Coases theory of the firm

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Coase (193 7) contrasted the resource allocation role of the market and the firm. He contended that the market influenced resource allocation by price signals, while within the firm it was assumed resources that were allocated or moved at the direction of an ''entrepreneur co-ordinator'' and the ''distinguishing mark of the firm is the suppression of the price mechanism.'' Thus, ''it is clear that these (the market and the firm) are alternative methods of co-ordinating production'' (p. 42).

Coase further defined a firm as a ''system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur'' (p. 45). The reasons entrepreneurs start firms is that they are a more efficient method of organizing production and because there is a cost attached to using the market. By organizing production within a firm where resource movements are directed by the entrepreneur-manager, such market or transaction costs can be avoided or reduced. Therefore, firms will come into existence when the costs of consciously co-ordinating resources (governance costs) within the firm are less than the transaction costs of using the market.

An entrepreneur wishing to organize the production of a product has a choice between co-ordinating its procurement in the market by contracting others to undertake the necessary tasks or to undertake some or all of these within a firm created to produce the final product. In making this decision for any given activity, the entrepreneur will compare the marginal costs of making market transactions with those of doing it within the firm. Thus, one activity may be undertaken in the market and others within the firm, depending on the balance of advantage. Some firms may hire an outside agency to plan and undertake their advertising, while another firm may undertake the activity within the firm. Thus, within any firm a decision has to be made as to those activities that will take place within the firm and those that will be organized through the market. According to Coase the key to the decision is to compare the marginal cost of a transaction conducted in the market with the marginal cost of the same transaction conducted within the firm. If the marginal transaction cost of the market is less than the marginal transaction cost within the firm, then the transaction will take place in the market; if the reverse holds, then the transaction will take place in the firm.


To analyse the boundaries of the firm it is necessary to examine in further detail the nature of transaction and management costs. Table 14.1 lists the various costs that a firm might incur.

A transaction is an agreement between two or more economic agents to exchange one thing for another. Transaction costs are those incurred when using the market.

Table 14.1 Economic costs


Costs of


Production and

Making products of services:

Industrial arts

distribution costs

Labour costs Capital costs Raw material costs

Production function

Transaction costs

Using the market:

Bounded rationality

Discovering prices

Asset specificity

Negotiating contracts

Monitoring contracts

Management costs

Co-ordinating the actions of specialized agents: Costs of obtaining information Costs of co-ordinating inputs in production Cost of measuring performance

Bounded rationality

Motivation costs

Motivating agents to align their interests with managers or owners:

Costs of cheating or opportunistic behaviour Agency costs of owners and managers


Source Author

Source Author

For example, workers agree to sell their labour in exchange for a payment, while consumers agree a payment in return for receiving a desirable commodity or service. For the producer, transaction costs include discovering the range of potential suppliers, the specifications of the products and their prices, negotiating contract terms, monitoring performance and enforcing the terms of the agreement. The costs arising from organizing the same transaction within the firm might be termed ''firm transaction costs'' or ''management or governance costs''. These costs derive from the organization and management of production within the firm. Demsetz (1988) suggests transaction costs are the costs of any activity undertaken to use the price system. In a similar way, management costs should include those of any activity undertaken to manage consciously the use of resources.

Transaction costs arise from decision makers initially having to discover potential suppliers and identify market prices. Such a process may seem simple, but even for the consumer it can be an expensive one. For example, a regular purchaser of chocolate bars will know the prices of competing brands, but an infrequent buyer will be unaware of current prices. The latter would need to spend time discovering prices before making a decision. Such research is especially needed when goods are expensive and infrequently purchased.

Firms can avoid or limit the costs of using the market by negotiating long-term contracts with their workers and suppliers. The fewer the number of contracts signed in a given period of time the lower will be some aspects of transaction costs. However, long-term contracts have certain disadvantages in that market conditions and production technology may change in ways not foreseen when the contracts were signed. These changes will advantage one or other of the parties. However, within the firm these problems can be overcome by the ability of the entrepreneur/owner to redirect employees to new areas of activity, retrain workers and alter wages. However, this ability may depend on the flexibility of the contracts signed. In the UK many industrial disputes have followed attempts to get workers to do work not previously part of their duties.

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