The Nature of the firm - R.H.Coase

The Nature of the Firm R. H. Coase Economica, New Series, Vol. 4, No. 16. (Nov., 1937), pp. 386-405. Stable URL: http://links.jstor.org/sici?sici=0013-0427%28193711%292%3A4%3A16%3C386%3ATNOTF%3E2.0.CO%3B2-B Economica is currently published by The London School of Economics and Political Science. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/lonschool.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is an independent not-for-profit organization dedicated to and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support@jstor.org. http://www.jstor.org Mon Apr 2 18:28:01 2007 The Nature of the Firm ECONOMIC from failuretheory has suffered in the past a to state clearly its assumptions. Economists in building up a theory have often omitted to examine the foundations on which it was erected. This examination is, however, essential not only to prevent the misunderstanding and needless controversy which arise from a lack of knowledge of the assumptions on which a theory is based, but also because of the extreme importance for economics of good judgment in choosing between rival sets of assumptions. For instance, it is suggested that the use of the word " firm " in economics may be different from the use of the term by the " plain man."l Since there is apparently. a trend in economic theory towards starting analysis with the individual firm and not with the i n d u ~ t r y , ~ it is all the more necessary not only that a clear definition of the word " firm " should be given but that its difference from a firm in the " real world," if it exists, should be made clear. Mrs. Robinson has said that " the two questions to be asked of a set of assumptions in economics are : Are they tractable ? and : Do they correspond with the real world ? "3 Though, as Mrs. Robinson points out, "more often one set will be manageable and the other realistic," yet there may well be branches of theory where assumptions may be both manageable and realistic. I t is hoped to show in the following paper that a definition of a firm may be obtained which is not only realistic in that it corresponds to what is meant by a firm in the real world, but is tractable by two of the most powerful instruments of economic analysis developed by Marshall, the idea of the margin and that of substitution, together giving the idea of substitution a t 1 Joan Robinson, Economics is a Serious Subject, p. 12 . 2 See N. Kaldor, "The Equilibrium of the Firm," Ecolrotnic Jounzal, March, 1934 Op. cit., p. 6. 19371 THE NATURE OF THE FIRM 387 the margin.' Our definition must, of course, " relate to formal relations which are capable of being conceived exa~t ly . "~ I t is convenient if, in searching for a definition of a firm, we first consider the economic system as it is normally treated by the economist. Let us consider the description of the economic system given by Sir Arthur Salter.3 "The normal economic system works itself. For its current operation it is under no central control, it needs no central survey. Over the whole range of human activity and human need, supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive." An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organisation but an organism.' The economic system "works itself." This does not mean that there is no planning by individuals. These exercise foresight and choose between alternatives. This is necessarily so if there is to be order in the system. But this theory assumes that the direction of resources is dependent directly on the price mechanism. Indeed, it is often considered to be an objection to economic planning that it merely tries to do what is already done by the price mechanism.6 Sir Arthur Salter's description, however, gives a very incomplete picture of our economic system. Within a firm, the description does not fit at all. For instance, in economic theory we find that the allocation of factors of production between different uses is determined by the price mechanism. The price of factor A becomes higher in X than in Y. As a result, A moves from Y to X until the difference between the prices in X and Y, except in so far as it compensates for other differential advantages, disappears. Yet in the real world, we find that there are many areas where this does not apply. If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so. Those who 1 J. M. Keynes, Essays in Biography, pp. 223-4. 8 L. Robbins, Nature and Significance of Economic S&cc, p. 63. a This description is quoted with approval by D. H. Robertson, Confrol of Industry, p. 85, and by Professor Arnold Plant, "Trends in Business Administration," ECONOMICA, February, 1932. It appears in Allied Sbipping Control, pp. 16-17. See F. A. Hayek, " The Trend of Economic Thinkmg," E c o ~ o m r c ~ ,May, 1933. See P. A. Hayek, op. cit. 388 ECONOMICA [NOVEMBER object to economic planning on the grounds that the problem is solved by price movements can be answered by pointing out that there is planning within our economic system which is quite different from the individual planning mentioned above and which is akin to what is normally called economic planning. The example given above is typical of a large sphere in our modern economic system. Of course, this fact has not been ignored by economists. Marshall introduces organisation as a fourth factor of production; J. B. Clark gives the co-ordinating function to the entrepreneur ; Professor Knight introduces managers who co-ordinate. As D. H. Robertson points out, we find < c islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk."' But in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organisation necessary ? Why are there these c c islands of conscious power " ? Outside the firm, price movements direct production, which is co-ordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator, who directs ~ r oduc t i on .~ I t is clear that these are alternative I methods of co-ordinating production. Yet, having regard to the fact that if production is regulated by price movements, production could be carried on without any organisation a t all, well might we ask, why is there any organisation ? Of course, the degree to which the price mechanism is superseded varies greatly. In a department store, the allocation of the different sections to the various locations in the building may be done by the controlling authority or it may be the result of competitive price bidding for space. In the Lancashire cotton industry, a weaver can rent power and shop-room and can obtain looms and yarn on redi it.^ This co-ordination of the various factors of production is, however, normally carried out without the intervention of the price mechanism. As is evident, the amount of "vertical " integration, involving as it does 1 Op. cit., p. 85. I n the rest of this paper I shall use the term entrepreneur to refer to the person or persons who, in a competitive system, take the place of the price mechanism in the direction of resources. 3 u r v e . y of 'Textile Industries, p. 2 6 , THE NATURE OF THE FIRM 38919371 the supersession of the price mechanism, varies greatly from industry to industry and from firm to firm. I t can, I think, be assumed that the distinguishing mark of the firm is the supersession of the price mechanism. I t is, of course, as Professor Robbins points out, " related to an outside network of relative prices and costs,"l but it is important to discover the exact nature of this relation- ship. This distinction between the allocation of resources in a firm and the allocation in the economic system has been very vividly described by Mr. hlaurice Dobb when discussing Adam Smith's conception of the capitalist : "I t began to be seen that there was something more imoortant than the relations inside each factory or unit captained by an undertaker; there were the relations of the undertaker with the rest of the economic world outside his immediate sphere . . . . the undertaker busies himself with the division of labour inside each firm and he ~ l a n s and organises consciously,~~ but "he is related to the kuch l a r ~ e r economic s~ecialisation. of which he himself is merelv " I one specialised unit. Here, he plays his part as a single cell in a larger organism, mainly unconscious of the wider r81e he fills."Z In view of the fact that while economists treat the price mechanism as a co-ordinating instrument, they also admit the co-ordinating function of the '' entrepreneur," it is surely important to enquire why co-ordination is the work of the price mechanism in one case and of the entrepreneur in another. The purpose of this paper is to bridge what appears to be a gap ill economic theory between the assump- tion (made for some purposes) that resources are allocated by means of the price mechanism and the assumption (made for other purposes) that this allocation is dependent on the entrepreneur-co-ordinator. We have to explain the basis on which, in practice, this choice between alternatives is effected.3 1 Op. cit., p. 71. Cap$ialisr Gnr~rprisr. and Social Progress, p. zo. Cf., also, Henderson, Siipply and Dc~na;id, P P :-5 3 I t is easy to see when the State takes over the direction of an industry that, in planning it, it is doing something urhich was previously done by the price mechanism. What is usually not realised is tha t any business man in organising the relations between his depart- ments is also doing something which could be organised through the price mechanism. There is therefore point in Lit. Durbin's answer to those rvho emphasise the problems involved in economic planning that the same problems have to be solved by business men in the competitive system. (See " Economic Calculus in a Planned Economy," Econornir Journal, December, 1936. ) The important difrerence between these two cases is chat economic planning is irnposed on industry while firms arise voluntarily because they represent a more efficient method of organising production. In a competitive system. there is an " optimum " amount of planning ! 390 ECONOMICA [NOVEMBER II Our task is to attempt to discover why a firm emerges at all in a specialised exchange economy. The price mechanism (considered purely from the side of the direction of resources) might be superseded if the relationship which replaced it was desired for its own sake. This would be the case, for example, if some people preferred to work under the direction of some other person. Such individuals would accept less in order to work under someone, and firms would arise naturally from this. But it would appear that this cannot be a very important reason, for it would rather seem that the opposite tendency is operating if one judges from the stress normally laid on the advantage of < L being one's own master."l Of course, if the desire was not to be controlled but to control, to exercise power over others, then people might be willing to give up something in order to direct others ; that is, they would be willing to pay others more than they could get under the price mechanism in order to be able to direct them. But this implies that those who direct pay in order to be, able to do this and are not paid to direct, which is clearly not true in the majority of cases.2 Firms might also exist if purchasers preferred commodities which are produced by firms to those not so produced; but even in spheres where one would expect such preferences (if they exist) to be of negligible importance, firms are to be found in the real world.3 Therefore there must be other elements involved. The main reason why it is profitable to establish a firm would seem to be that there is a cost of vsing the price mechanism. The most obvious cost of " organisiilg " production rhrough the price mechanism is that of discovering what tlie relevant prices a r e . V l i i s cost may be reduced but it will not be eliminated by the emergence of specialists ~vhowill sell this information. The costs cf negotiating and 1 Cf. Har ry Dawes, '' Labour nlobility in t h e Steel Industry," E~oiio, i i icgourtzal, hlarcl?. r?j+,, who inst:~ncca " t h e t r ek to retail shopkeeping and insurance work b y the better paid or sk~ l l ed inen due t o the desire (often t h e main aim in lite of a worker: L O he independent " (P. 86). 2 None tlie !ess, this is not al together fancifl~l . Some small shopkeepers a re said to eazn less than their assistants. 3 G. F . Siiove, " T h e Imperfection of the hlarkrc : a Fur the r Notr!" Ecorion~ic Jouriinl, Atarch, 1933, p. " 6 , note I , points ou t t h a t such preferences niay exist, al though t h e rxample h e gives is almost the reverse of the instance given in the text . 1 According t o !<. hnldor , " A Classificatory I io te of the Detern3inaicness of Equilibriiun," Rav iw gi Ecoizo,,tlr Studies, February, 1934, i t is onr of the ;issumptions o i stat ic theory tha t ":?I1 rhe relevzint prices arc known to all individuzils." R u t i h i r is clearly no t true of the real world. 19371 THE NATURE OF THE FIR^^ 391 concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account.] Again, in certain markets, e.g., produce exchanges, a technique is devised for minimising these contract costs ; but they are not eliminated. I t is true that contracts are not eliminated when there is a firm but they are greatly reduced. A factor of production (or the owner thereof) does not have to make a series of contracts with the factors with whom he is co-operating within the firm, as would be necessary, of course, if this co-operation were as a direct result of the working of the price mechanism. For this series of contracts is substituted one. At this stage, it is important to note the character of the contract into which a factor enters that is employed within a firm. The contract is one whereby the factor, for a certain remuneration (which may be fixed or fluctuating), agrees to obey the directions of an entrepreneur within certain linzits.2 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. There are, however, other disadvantages-or costs- of using the price mechanism. It may be desired to make a long-term contract for the supply of some article or service. This may be due to the fact that if one contract is made for a longer period, instead of several shorter ones, then certain costs of making each contract will be avoided. c 3 Or, owing to the risk attitude of the people concerned, thev mav refer to make a long rather than a short-term i , I " contract. Now, owing to the difficulty of forecasting, the longer the period of the contract is for the supply of the commodity or service, the less possible, and indeed, the less desirable it is for the person purchasing to specify what the other contracting party is expected to do. It may well be a niatter of indifference to the person supplying the service or commodity which of several courses of action is taken. but not to the ~urchaser of that service or corn- I modity. But the purchaser will not know which of these several courses he will want the supplier to take. Therefore, 1 This influence was noted by Professor Usher when discussing the development of capitalisn~. Hr says : " Tne successire buying and selling of partly finished products were sheer waste ili energy." (1,rtrodtdrtion i o the I ~~du s t r i a lHistory of England, p. 13). But he does not develop the idea nor consider why i t is tha t buying and selling operations still exist. 11 would be possible for no limits to the powers of the entrepreneur to be fixed. 'l'liis ~roiildbe voluntary slavery. According to Professor Batt , The La:; o j .Ilasiet. nrrd Scrvonl, p. IS, such a contract mould be void and unenforceable. 39= ECONOMICA [NOVEMBER the service which is being provided is expressed in general terms, the exact details being left until a later date. All that is stated in the contract is the limits to what the persons supplying the commodity or service is expected to do. The details of what the supplier is expected to do is not stated in the contract but is decided later by the purchaser. When the direction of resources (within the limits of the contract) becomes dependent on the buyer in this way, that relationship which I term a " firm " may be obtained.' A firm is likely therefore to emerge in those cases where a very short term contract would be unsatisfactory. It is obviously of more importance in the case of services- labour-than it is in the case of the buying of commodities. In the case of commodities, the main items can be stated in advance and the details which will be decided later will be of minor significance. We may sum up this section of the argument by saying that the operation of a market costs something and by forming an organisation and allowing some authority (an " entrepreneur ") to direct the resources, certain marketing costs are saved. The entrepreneur has to carry out his function at less cost, taking into account the fact that he may get factors of production at a lower price than the market transactions which he supersedes, because it is always possible to revert to the open market if he fails to do this. The question of uncertainty is one which is often considered to be very relevant to the study of the equilibrium of the firm. I t seems improbable that a firm would emerge without the existence of uncertainty. But those, for instance, Professor Knight, who make the mode oj payment the distinguishing mark of the firm-fixed incomes being guaranteed to some of those engaged in production by a person who takes the residual, and fluctuating, income- would appear to be introducing a point which is irrelevant to the problem we are considering. One entrepreneur may sell his services to another for a certain sum of money, while the payment to his employees may be mainly or wholly a share in profit^.^ The significant question would ' O I course, i t is not possible to draw a hard and fast line which determines whether there is a fir111 or not. There may be more or less direction. I t is similar to the legal question of whether there is the relationship of master and servant or principal and agent. See the disc