two fundamental conclusions which are that: it is impossible for a firm to emerge without the existence of uncertainty and again that a firm will emerge in cases of very short term contracts. With regards to costs, Coarse states that the size of a firm will arise out of the firm getting an optimal balance between the tendencies of the competing costs. If these transaction costs can be absent, then Coarse argues that certain surprising results will hold. For one, if externalities are present, then in the absence of transaction costs to the creation of private meetings, production levels of goods and services will be the same regardless of the party which has a legal claim to the externality. Therefore, even if the government intervened in this case of externality, it will have no effect on the production level if there are no transaction costs (Krugman & Wells, 2006). The profit maximization concept Consumers are known to act with a view to maximizing their utilities whenever the purchase production goods while, firms on the other hand maximize their profits. In this case, the profits will equal the total revenue earned by the firm minus its total costs i.e. Π= TR- TC Where Π is the profit function of the firm TR is the total revenue received by the firm in its operations TC is the total costs incurred by the firm. The theory of the firm as proposed by Coarse also acknowledges that firms face certain three main constraints. These are: the technology of operating, the prices of the factors of production and the demand of the products it produces. If the firm is perfectly competitive, then it will maximize its profit at the point where its marginal revenue equals the marginal costs (Krugman & Wells, 2006). Supporting Coarse’s Views By stating that firms exist and survive because of an efficient planning, Coarse arrives at this view by reasoning out the impacts of the short-term and long-term contracts of the firm and how these contracts directly impact on the transaction costs of the firm. With reference to the discussions above, where there is any unsuitability of the contracts, it arises from the costs incurred in collecting the information about the contracts and the costs of negotiating the contracts (Putterman & Kroszner, 1986). A result of these is the long term contracts. A second view by Coarse is that the short run and the long run production levels of a firm are well worked out in the economic theory and as such market inconveniences are not well outlined. On the other hand though, he does not clearly perceive the size of the firm as clearly developed. Consequently, Coarse notes that in the presence of these market inconveniences, if the price mechanism system does not govern the transactions then, an organization must be formed (Putterman & Kroszner, 1986). This business organization formed will have an objective of ensuring that it reproduces the competitive market conditions for the factors of production within the firm at costs which are much lower when compared to the actual market of the goods. Coarse’s theorem focused on the relationship between two parties and the conflicting activities between them as well as the roles they have assigned to the rights or liabilities. While analyzing this theory from an efficiency view, one can find out that the outcome that is prevailing will be efficient even when the transaction costs are non-existent. The theory takes the condition of zero transaction cost as one that implies no impediments to the bargaining factor between the two parties. Ideally, when the inefficient allocation leaves the all contractual opportunities unexploited, then the allocation cannot be perceived as that which is contractually at equilibrium. The Coarse theory also accepts the fact that when the two are compared, the markets will relatively tend to be more efficient than the firms when faced with issues of handling transactions between large numbers of consumers (Frank & Bernanke, 2004). Another view expressed in this theory is that of why some transactions are performed within the firm and other are not. According to Coarse, the costs allied with the transactions together with the human cognitive limitation consequences as well as the basic assumptions of efficient markets may fail to hold. It is for these reasons why it is easy to and advantageous to structure several transactions within the firm. This is the reason that makes firms worth studying in the society. The firms are therefore, seen as islands since they execute their plans and are organized consciously. Economists most of the time perceive firms as puzzles that need to be solved due to the nature of their operations. Alongside other phenomenon that constitutes the market system, firms require explanation as they have never been before incorporated into conventional economics (Ichiishi, 1993). Most of the time they will be seen as islands of planning, which the individuals are end-related in. These issues of planning have to be practiced taking into consideration the rationales of the firm. Basically, there are four rationales of the firm. These include: a technological explanation approach that recognizes that firms exist due to definite process of production which cannot be separated. A second approach is that firms have to be viewed as having the same nature. As such the distinct nature of firms is denied and as such any action in the market is subject to all the firms without discrimination (Frank & Bernanke, 2004). Thirdly, firms are viewed as having costs associated with their use of the price mechanism. Hence, at times it is efficient to avoid using the market system directly and instead, a person can just isolate some of the relationships within the firm. To this extent, Coarse’s theory can be applied to develop the transaction costs in two different ways. The first way can be through the measurement-cost approach method and the second way is through the assets-specificity method. In the first scenario, issues relating to administration, direction, negotiation and monitoring of the performance of the two teams is examined. The assets-specificity approach addresses post-contractual issues such as hold up, bounded rationality and moral hazard. The fourth rationale revolves about the evolutionary theory and the rent. The argument is that the source of a firm can be found in potential rents that exist and be created by a team of individuals that are working together. To be able to capture the rents, Coarse argues that one needs first of all to establish the firm. Conditions that support Coarse’s theory In writing his other economical paper, “The Nature of Firms”, Ronald Coarse must have been led by the interpretation he made concerning the economic situation back then which he notes were leaning towards an understanding of market system (Coarse, 1988). This observation is what made him wonder about the “islands of conscious power” to which firms can now be regarded as islands of planning. His development of this theory was for the reason that he was able to identify a crucial idea and go a step further to establish its logical implications to the nation. Consequently, his success in discussing the theory was based on his understanding of the price mechanism system and suppression of it by firms. The implication of this is that it might appear advantageous to replace the market transactions with those taking place within the firm. For this action to take place, Coarse concluded that there must be costs involved in it. Finally, Coarse’s theory is perceived as that which is based on the perfect competition market framework. In his theory, the goods to be produced together with the methods by which they are to be made are given hence, the whole theory being based on a general equilibrium framework. Conclusion The Coarse theorem focuses on explaining the relational activities of the firm with regard to its immediate market and the internal factors affecting its production. By incorporating the transaction costs theory and the theory of the firm, coarse wanted to understand the origins of actual or real markets as well as the legal institutions which could not be explained by the perfect competition framework (Coarse, 1988). These he achieved to bring out clearly by elaborating them more in the theory of the firm. Therefore, it is true that firms are islands of planning in a sea of markets and that these firms exist and survive due to the more efficient planning they engage in. Bibliography Coase, R. H. (1988). The firm, the market, and the law. Chicago: University of Chicago Press. Frank, R. H., & Bernanke, B. (2004). Principles of economics (2nd ed.). Boston, Mass.: McGraw-Hill. Ichiishi, T. (1993). The cooperative nature of the firm. Cambridge [England: Cambridge University Press. Krugman, P. R., & Wells, R. (2006). Economics. New York: Worth Publishers. Mankiw, N. G. (2007). Macroeconomics (6th ed.). New York: Worth Publishers. Putterman, L. G., & Kroszner, R. (1986). The Economic nature of the firm: a reader. Cambridge [Cambridgeshire: Cambridge University Press. Rasmusen, E. (2007). Game theory and the law. Cheltenham, UK: Edward Elgar Pub. Samuelson, P. A., & Nordhaus, W. D. (1985). Economics (12th ed.). New York: McGraw-Hill. Sloman, J., & Sutcliffe, M. (2003). Economics (5th ed.). Harlow, England: Prentice Hall/Financial Times. Williamson, O. E., Winter, S. G., & Coase, R. H. (1991). The Nature of the firm: origins, evolution, and development. New York: Oxford University Press. Read More