MEMORANDUM
DATE:
May 24, 2013
TO:
Prof. Rajiv Krishnan Kozhikode
FROM:
Team 12 Class BUS 374 D100
Colton Dow
301124297
Pierre Levesque
301210629
Gurneet Takhar
301064886
Tiffany Sun
301158475
Shuying (Lavina) Tan
301157828
SUBJECT:
Adding Value to Coase’s Essay: The Nature of the Firm?
In the 1930’s Ronald Coase (1937) released an article regarding “The Nature of the Firm”. In his
article Coase (1937) explains the components, benefits, and changing factors relating to firms. In
completing his research Coase (1937) concludes some viable reasons as to why organizations
such as firms exist in a capitalistic society. Coase (1937) identifies a discrepancy between
economic resource allocation and business leaders’ role on these allocations. More precisely,
Coase (1937) identifies the purpose of his paper “to bridge what appears to be a gap in economic
theory between the assumption that resources are allocated by means of the price mechanism and
the assumption that this allocation is dependent on the entrepreneur co-ordinator” (Coase, 1937).
The task of this memo is to answer the question of “why do organizations exist?” using the
principle benefits of a firm in Coase’s article. Our group will accomplish this by examining an
article that challenges a select few of Coase’s arguments. One specific argument Coase (1937)
makes that is to be challenged is how technology affects transaction costs. This argument will be
investigated in further detail later on. Prior to these investigations,it necessary to lay out Coase’s
main arguments and assumptions.
To demonstrate the reasons for the existence of a firm, Coase (1937) starts with the question
“why it is profitable to establish a firm”? The answer is the existence of marketing costs of
allocating resources through the price mechanism while a firm can direct resources more
efficiently depending on entrepreneur-co-ordinator, and reduce these costs including transaction
costs, costs of negotiating and contracts for each exchange transaction in an open market (Coase,
1937). When a firm comes into being, some authority such as an entrepreneur can direct
resources within the organizations, enabling production costs to be lower than costs of obtaining
a good or service from the outside market (Coase, 1937). Also, with short-term contracts, costs
are generated when every new contract is created. Accumulated costs can be large and so longterm contracts are desired, which can reduce costs and risk at the same time. This so called longterm contract leads to the establishment of a firm (Coase, 1937).
Another reason why firms emerge goes to the existence of uncertainty in market (Coase, 1937).
Coase (1937) starts with the assumption without uncertainty, in which case every worker is
doing exactly the right thing at the right time and hence managers are performing purely routine
function. However, in reality, with the introduction of uncertainty, the primary problem of
operation is to forecast future wants, and to determine what to do and how to do it (Coase, 1937)..
Production then requires and is based on the producer’s forecasting on customers’ wants.
Consequently, firms emerge to provide central direction for the process of production with the
knowledge, skills and judgement of an entrepreneur (Coase, 1937).
Last but not least, the division of labour contributes to the forming of a firm. Although this
rational is not as popular as the ones mentioned above, it does provide some insight for our
thinking. The growth of economy arouses differentiation and complexity, which is likely to
collapse into chaos (Coase, 1937). Integrating force is therefore of chief significance (Coase,
1937). Coase’s argument is that organization provides better integrating force than price
mechanism. It is human nature that A would guarantee B some benefits such as wages to get B
under control, only if the man is given that power to do so (Coase, 1937). And B is willing to be
under direction only with the guaranteed benefits. Hence enterprise and wage system come into
being and that prompts the establishment of a firm (Coase, 1937).
Coase (1937) argues that as the transaction costs of a firm decrease they have a tendency to limit
its expansion. The limit of a firm size is limited by its transaction costs until its value is zero
there is no need to increase the size of the firm because it would not give value to the transaction.
In Geoffrey Samson essay “The Myth of Diminishing Firms” (Sampson, 2003), he explains that
with today’s technology; the Coase’s argument does not stand. He explains that firms who uses
ERP (Enterprise resource planning), even though they lower their transaction costs, it does not
come as a variable on the sizes of the firms. Coase argues that as the transaction costs of a firm
decrease it also decrease its tendency to limit its expansion. We see examples of companies that
are still lowering their transaction costs but still increase in size. We can notice that when Coase
made ihs essay in 1937, computing companies did not exist. Companies were starting using
telephone or telegraph to do B2B transactions. These technologies help decrease transaction but
not as significantly as the arrival of computer and the different software that are implemented in
large sections of the manufacturing process and in B2B transactions. We believe that with this
new technology, and the facility to access any component of manufacturing transactions. The
threats of losing or sharing valuable information to undesirable outsiders or competition could
also demonstrate a reason to create firms or increasing their sizes. Trust is another reason to
create or increase the size of a firm because a firm would not have a leak of information or
knowledge travelling around between firms’ communication exchanges. The two latter reasons
were not expressed in Coase’s essay, but with the advance communication technologies already
in used, which were not invented in 1937; it should be taken into consideration.
Even though Coase’s (1937) theory has been around for many decades, we didn’t worship it as if
it was a holy bible. It can be challenged in terms of how well his theory answered the question:
why do firms exist. From Coase’s (1937) point of view, firms arise when they can arrange to
produce internally without the cost of the market such as information cost, negotiating cost,etc.
This can be very true by itself, but not quite complete when we look at it from a big picture.
Coase’s focus was on the imperfection of the market, rather than the strength of firms, which
should not be overlooked. It is also true that firms exist because they have functions that
individuals would not have.
Apple Inc. exists as a firm not to avoid transaction costs, but because they have the talents and
resources to invent and produce what’s not yet in the market. They do not exist to meet the
demand of the market, but to create demand for the market. Apple is only one example of
thousands of innovative companies existing in the current business world. As a matter of
fact, individuals can be inventors but don’t necessarily have the resources to make their
inventions available for the market. It is not uncommon to see patents from individuals sold to
companies to be further developed and commercialized to the market. At the same time, firms
have the power to invest in long-term bets on innovations that might not succeed. But once they
are successful, they are likely to disruptively redefine the market.
Firms also come into existence because they have the power to bring different talents together to
create value for the society, achieving the ideology of 1 plus 1 being larger than 2. Firms
facilitates education and culture where people compete and learn from each other, eventually
accomplish goals that are impossible for individuals to reach.
Although aspects of Coase’s theory are applicable to the nature of a firm ,and their existence, the
growth of technology and advancement of the business world has created instances that could not
have been foreseen by Coase. The expansion of the internet has connected the market to become
globally more accessible and has allowed firms to lower costs and connect with consumers with
much more easily. The new level of complexity in the market has diversified the existence of
firms to focus on innovation and creating products and services not already in the market. Coase
‘s idea of transaction costs effecting a firms ability to produce unless they are lowered by
producing internally is seen as narrow and challenged by current day trends of lowering costs
through virtual firms. From a big picture, Coase has ignored firm's strength also give rise to
firms existence and innovative firms exist to redefine the market rather than simply meet the
market's needs.
References
Coase, R. 1937. The nature of the firm. Economica, 4(16): 386–405.
Sampson, G. 2003. The myth of diminishing firms. Communications of the ACM, 46 (11): 25-28.