Coase and the Nature of the Firm

Economist and Noble Laureate Ronald Coase died earlier this month just three months short of his 103rd birthday. Coase is mostly famous for two papers: “The Nature of the Firm” (1937) and “The Problem of Social Cost” (1960). He came up with many of the ideas for the first paper when he was just 21. Coase asked the simple question of why companies exist. According to Adam Smith it should actually be more cost-effective for a person to contract out work rather than hire people. Coases’s answer was that there are always transaction costs or frictions that make a firm more cost-effective. In other words, the market (i.e. price mechanism) is not always the most efficient way to organize production. The size of a firm is determined by the point when the extra (marginal) cost of organizing an extra employee balances the transaction costs of obtaining her services on the free market. Hence, the great irony of modern capitalism is that its main pillar, the firm, is a paragon of central planning. Firms in essence are totalitarian regimes where the citizens are free to leave.

Conservative and libertarian leaning individuals generally prize  private companies and free markets over governments. They argue that many of the functions of government, such as schools and healthcare, would be more efficient if privatized. The question then is why are private firms more efficient than government? When we hand over functions formerly performed by a democratically elected government, we are in essence making society less democratic. One could argue that firms are more efficient because they are subject to competition. That is why we want to break up monopolies. However, that should be true of government too. If we don’t like the government we have then we can always elect another one. We can even change the constitution to our liking. In principle, no one is under more competition than our elected officials. It is the job of the citizenry to ensure that they are doing their job.