The Nature of the Firm

Abstract

Economics and laypeople use the term 'firm' differently. In explicitly defining both usages, Coase (1937) reconciles the gap between the idea that the price mechanism controls the allocation of resources within a market and the idea that conscious power, in the form of the entrepreneur, must do so. The entrepreneur embodies both initiative, or forecasting people's desires, and management, or responding to market forces. The relationships that form when an entrepreneur directs resources define a firm. Firms may emerge when uncertainty allows buyers to dictate longer term contracts, when an entrepreneur can save marketing costs, and/or when government regulations like sales tax encourage it. Coase critiques a number of definitions of firms and explanations of their birth and growth. Usher and Dobb argue that the division of labor engenders the firm's emergence, but the price mechanism is already an 'integrating force in a differentiated economy.' The real question is why the entrepreneur should replace the price mechanism as the integrating force. Knight argues that uncertainty breeds a group that guarantees wages. Coase objects for two reasons. Not only do knowledge and expertise become commodities, Knight also hypothesizes that it would be impractical for one to purchase goods or services without supervising the work. But contracts illustrate the flaw: first, expertise and knowledge can be purchased via a contract; second, purchasers don't necessarily - and often don't - supervise contracted labor. Thus Knight's conceptualization cannot explain why the entrepreneur should supercede the price mechanism. Coase examines how firms grow: many assume that a firm's size is limited if its cost curve slopes upward under perfect competition, because it will not pay for more output than can be produced when marginal cost equals marginal revenue. The proposition fails to explain not only why a market contains more than one variety of a good, but also that there may be a point at which producing a new product is less costly than an old one. Four factors determine firm growth: the cost of using the market, the cost of organizing different entrepreneurs, the number, and finally the quantity produced. These definitions approximate the firm's organization. The question will always be whether it pays for the entrepreneur to take on additional costs and therefore grow. At the margin, the costs of organizing under the firm will equal the costs of organizing within the firm or of allowing the price mechanism to organize it. Businesses will continue to experiment, maintaining equilibrium. While equilibrium implies a static market, dynamic factors are also present; changing costs within both a firm and the larger market explain changes in firm size. This theory of moving equilibrium allows for a better understanding of the entrepreneur, who both innovates and manages. (RAS)

Keywords: Resource allocation, Contracts & agreements, Equilibrium, Firm growth, Prices, Costs, Transaction costs, Market resources, Uncertainty