Coase explains that firms, as an institution, arise to economise on transaction costs. He believes that the market will work at its best when transaction costs are low. If the costs are high then, firms have this incentive option to use its internal mechanisms instead of the market transactions.
As transactions become more complex and too difficult for individuals in a firm to manage, the market can be brought in to maintain the level of competitiveness. This suggests that even though it will cost less to carry out transactions within firms yet, does not rule out the need for contracts totally. The result of this is that the number of unnecessary contracts will be reduced and replaced by a single (longer-term) contract. ‘This single contract sets out the extent of the power that the entrepreneur has over the factor in directing production’ Firms may expand to a certain point where an additional allocative measure would cost more internally than if it would through market. If the transaction cost is zero, there would be no rises of firms. All transactions would take place through little contracts between normal individuals instead of firms again.
Coase caught the factors which are responsible for why firms are held together. He focused on the practices of entrepreneurs and observed how they would determine the direction of factors or production and to control and direct employees working within the firm. By doing so, certain marketing costs are saved. Once the directions of resources are dependent to the buyers now, firms’ relationship is established and this may give rise to the emergence of firms of longer-term contracts.
Having accounted for why do firms exist, this brings us to the question regarding the size of the firms. Firms, as argued in this essay, if to internally transact would lead to the further increase in its size and number of transactions internally rather than through the price mechanism. However, Coase asked, why if the costs when transact internally is lower, do we not have just one large firm carry out the transactions? Coase explained that there are ‘diminishing returns to management’ and suggested three problems in relation to the factors that limit the growth of the firms.
- The costs of organising additional transactions internally may rise as well as decreasing returns as firms increase in its size. The cost of an additional transaction within the firm maybe equal to transacting within the market.
- The entrepreneur might fail to allocate resources where the value is highest as the number of transactions that are organised internally increases.
- Smaller firms may get the advantages at lower supply price.
In Coase's view, the limit of the firm growth is at the point where the marginal cost savings from transacting within the firm is equal to the cost of combined of errors and administrative rigidity. ‘a firm will tend to expand until the costs of organising an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organising in another firm’.
However, it is not clear than an employer can tell an employee what to do, any more than a consumer can tell her grocer what to do (what vegetables to sell at what
prices); in either case, a refusal will likely lead to a termination of the relationship, a firing. Coase's theory is subject to the criticism that it is unclear why the problems
of joint production and monitoring must be solved through the firm and cannot be solved through the market.
The transaction costs approach is advantageous because it can be broadened to encompass a wide range of factors which may affect firm behaviour
including informational uncertainty, the number of competitors (market concentration), and key human factors like bounded rationality and
opportunism (Carlton and Perloff, 1994; pp. 5).
The benefit of the transaction costs model in economics is that:
...Unlike neo-classical theory, This approach does not take production in the economy to be a purely technical question, a matter of
combining inputs according to known blueprints. Instead, it sees economic activity as requiring skills and organisation. Neither of these
are in a sense given. Economic actors must struggle with the limitations to human knowledge and what those actors do know is mostly
know-how, the inarticulate form of knowledge Michael Polanyi described as Tacit...It is in this sense, then, that an organisation can be
a co-ordinating institution: it can sometimes avoid the co-ordinating costs of informing, negotiating with and persuading potential
contracting parties who may not share one's faith in the proposed innovation or even, in a fundamental sense, one's view of the world
(Silver, 1984; Langlois, 1988) (Langlois, 1994; pp. 175-177).
The transaction costs model is important because its implications are valid for economic changes occurring today. During the industrial era, people
wanted basic goods in their cheapest form. In response to demand, firms focused on economies of scale, creating mass produced commodities at the
lowest price. As a result, there was no large market for unique goods. The operation of the industrial firm was well illustrated by the neo-classical
production function and the pursuit of optimally priced products.
Since the 1970s, there has been a resurgence of demand for specialised products. The advances in flexible manufacturing, made possible by
computers, allow different products to be developed without a major increase in price. The conversion from a transforming function to a creative
co-ordinating process is the result of flexible production methods observed by David Lyon:
By the 1970s, however, falling demand for standardised, mass-produced goods, plus competition from newly industrialised countries
such as those on the Pacific rim, stimulated the search for new ways, less rigid and confining than Fordism. Flexible manufacture -
post-Fordism - introduced a more volatile labour market, faster switches from one product to another, and a far greater consumer
orientation. A scramble for new technologies, new patterns of management and new global inter-connections, from finance capital to
markets, was the result (Lyon,1994 pp. 45).
Therefore, the decreasing demand for standardised products has led to flexible manufacturing techniques for developing niche goods. The rise of
consumerism, fuelled by the demand for new and differentiated products, requires a reassessment of the firm. Because of the change in context,
firms must be malleable so they can transform themselves as their products change frequently with demand.
There are two reasons why industrial firms may have a problem with product re-alignment. First, firms have traditionally focused on the production of
a singular product. Yet, as information technology enables versatility, large firms must reorganise as the demand for bulk products wane and product
life-cycles become shorter. The second reason why firms need to adapt is their traditional focus on long-term contracts for stability. Coase claims
that firms enter into long-term contracts to assist with planning by reducing uncertainty (Coase, 1991; pp. 21). In the past, legally binding agreements
were essential to co-ordinate a firm's activities because they enabled detailed planning. If a firm could sign multi-year contracts to provide a
particular good or service this sanctioned their use of long-run forecasts. In an environment where the structure of demand can be altered quickly,
inflexible firms that cannot adapt to the inherent uncertainty will become extinct.
However, firms using computers and telecommunications benefit from an increased span of managerial control. Extended managerial control is
manifest in both the numbers of people one person can oversee, and the space needed to oversee them. Computers and telecommunications allow
information to be distributed quickly, decreasing the uncertainty of coordinating actions. A decrease in uncertainty leads to a lower set of transaction
costs and a de-centralised organisational structure. A de-centralised firm structure will support flexibility needed for changing demand.
The central observation of Coase was his emphasis on transaction cost theory. Coase reasoned that interaction between players in the market does not happen
costlessly; every transaction in an economy has a cost associated with it which has to be accounted for somewhere. As transactions become more complex and too
difficult for single individuals to undertake, organisations form (firms) to manage and contain the transaction costs.
Coase observed the factors which cause firms to be held together. He drew on the practices of entrepreneurs and managers and observed their capacity to control
and direct the people working in the firm. This control and direction of individuals inside firms by the managers is legally possible, observed Coase, due to the
existence of the master and servant, common law employment relationship. Coase reasoned that if the entrepreneur did not have the legal "right to control" the
people working in the firm, then transaction costs could not be contained and (presumably) the firm could not exist. This view is widely held.
In this manner Coase's observation exclusively tied the existence of firms to the maintenance of internal control through the master/servant, employer/employee legal
relationship. In so doing he postulated, I think without realising, a direct interdependence between the very existence of markets and the legal right of one human to
control another human.
This link is in direct contradiction to everything we know about markets, namely that markets depend for their existence on legal and actual freedom of the individual
to choose.
This observation of the legal employment control structure of the firm, is not I believe an observation and explanation of free markets but rather an observation of
market restrictions and perversions. Firms under master servant models are models of anti-markets. In addition, macro economic modelling based on the "right to
control" assumption is anti-market.
Firms arise to economize on transaction costs. The existence of firms is due to the thinking, planning and contracting costs that accompany any transaction, costs
usually ignored by the neoclassical paradigm. The idea is that in some situations these costs will be lower if a transaction is carried out within a firm rather than in the
market. According to Coase, the main cost of transacting in the market is the cost of learning about and haggling over the terms of trade. But, according to Coase,
this authority is precisely what defines a firm: within a firm, transactions occur as a result of instructions or orders issued by a boss, and the price mechanism is
suppressed. In Coase's view, the boundaries of the firm occur at the point where the marginal cost savings from transacting within the firm equal the resulting cost of
added of errors and administrative rigidity.
However, it is not clear than an employer can tell an employee what to do, any more than a consumer can tell her grocer what to do (what vegetables to sell at what
prices); in either case, a refusal will likely lead to a termination of the relationship, a firing. Coase's theory is subject to the criticism that it is unclear why the problems
of joint production and monitoring must be solved through the firm and cannot be solved through the market.
In this manner Coase's observation exclusively tied the existence of firms to the maintenance of internal control through the master/servant, employer/employee legal
relationship. In so doing he postulated, I think without realising, a direct interdependence between the very existence of markets and the legal right of one human to
control another human.
