The Nature of the Firm (Coase 1937) I-Chen Wang (adapted by Joe Mahoney)

Motivation & Purpose To show a definition of the firm with realistic and manageable assumptions To bridge a gap between the assumptions about two resource allocation mechanisms in economic theory

Main Assumptions Mechanism for resource allocation outside the firm differs from that within the firm Firm is featured by the suppression of the price mechanism by the entrepreneur coordination

Main Inquiries What is the basis on which the choice between the two alternative mechanisms is made? Question to ask: Will it pay to bring an extra exchange transaction under the organizing authority? Costs of organizing in another firm (in-house) vs. costs involved in leaving the transaction to be organized by the price mechanism (spot market). More broad questions: Why do firms exist? Why do markets exist? What determines the size of the firm? What constitutes a firm?

Main Arguments Cost of using price mechanism: Price discovering Contract negotiation Uncertainty of a series of contracts Cost saving by using authority coordination: Transfer pricing Great reduction of contracts Feasibility of long-term contracts

Main Argument Cost of using organizing/Constraints on firm size: Decreasing returns to the entrepreneur function Efficiency loss of resource allocation Rising supply price of some production factors Some other influences on firm size: Relative costs of organizing by two firms Advancements of communication and managerial technology

Firm size and number of firms Firm gains its size when the transactions organized through entrepreneur increase One large firm is difficult because of Deteriorating efficiency (size limit) Slackness in resource utilization p.394 . Monopoly gain offers a powerful incentive to continuous and unlimited expansion of the firm, which force must be offset by some equally powerful one making for decreased efficiency with growth in size. 7

Theoretical Contributions Transaction Costs Theory “The operation of a market costs something and by forming an organization and allowing some authority to direct the resources, certain marketing costs are saved” “A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur” Property Rights Theory “The essence of the contract is that it should only state the limits to the powers of the entrepreneur. Within these limits, he can therefore direct the other factors of production”

Theoretical Contributions Arguments related to Firm Growth “the actual point where the expansion of the firm ceases might be determined by a combination of the factors” like the diminishing returns to management Arguments related to Behavioral Theory “the service which is being provided is expressed in general terms, the exact details being left until a later date” (Barnard-Simon theory of authority)