THE NATURE OF THE FIRM

R. H. COASE

PGPM Section B Group 1

Abhishek Goyal(10P 061 ) Debajyoti Mitra(10P072 ) Harsh Gandhi(10P076 ) Jayant Bahel(10P 081) Richa Gupta (10P105) Shantanu Dwivedi (10P110)

About the Author: RONALD H. COASE

Showed that traditional basic microeconomic theory was incomplete because it only included production and transport costs, whereas it neglected the costs of entering into and executing contracts and managing organizations.

Such costs are commonly known as transaction costs and they account for a considerable share of the total use of resources in the economy. Awarded the Nobel Prize in Economics in 1991 for his Breakthrough in Understanding the Institutional Structure of the Economy

IDENTIFICATION OF THE PROBLEM

HOW IS PRODUCTION COORDINATED IN AN ECONOMY?

IN THE MARKET: Price Control acts as an integrator coordinating production through a series of exchange transactions

INSIDE A FIRM: Market transactions are eliminated. Entrepreneur1 acts as an integrating force directing production.

Alternative methods of coordinating production: PRICE MECHANISM ORGANIZATION WHY THE FIRM AND NOT THE MARKET?

DEVELOPMENT OF PROBLEM

WHAT DRIVES MANAGERS TO PRODUCE SOMETHING INSIDE A FIRM RATHER THAN ACQUIRE IT IN THE MARKET PLACE?

WHY ORGANIZE ECONOMIC ACTIVITY WITHIN A FIRM?

WHY DO FIRMS EXIST?

COASES EXPLANATION Primary Reasons

How does a firms hierchical structure coordinate production better than the market?
COST SAVINGS Cost of using the Price Mechanism Organizing production within the firm makes sense because operating costs are less than the transaction costs in the market. The most obvious cost of organizing production through the price mechanism is that of discovering what the relevant prices are.

COASES EXPLANATION contd. Primary Reasons

What are the advantages of not allocating resources directly by the price mechanism?
COST S
Contr ct egoti tion costs A fir is lik l t

h r v r sh rt-t r c ntr ct is uns tisf ct r .

, ut r tl r uc .

ntr cts r n t li in t

A f ct r f r

ucti n ( r th

n r th r h is c fr

f)

sn th v t r tin rkin

s ri s f ul

c ntr cts ith th f ct rs ith h n c ss r if this c r ti n r sult

ithin th fir , s f th ric ch nis

COASES EXPLANATION contd. Primary Reasons

Why should one integrating force (the entrepreneur) be substituted for another integrating force (the price mechanism)?
COST SAVINGS
Contract Negotiation costs and Vertical Integration Both integration and long-term contracts are ways of binding people. The scope of a contract may be increased by including more operations but this comes mainly from an increase in the period of time for which the contract runs. Integration improves quality of the product and also improves efficiency.

COASES EXPLANATION contd. Primary Reasons

Are there other benefits ?

COST SAVINGS Government regulations foster firm emergence Market transactions in a specialized exchange economy are regulated by various taxes, quota schemes, other price control methods unlike the same transaction organized within a firm.

SCOPE OF A FIRM
If it is more efficient for a transaction to take place within a firm than anywhere else, then it will take place within the firm. If not, then it will take place under some other institutional arrangement:
 in

another firm  mediated by the market

COROLLARIES
Coases explanation also sheds light on the following pertinent issues:
What

Determines the Size of the Firm?

If

organizations reduce cost of production, why are there any market transactions at all? is not all production carried on by one big firm?

Why

COROLLARIES
WHAT DETERMINES THE SIZE OF THE FIRM?

Trade off between Efficiency and Size

Additional transactions lead to increase in size of the firm The entrepreneur fails to make the best use of the factors of production. A point must be reached where the cost of additional transaction or loss through the waste of resources is equal to: the marketing costs of the exchange transaction in the open market, or to the loss if the transaction was organized by another entrepreneur.

COROLLARIES
WHAT DETERMINES THE SIZE OF THE FIRM?

Other things being equal, therefore, a firm will tend to be larger: the less the costs of organizing and the slower these costs rise with an increase in the transactions organized the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organized the greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size1

WHAT ELSE DOES COASE TALK ABOUT ?

COST CURVE OF THE FIRM


A cost curve is a graph of the Costs Of Production as a function of Total Quantity Produced Used to find the optimal point of production, i.e., where firms make the most profits. Argument exist - given a firm produces one product, incase of competitive scenario size of the firm is limited by cost curve slopes upwards. Coase argues against this.

WHAT ELSE DOES COASE TALK ABOUT ?

LEGAL ASPECTS OF EMPLYER-EMPLOYEE RELATION


Coase examines correspondence of his developed theory with reality. The servant (employee) must serve the master (employer). If not, the contract is as good as of contract of goods. The master has the authority to control the servants work either personally or through another servant. The servant does not have any rights to work as an individual.

ANALYSIS
A firm can be viewed as
 

A collectivity of transactions (focus on costs) A collection of resources (focus on firms skills, capabilities, knowledge)

The costs dealt in the paper are the costs of obtaining the same output.
 

Similar output at lower cost Superior output at same level of cost.

A firms comparative advantage also lies in producing superior goods/services which cannot be emulated by the market or other firms within a reasonable cost or time.

ANALYSIS contd.
A firm, by its very existence, reduces transaction costs.
Justifies existence in terms of cost reduction, but does not expound how and why this happens inside a firm.

Treats a firm as a single entity rather than a complex set of human interactions. Agency theory: Cost reduction is achieved through the establishment of agency relationships between shareholders (principal) and manager (agent).1
(Jensen and Meckling, 1976)

REFERENCES
The Nature of the Firm, R. H. Coase, 1937 The Nature of the Firm: Origin, R. H. Coase, 1988 The Nature of the Firm: Meaning, R. H. Coase, 1988 The Nature of the Firm: Influence, R. H. Coase, 1988 Web Resources:

http://www.dallasfed.org/research/ei/ei0303.pdf http://wikisum.com/w/Coase:_The_nature_of_the_firm#Transaction_Costs http://www.jstor.org/stable/25123810 http://www.jstor.org/stable/27646842 http://www.jstor.org/stable/1600542

THANK YOU