Coases Theory of the Firm - Essay Example

Coase’s Theory of the Firm COASE’S THEORY OF THE FIRM Introduction In his seminal paper, “The Nature of the Firm”, Ronald Coase argued that there was more to the firm than the incorporation of inputs in order to generate outputs. Developing one of the first economic theories about the firm, this theory contends that firms have concrete existences and that the modes of internal organization, such as the use of hierarchies to coordinate individuals, are different to price-coordinated market transactions (Curwen, 2012: p49). This theory encouraged the elaboration of hypotheses about what firms are, as well as what they do, among future economists. Coase also proposed that the marginal costs involved in coordination by firms increases as the number of transactions increase. Coordination with another firm through the use of price mechanisms becomes less costly at a point. The size or scope of a firm is, thus, determined by this point at which marginal costs involved in organizing more transactions in a firm are more than those involved with another firm or within the market (Curwen, 2012: p49). This paper will seek to discuss Coase’s theory of the firm, investigating the extent to which transaction costs explain the existence of firms, as well as whether this theory explains the reasons for different performance for different firms. Ronald Coase’s Theory of the Firm The theory of the firm seeks to address two major themes; the reason why firms exist and the determinants of a firm’s scope and scale. Classical economics assumes the existence of firms and characterizes these firms in terms of demand and cost curves and production functions (Curwen, 2012: p51). It is easy to imagine production in the absence of firms, which would result in the exchange of labor and capital between individual traders for payment. Firms are normally understood as being the embodiment of an institutional structure, in which economic activity coordination occurs through price control. Coase, however, observed that this coordination of economic activity through the use of price mechanisms had costs, which he referred to as transaction costs. Therefore, the cost of economic activity can be lowered using alternative institutional arrangements. Firms exist in order to make the coordination of economic activity less costly. In addition, firms are also characterized by the lack of mechanisms of price. There are several sources of transaction costs, including the cost of writing contract, negotiating contracts, and learning prices (Curwen, 2012: p52). This theory is based on the assumption that price mechanisms are not utilized where it is possible to conduct transactions under alternative institutions that will decrease the cost of transaction. Following from this, a transaction will occur within the firm if this option is more efficient than using another institutional arrangement. If not efficient enough, the transaction occurs either in another firm or through market mediation. For example, if the cost of separate economic activity coordination between two entities is higher in comparison to doing so under one entity’s coordination, these two entities will merge to form a firm (Casson, 2013: p34). In addition, coordination by the one entity will be less costly compared to price mechanism mediation. Thus, the scope of a firm is limited by decreasing managerial ability returns or an increase in the marginal costs required to coordinate additional intra-firm transactions. This means that a firm’s scale or scope is determined at the point at which coordination of an additional transaction inside the firm is the same as that of using other institutional arrangements (Casson, 2013: p35). Therefore, Coase’s theory addresses three fundamental issues, including the reason for the existence of firms, what characterizes these firms, and the determinants of the firm’s scope and scale. Coase, in his theory, seeks to explain the reasons why the economy is composed of firms, rather than exclusive individuals involved in self-employment and linked together by contract (Casson, 2013: p35). Therefore, his theory, attempts to offer insight into the reasons and conditions for the existence of firms, especially since it is possible for production to occur sans the existence of firms. His theory proceeds on the basis that, because firms come into existence after hiring of individuals by an entrepreneur, there must be necessary conditions for the entrepreneur to hire help, rather than outsource the task. Prior to his assertions, traditional economic theories contended that contracting was cheaper than hiring because of market efficiency. His theory made note of several costs of transactions that were present within the market, such as bargaining costs, information costs, and the costs of keeping trade secrets. Thus, firms come into existence if it possible to avoid these costs by internalizing production of services and goods needed in the delivery of products (Casson, 2013: p36). This is the basis for Oliver Williamson’s later contention that hierarchies and markets can provide alternative mechanisms of transaction coordination (Williamson, 2013: p26). However, from Coase’s theory, it is also clear that a natural limit exists for which internal production by firms can continue, especially decreasing entrepreneur function returns, influenced by factors like increased potential for resource misallocation by overwhelmed managers and high overhead expenses (Cyert & March, 2009: p61). Thus, the scale and scope of the firm as discussed results in the calculation of optimal balance between these costs and their competing tendencies. The firm’s size is measured by the number of contractual relations it has as internal functions compared to those outside the firm. Although, increasing a firm’s size is advantageous to begin with, there will be eventual decline in returns, which acts as the limit to infinite firm growth. Firms, therefore, become larger when organizing costs are low and slow to rise as the number of organized transactions rise. They will also grow larger if entrepreneurs make fewer mistakes or if the number of mistakes increases slowly as coordinated transactions rise. These two factors tend to increase as dissimilar transactions emerge and as the coordinated transactions become more spatially distributed (Cyert & March, 2009: p62). It is for this reason that firms either tend to conduct different functions or are located in diverse locations. Technological advances, such as cheap air travel and ICT, have also made it less costly to coordinate transactions across distance, which has enhanced the ability for firms to increase in scope and size. However, Coase’s theory of the firm has been criticized in literature in the past. For example, while his theory intimates that a characteristic of firms is relations between employees and authority, his theory fails to offer any insight into the reasons why employees follow instructions from authority (Cyert & March, 2009: p73). In addition, the theory’s contention that mechanisms of price are absent within the firm has been challenged by the presence of transfer pricing present in a multi-divisional firm. It has been proposed an extension of the theory on the basis of monitoring and joint production, of which the former enhances the assessment of contributions made by the agents within the firm. In their postulation, they argued that rights to making decision in the firm are given to those possessing the biggest incentive to maximize value. In addition, ownership of firms was defined as being endowed by the right to observe behavior of input, be central to all input contracts, be a residual claimant, alter team membership, and the ability to transfer these rights to another party (Cyert & March, 2009: p73). This theory, however, also eventually fails to make clear why monitoring and joint production could not also be solved through contracts. Transaction Costs and the Existence of Firms Coase’s theory of the firm created the transaction cost concept. Transaction costs, as mentioned, are the costs involved in the provision of services and goods via the market, instead of having them provided for within the firm. Conducting a market transaction requires the identification of the entity one will deal with, bargaining through negotiations, contracting, and enforcing the observation of the contract terms (Dietrich, 2012: p66). In this case, the theory contends that it is not possible to understand how an economic system works and establish effective economic policy sans accounting for transaction costs. The relationships between are controlled by the market prices but decisions taken in a firm are made on a different basis to market price-dependent profit maximization. Entrepreneurial coordination is the basis of decision taken within a firm. Diverse arrangements exist in the production of services and goods. For example, some firms may conduct repair services internally, while some get repair services from external specialized sources. In addition, while labor force is used on a working day basis in agriculture, other industries may prefer to use permanently employed workers. Long term contracts in firms are dependent on short-term contracts becoming unsustainable and unsatisfactory (Dietrich, 2012: p66). Because of costs involved in the continuous negotiation of contracts, as well as collection of information, short run contracts become unsuitable, necessitating the formation of long-term contracts with specified remuneration that allows the entrepreneur to direct the contractee within limits (Dietrich, 2012: p68). The theory of the firm’s central insight is that firms exist due to the heavy transaction costs involved in having to hire work, enforce contracts, and negotiate prices. In essence, therefore, firms are devices created to offer long-term contracts when they are more sustainable and satisfactory. In addition, these organized entities also impose their own transaction costs that increase with the enlargement of the entity. Competition forces will constantly vary the balance between markets and hierarchies, which makes entrepreneurs to create firms in order to decrease transaction costs. The existence of the firms through the influence of transaction costs can, for example, be used to explain the reason why highly diversified and vast business groups, such as Koc Holding and Tata Group, have emerged. While it is feasible for one to dismiss these business groups as capitalist relics, the formation of these groups makes sense when the transaction costs are taken into account. Because the established institutions are not efficient, it is necessary for organizations to extend their brand to cover a wider industrial range (Dietrich, 2012: p69). In addition, because of inefficiencies in labor and capital markets, these organizations also seek to train their own working staff and conduct their own capital allocation. However, it can also be posited that this view of transaction costs is too narrow, particularly as it offers but a partial explanation of why some firms are stronger than others. His explanation of why firms exist using the transaction costs concept has faced criticism from management theorists, especially those supporting the resource based theory as the reason for the existence of firms (Rao, 2013: p73). This alternative theory proposes that, on top of firms existing because of inefficiencies in the market, they also exist because they are successful. For instance, a firm is able to source a wide array of resources, especially those that are not accessible on the market like collective knowledge and corporate culture. Firms also exist because they are able to create knowledge and coordinate production in ways that are unique to them. In addition, firms can strategize in the long term on R&D innovations that could usher a redefining of markets, as opposed to simply pursuing the satisfaction of demand (Rao, 2013: p74). Therefore, the existence of a firm can be explained by the transactional costs concept proposed by the theory of the firm by complementing market failure with the organizational advantages theory. Although the theory of the firm as proposed by Coase seems to become more complicated as it is expounded upon, it does vindicate his decision to look within the firm and to examine its business to discover how and why it exists (Rao, 2013: p76). The entire theory is based on how business units are organized, and the impact that transaction costs have on this organization. From the above, it follows that, in the absence of price systems to govern the cost of transactions, an organization will emerge to govern the costs better. This organization, the firm, will seek to reproduce similar conditions to those of an efficient and competitive market, in order to lower the cost of production factors within the firm below that in the real market. However, a question arises as to the reason why there are still market transactions if firms come into existence with the ultimate goal of reducing transaction costs. The theory of the firm answers this question by giving two reasons. First, the costs expended in coordinating additional transactions are proportional to the firm’s scale. These costs are equated or balanced against additional market transaction costs (Rao, 2013: p77). Secondly, increasing the scale of the firm does not automatically reproduce similar effects to real market conditions. Therefore, the transaction costs concept offers a logical explanation for why firms exist. Why Different Firms Perform Differently The size and complex nature of firms are normally offered as an additional objection to the focus laid on modern organizations as entities focused on profit maximization by operating outside market-price mechanisms (Hart, 2009: p56). Production of services and goods occurs in organizations with multi-plant operations that are, in turn, structured into accounting, sales, advertising, production, R&D departments among multiple other divisions. A firm’s activities may grow increasingly apart as their size increases, making it more difficult to communicate information accurately and on time among and between these business activities. However, the risk of bureaucracy becomes real when it becomes increasingly difficult to enforce decisions that are consistent with maximizing profit across these activities (Hart, 2009: p57). Additionally, this separation could lead to conflicting and diverse objectives. These will eventually lead to differences in performance among firms depending on how the different activities are coordinated to avoid these pitfalls. These differences in performance are the result of two broad reasons; technological factors and psychological/or cultural factors. Technological factors lead to differences in performance due to differences in the products produced efficiently by various parts of a firm (Hart, 2009: p60). For instance, a software firm that produces software manuals internally may require the printing of ten thousand manuals for each print run in order to minimize the average manual printing cost. However, the function responsible for distribution may only need one thousand of these manuals in a single printing function delivery. While the firm has techniques available in decision making to solve this problem, like the inclusion of the manuals’ storage costs in production costs, failure to resolve the issue may impact on the firm’s performance (Hart, 2009: p61). A firm that is able to reduce its technological transaction costs performs better than firms that fail to do so. Psychological or cultural reasons may also explain why performance of firms differs. This reason is as a result of established practices and customs due to different experiences, education, and training of different functions, which may lead to different performance and actions by the firm and its functions (Penrose, 2010: p82). For instance, a pharmaceutical company’s R&D department may be convinced of the inevitability of making a medical breakthrough. However, the accounting department may already have used up all resources directed to that project. Therefore, requests by the R&D division for more finance may be met by a refusal from the accounting division. While the R&D department is optimistic of a breakthrough, the finance department is perceptive of its role in containment of transaction costs and ensuring that expenditure is confined to original estimates and targets. In the presence of such a conflict between divisions of a firm regarding internal transaction costs, an effort may be made to involve senior management in decision-making (Penrose, 2010: p83). However, senior management may also be affected by each division attempting to make their case to achieve their end. In addition, senior management with accounting backgrounds may seek to take decisions based on constraining transaction costs. The aforementioned will undoubtedly impact on the performance of the firm. A partial counter-argument exists, which contends that increasing complexity in the formation and growth of firms is an impediment to increased performance and profit maximization (Penrose, 2010: p85). As a business entity becomes more complex and transforms into a firm, there is a need to control transaction costs. Costing problems and the interest it arouses in the study firm performance has increased as businesses become more complex and large in scale, which may necessitate the need for price setting methods for services and goods. In addition, the effect of decisions on the performance of different divisions in a firm can be assessed by considering a firm’s value as the net present value of differences present between future revenues and transactional costs. For instance, in the case of the software firm, whatever decision is taken, including increase manual printing efficiency by outsourcing printing will be analyzed against the impact on the entire firm’s value. Although there will be transaction cost reduction with regards to printing, costs would increase for the distribution department. Therefore, the performance of a firm is dependent on the decisions taken with regards to transaction costs in individual divisions (Penrose, 2010: p85). Therefore, while the growth in scale, complexity, and size of all firms is dependent on them finding ways to measure transaction costs and integrating them into various decisions taken at divisional level, the potential for intra-firm incongruence also affects how the firm performs as a whole (Medema, 2013: p90). This is especially so because of the separation of control and ownership, whose existence will always create incentives for misinformation and interdivisional conflict within the firm. Thus, differences between and within firms all raise the difficulties facing the theory of the firm. Differences within the firm engender interests that are separate from the firm’s, while differences between firms indicate the presence of different modes of behavior in seeking to operate outside the influence of market mechanisms. Conclusion Coase’s theory of the firm answers several questions related to firms. It explains the reason for the emergence of firms and the reasons for all economic transactions not being mediated by market mechanisms. It also explains the boundaries between markets and firms being present at an exact point with regards to output variety and size, as well as the performance of transactions internally and through market mediation. It also explains the need for hierarchy in the structure of firms, as well as the heterogeneity of the performance or actions of a firm, including the drivers of a firm’s performances and actions. Firms offer an alternative to market-price mechanism in instances where production outside the mediation of markets is more efficient. It could be difficult, for example, for a firm to produce if they constantly have to hire workers on the basis of supply and demand. In addition firms may also find it difficult to source new suppliers everyday. This necessitates the engagement of employees and suppliers into long term contracts to maximize property rights and minimize transaction costs. References Casson, M. (2013). The theory of the firm. Cheltenham, UK, E. Elgar Pub. Curwen, P. J. (2012). The theory of the firm. London, Macmillan. Cyert, R. M., & March, J. G. (2009). A behavioral theory of the firm. Englewood Cliffs, N.J., Prentice-Hall. Dietrich, M. (2012). Transaction cost economics and beyond towards a new economics of the firm. London, Routledge. Hart, O. D. (2009). Reference Points and the Theory of the Firm. Cambridge, Mass, National Bureau of Economic Research. Medema, S. G. (2010). The legacy of Ronald Coase in economic analysis. Vol. 2. Aldershot, Edward Elgar. Penrose, E. T. (2010). The theory of the growth of the firm. Oxford, Oxford University Press. Rao, P. K. (2013). The economics of transaction costs theory, methods, and applications. Basingstoke, Palgrave Macmillan. Williamson, O. E. (2013). The transaction cost economics project: the theory and practice of the governance of contractual relations. Northampton, MA: Edward Elgar Read More