In his well-known 1937 article “The Nature of the Firm” Ronald Coase explains the reason for firms as a solution to inherent problems in a market context. The argument is basically that firms arise because their hierarchical and process-controlling structure offer a way of arranging and supplying the factors of production that is in many ways cheaper than the “normal” market solution.
The market solution, according to the main body of economic theory, is based on the assumption that there are no real costs of transacting, since there is no cost of knowledge. All actors in the market have “perfect knowledge” and thus there cannot be costs associated with “finding” and communicating knowledge. This “ideal” situation may offer a number of simplifications important to the numerous, but is essentially wrong if thought of as descriptive of the real world.
In the real world, whether the market is free or regulated, there is no such thing as perfect knowledge. Rather, every action and interaction entails cost only in order to come about. Any seller and buyer need to find each other, negotiate terms, as well as monitor the other party so that he or she complies with the terms of the contract. These costs, generally called “transaction costs” since they occur to make the transaction happen, are generally high and difficult to overcome (if at all possible).
Since transaction costs permeate the real market, which is not the case in the economic theory of the market, every action and interaction is costly. Every decision that has to be made in order to bring about production of or trade for goods and services entails these costs. Coase’s argument for the firm is here that the firm, through management planning, can internalize these costs and make them part of the interior workings of the firm and thereby avoid the lion’s share of these costs.
This is done through establishing for instance employment contracts, where the employer pays the employee to “follow orders” rather than negotiate and establish contracts with other actors in the marketplace each and every time a new type of task needs to be carried out. As long as the manager of the firm manages to plan the internal processes in a way that is at least as efficient as the workings of the price mechanism in the market this internalizing makes sense.
Following the assumption that the manager, or “entrepreneur” to use Coase’s terminology, is a profit-maximizer (as is usually the case), he or she will want to internalize costs as long as the marginal benefit is at least as high as the marginal cost. In layman’s terms, the manager will choose to hire more people as long as the cost of doing so does not exceed the costs of carrying out the same tasks “on the market.”
We will thus, if Coase is right, see firms find internal solutions rather than rely on the market and its price mechanism for as long as:
Marginal benefit (MB) > Marginal cost (MC)
But this should not be interpreted as firms will internalize costs whenever MB > MC and “externalize” these costs again as soon as something in the market changes (e.g. price) so that MB < MC and there is actually reason for “outsourcing.” These processes are subject to tardiness – they take time and require the firm to focus and invest money in restructuring production processes rather than producing. Thus, we should, to a certain degree, be able to truthfully claim the firm will only act if there is a sufficient amount of savings to be made from acting.
Does this tardiness work the same way for both internalizing and externalizing? Can we claim a firm will always choose to restructure as soon as the difference between marginal benefit of internalizing (or keeping internal) and marginal cost of externalizing (or keeping external) is above the sufficient level?
The answer to this question should be no, and there are multiple reasons for this.
Firstly, the costs of internalizing are explicit and in general more “visible” than costs of making transactions in the market place. This should mean that if a firm chooses to internalize a certain function or process, it is done because it is believed that the firm “can afford it.” It is not as easy to calculate the real costs of externalizing, which means there should be a greater tardiness for the latter simply because understanding and predictability of the two situations is fundamentally biased towards internalizing.
Secondly, there are psychological reasons for internalizing and not externalizing. The firm, following Coase’s argument and definition, is about control. It is through control of the production processes, established by the set up of “open ended” employment contracts, the entrepreneur manages to outdo the market, at least in the short term.
It is reasonable to assume that the entrepreneur, a person who (at least initially) knows what to do, seeks control. (Control should here be interpreted as in “setting up production processes” or “organizing/arranging inputs in a specific way to make outputs.”)
This point can be further understood when considering the so-called endowment effect. The theory of the endowment effect states that a person tends to place a higher (subjective) value on objects they own than in “desirables” they do not [yet] own. Ownership is a form of control – the property right is the right to control the owned object, to be the ultimate decision-maker for what is to be made of the property (at least with respect to other people).
Would it not, considering the endowment effect, be reasonable to assume there is an endowment effect in firms too? The entrepreneur, again using Coase’s definition of the term, seeks and establishes control of the production process through founding the firm. The control of the production process through the firm is a form of ownership/control, and thus we should be able to safely conclude that there is a psychological tardiness to externalize – the entrepreneur should thus hesitate to give up control, and thus ownership.
What we see here is that there should be a psychological bias towards control, hierarchy, and firm-building as opposed to market solutions. And there is also a bias (see 1 above) regarding information: the entrepreneur can more easily foresee the effects of internalizing whereas the effects of externalizing are difficult, if not impossible, to foresee.
Of course, the entrepreneur can overcome such information problems in the case of externalizing, but that would undoubtedly lead us back to transaction costs and the Coasean argument for the firm.
Can we then conclude that there is an overall market bias towards structure and control rather than decentralization and competition? At least the two aspects discussed above – the information problem and the endowment effect with respect to the internalizing/externalizing decision – seem to suggest that the market “calls for” firms rather than independent contractors. This view, if true, fundamentally undermines the common understanding of the market.