R.H. Coase The Nature of the Firm Eva Herbolzheimer University of Illinois at Urbana-Champaign

Coase’s Objective in 1937 (I)  Definition of the word “Firm” that is  Realistic (corresponds to real world)  Tractable (by Margin and Substitution)  Why do Firms exist?  What determines the size of a Firm? The Nature of the Firm

Coase’s Objective in 1937 (II)  Bridging the GAP between two assumptions of Economic Theory 1)The Market Mechanism: Resources are allocated by means of the price mechanism 2) The Firm Mechanism: This allocation is dependent on an entrepreneur-coordinator (or a manager-coordinator) The Nature of the Firm

Why do Firms Emerge? (I)  Profitability  The existence of uncertainty  Cost of Using the Price Mechanism - Marketing Costs or Transaction Costs  Costs of Discovering Prices  Cost of Negotiating and Writing Contracts  Regulations costs and taxes The Nature of the Firm

Why do Firms Emerge? (II)  Cost of Negotiation and Contracts: Entrepreneur does not have to make contract with every factor e.g.: employee agrees to obey directions within certain limits; within those limits, the entrepreneur has the authority to direct the employee.  Firms are characterized by the supersession of the price mechanism  Firms economize on the cost of coordination of economic activity The Nature of the Firm

Factors Influencing the Size of a Firm  Firms are regularly treated differently by regulatory bodies (gov)  Firm = “System of relationships which comes into existence when the direction of resources is dependent on entrepreneur.”  Entrepreneur can decide to either take on more transactions (grow) or abandon the organization of certain transactions (shrink)  If it is efficient to organize transaction within firm, it will take place within the firm  Firm exists because the cost of a central authority organizing transactions internally is cheaper than organizing them externally in the market The Nature of the Firm

Limits to the Size of a Firm  Decreasing returns to the entrepreneur function  e.g., wrong allocation of factors, ability, etc. (waste of resources) “Diminishing Returns of Management”  Increasing costs of organizing more transactions in the firm  Cost of organization and losses through mistakes will increase with an increase of spatial distance of transactions, dissimilarity of transactions, and changes in relative prices The Nature of the Firm

What will tend to make a Firm Larger?  Low cost of organization and slow increase in cost with additional organization of transactions  Low likelihood of mistakes made by entrepreneur and slow increase of mistakes with additional transactions  Low rise in supply prices of factors to to larger firms  Innovations can help to reduce costs due to spatial distribution  Innovation that reduces firm cost more than it reduces the cost of using the price mechanism will increase the size of the firm The Nature of the Firm