Economist R. Coase and The Nature of the Firm

By Zikuan (Daniel) Zhu | October 27, 2022

Ronald Coase is one of the most influential economists in the 20th century. Though, his study spanned different fields exceeding economics. He was known for his theoretical analysis about the formation of firms in his early years and his essay “The Problem of Social Cost”. The main purpose of this article is to offer a brief introduction to Coase and offer roles about his article “The Nature of the Firm” in economics and highlights in the essay.

Based on the account Kiesling, in her writing the essential of Ronald Coase, Coase was born in Willesden, a London suburb, on December 29th 1910. He received his Bachelor of Commerce degree in London School of Economics and Political Science (LSE) in 1932 and continued his doctoral study on economics in LSE. During his college years, he was awarded a scholarship which supported him to have research in the U.S. from 1931 to 1932. During his visit to the U.S, he studied at the University of Chicago and visited the factories of Ford and General Motor. Studies on large firms like General Motors and Fords provided the basis for his empirical data and support for his essay The Nature of the Firm which was written in 1937 and published in the Economia. Coase spent the rest of his life in school doing teaching and research in the U.K and the U.S. He was awarded the Nobel Prize in 1991 for his research on the firms.

Coase’s essay “The Nature of the Firm” has a significant role in economics for it talks about how firms functioned in the market system. In the past, Economists generally assumed that the firms transformed the inputs which are the factor of production into output to satisfy the demand of the output in a miracle. This neglect of analysis of firms’ mechanics left a logical discrepancy in the economic explanation of market structure at that time for the market allocates its resources by changing prices and the firm allocates its resources often through the commands of entrepreneurs. This creates a contradiction for the fact that firms are parts of the market and there would be a necessity to explain the phenomenon of why firms don’t allocate their resources through prices. The explanation would be significant because otherwise we could not identify the shifters of the supply curve in the market because the firms are the cells of the market supply curve. Under this circumstance, Coase explained the mechanics of the firms.

There are three highlights in the essay. First, Coase named the dichotomy between the firm and the market as price suppression. He first pointed out that the price mechanism cannot be applied to be the explanation for the formation of the firms. He reasoned as follows: it would be illogical for firms to have to pay their workers in order to direct them which implies that there is no incentive for creating a firm. However, given that the firms already exist, Coase provides another insight to explain the formation of the firms decrease of the transaction costs. Coase reasoned that it would be cheaper for firms to create long term contracts with employees for the employers could set up plans in the long term and consider training the workers for higher efficiency and therefore reducing the cost of negotiating for short term contracts. Next, Coase talks about the transaction cost, including search cost, cost of acquiring information etc, determining the things that firms buy and things for firms to produce. This is intuitive because the firms are more willing to decrease the cost as much as possible and there would be a trade off between purchase and production. This idea is easier to manifest by considering the example of Ice-Cream shops, quoted from Kiesling’s book The Essential Ronald Coase. In the present market there are two types of shops: ice cream retail shops and ice cream producing shops. The manager of the retail shop is willing to buy ice-cream from the ice-cream factory because it would be too expensive for the store to produce the ice-cream. On the other hand, the chef of the ice cream shop is willing to produce ice cream in his or her shop because the chef has skills to make ice cream and it is not necessary to buy ice cream from outside. Then Coase talks about how transaction costs and management costs determine their scale. If both transaction and transaction costs are low, the firm would increase the scale which would increase the management cost, and it would decrease otherwise if there is a high management cost. We need to appeal that the firms would produce in the quantity where marginal cost is equal to the marginal revenue and it is determined by both cost and the revenue.

Edited by Zachary Elias