Comparison of theories of the firm

Ronald Coase is the author of the first well known theory of the firm, titled “Nature of the Firm”. He was the first to question and analyze the reason of firm existence in the economy. Coase’s “Nature of the Firm” raised both positive and negative critics among other economists which resulted in creation of other theories of the firm. One of those theories is “Production, information costs, and economic organization” written by A. Alchian and H. Demsetz. Their theory was not meant to dispute Coases’ theory, but it stated some new reasons that Coase did not elaborate on.

“Nature of the Firm” is based on the Coase Theorem, for which Coase was awarded with the Nobel prize. In brief, the theory discusses about transaction costs between two contractors, and what effect they have on the outcome of each contract. He compares the unrealistic case of no transaction costs with the realistic one which makes them present in every day life. Even the most competitive and perfect markets may only be perfect from the perspective of price, but not from the perspective of information. Coase divided transaction costs of using any market into costs of searching inputs and suppliers, measuring their suitability, negotiating the price, monitoring the supplies and the costs of renegotiation and litigation. Coase states that these costs make an incentive of forming a firm, as firm would avoid them if it was producing the same good instead of buying it. The firm avoids the price mechanism cost through entrepreneurs authority. This rises another question of why the market exist at all and why there isn’t only one big firm producing all the goods. The answer is in the transaction cost of the firm itself. Although the firm solves some market costs, it creates new costs of hierarchy, such as employment contracts. Its cost can be divided in the same way as market transaction costs: costs of searching appropriate workers, measuring their suitability, negotiating their wages, supervising and disciplining them. These costs are not related only to the existence of the firm, but to its size as well. Stated by Coase, the costs of rising size of the firm are the decreasing returns to entrepreneurs’ function, which means less efficient organisation of additional transactions within the firm, and less efficient use resources. Coase also stated three conditions for a firm to expand: 1. if the costs of organising are smaller then the benefits, 2. if the entrepreneur is not likely going to make more mistakes in allocation of resources 3. if the price of inputs decreases(economies of scale). Compared with the perfect market, firms may bring some social costs such as decrease in innovation, higher prices as a consequence of profit maximization and lesser economies of scope although the firm may bring about economies of scale. The costs and benefits of markets and firms is what puts them in the balance. One of our basic assumptions is that both firms and individuals want to maximize their profits, which means equating the marginal costs and marginal benefits of expanding the firm and using the price mechanism of the market.

Alchian and Demsetz agree with Coase about the transaction costs, but they argue that transaction costs are not the main reason for creation of firms. The point at which they disagree with Coase is authority and power within the firm. “Production, information costs, and economic organization” begins with explaining how contracts within the firm have no greater importance or consequences if broken than those in the market. Results of failed contracts or services can either resolve in the termination of any future contracting between the two parties or by a court case. It is illustrated with an example of how firing your employee is not very different from breaking a contract whit your grocer by stopping purchasing his goods. What Alchian and Demsetz emphasize as the reason of firm existence is teamwork and monitoring. They argue that if a job could be done more efficiently within a team that it should be done so. But teamwork brings a negative consequence known as the “tragedy of the commons”. It happens as a result of different individual and social rationalities. The individual will tend to act in an opportunistic way whenever he can gain privately and at the same time share the costs with others. One example is overusing common resources, e.g. over-fishing, other example is contributing less to the common resources, e.g. shirking in a teamwork. In extreme cases when everyone would act in that way there would be no common resources as they would either be overused in the first example or not made at all in the second. If everyone was altruistic there would be no problem at all, but unfortunately that is not the case. So when there are transaction costs, it matters very much who owns which assets and how they are used. So what enables the firm to successfully cuts down shirking among the workers are the property rights of the firm. They consist of positive rights which state what owner can do to his property, and negative rights which state what owner cannot do. It is also important to note that under the ideal conditions, an efficient property rights system has three following factors: universality, exclusivity and transferability. Universality means that all the assets are owned, by one or between more parties, exclusivity means that non-owners can be excluded from any property rights and transferability means that the property may be sold. The owner has the right on the profits, which is his biggest incentive not to shirk himself and to monitor his employees. He also has the right to hire and fire workers and has complete control of all other inputs.

In conclusion, the points on which Coases’ theory differs from the one of Alchian and Demsetz is that Coases’ main and only reason for existence of the firm is the presence of transaction costs. According to him, owners’ authority will displace costs of the market, and the firm should grow until the marginal cost of market and firm become equal. Alchian and Demsetz disagreed with the importance of authority, they introduced the “tragedy of the commons” and offered firms’ monitoring function as a its solution. What the two theories agree on is the presence of transaction costs, as mentioned above, and on diminishing returns to size. While Coase says that production of an additional unit within the firm may be more costly than buying it on the market Alchian and Demsetz say that monitoring an extra worker may be more costly than the contribution he would bring.

1) Alchian and Demsetz. 1972. Production, information costs, and economic organization. American Economic Review 62 (December): 777-795

2) Coase. 1937. The nature of the firm. Economica 4 (November): 386-405.