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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.
Nice post, interesting ideas. Some quick reactions:
1. There’s a large “managerialist” literature, dating back to Baumol (1959), Marris (1964), and Williamson (1964) arguing that managers pursue growth, complexity, and entrenchment rather than profitability. Their arguments are different from yours, however.
2. The loss-aversion story could make sense for an owner-managed firm, but is harder to see in a corporation with a large and potentially diverse top management team. Acquisitions and divestitures in these firms are complex decisons involving many individuals, variables, and relations. Can we apply individual psychological concepts to such teams?
3. Even if the biases you describe are true, they tell us something about managers’ preferences, not necessarily their actions, because they are constrained by internal and external control mechanisms. Will the Board permit non-value-maximizing growth? What about the market for corporate control? Won’t the stock market penalize firms that grow to satisfy managers’ tastes for size? Won’t such firms be easy takeover targets, a la Manne (1965)?
4. I’m not sure I buy your point about internal transaction costs being more visible than external transaction costs. If a firm has been outsourcing a particular function for a long time, then it has historical cost figures on external sourcing, but only conjectures about the costs of internal procurement. It seems to me this difference could go either way.
5. In general, I agree that the Coasian story is usually told in comparative-statics terms that don’t take adjustment costs into account. (See Richard Langlois’s work on “dynamic transaction costs” for an exception, however.)
Response to some of Peter G. Klein’s points:
2. I agree. The firm I was thinking of when writing this post was a newly started or at least not fully grown firm. Part of the reason for this is the rather intuitive idea that a firm being started as a “response” to high transaction costs is not a corporation “with a large … top management team.” The firm that is established to internalize transaction costs, as Coase discusses, might very well become extremely big – but it shouldn’t normally be a big corporation from day one.
3. The manager and board may have different aims, and it is well known that the board might not be able to monitor the manager at all times. The so-called principal-agent problem might mean the manager can make decisions that are not in the value-maximizing interest of the firm. Also, the drivers of internalizing, as discussed in this blog post, could have effect on board decisions as well – there is no reason a board, with responsibility for strategic decisions, would not take the same stand as the manager when considering plans for the future. The visible vs invisible costs and endowment effect could affect boards and even stock holder (even though I grant that the latter is much less likely).
4. The point of internalizing transaction costs, at least following Coase’s view of the firm, is that they are avoided or minimized in a non-market production process. There are transaction costs within the firm, but I would expect a firm management to be rather knowledgeable of what costs are effectuated by the production process. They might not be as knowledgeable of what costs might arise from “externalizing” already internalized costs and processes. It is a matter of what we know and what we don’t know – and what we think we know of possible alternative arrangements. (This is, essentially, the first argument above.)
1.The discussion is very interesting and I totally agree with the effort to try to develop the film or try to construct a more dynamic interpretation.
2.But, even if that bias you mention exist. Those firms would be less efficient that one more decentralized. In a dynamic perspective, we expect that those entrepreneurs that overcome their psychological propensity to centralize and do decentralize some activities, would lead their companies to a higher growth. Then other entrepreneurs would copy the organization innovation in order to survive. So in the long run, the bias would no exist.
3.Title. The existence of firms in the economic system has nothing concern to socialism. It is implicit in the title that an economic system with higher firms or more vertical integrated production activities is more close to socialism. I don’t see the connection.
Response to Mario Mondelli:
2. There are two comments I wish to make to this point you are making. The first one regards the endowment effect, as referenced in the blog post. If there is such a thing as an endowment effect, which is one of the assumptions in this post, it wouldn’t be reasonable to assume people are able to “overcome” this “psychological propensity” to such a degree that it ultimately changes the market in such a way that it rejects the bias.
I fully understand the argument, but it is essentially flawed: if it is in man’s psychological nature to value that which is owned higher than that which is not, then that is one of many “laws” in the market. It is a fundamental property of the market, since the market consists of individuals interacting, and as such it cannot be undone, overcome or rejected. The very reason the endowment effect is used in this blog post is that it tells us about the nature of man – and that nature, by definition, is fixed.
The other point I wish to make has to do with the argument that it is generally [much] easier to foresee the effects of internalizing than to externalize costs. If this is true, and this is another of the assumptions in the argument, then your argument again is flawed or at least not applicable.
I agree that firms in a free market will adopt processes and activities that have been proven effective and efficient, and that those firms refusing to adopt more profitable processes will eventually be “weeded out.” The argument is both valid and important, but it does not target the assumptions made. And since the assumptions are of such nature that they, if accepted, necessarily bring about such effects as the ones I have described, your argument is simply invalid.
3. There is good reason for using the word “socialism” in the title for this blog post. In a Misesian/Hayekian sense socialism means planning of production in a “command” sense rather than market sense; socialism is the production in absence of the price mechanism. This definition, and the Hayekian discussion on the importance of tacit knowledge and information of the specific situation (not available to central planners), was discussed at length in the so-called Socialist Calculation debate.
Coase, in his 1937 paper cited above, talks of such planning in the market: firms. In his words, there are “[i]slands of conscious power” where the price mechanism is set aside or essentially overruled to the benefit of “central planning” by the entrepreneur organized in the firm. Indeed, this theory-contradicting phenomenon is one of the reasons Coase decided to study the reasons for the firm.
Three points:
(1) I accept the endowment effect argument. It could even explain the deviation of decision of most managers to internalize rather than externalize transactions because they assign a higher value to have control over certain assets (human and physic).
But, it does not necessary have to be a universal law for every manager behavior. A small number of managers, even randomly, could take different decision. You may agree that in a market economy you have a high variation of strategies being implemented everyday. And the point is that if those decisions of decentralized leads to higher profits, then others would follow the success formula.
If we want to see it in a dynamic perspective, you could have the endowment effect at t=0, but at t=n this effect will be vanished.
(2) I believe we are discussing about an underling assumption. The regularities in organizational structures (production coordinated through market, hybrid forms or within the firm) that we observe in an economic system are the most efficient within their institutional environment. If you agree with this assumption, as I understand Coase agree, then the endowment effect could explain some manager’s strategies, but it may not explain the regularities in the long run.
(3) I am glad that you explicit the concept of socialism you referred in the title. Two points on this:
(i) As you state “socialism is the production in absence of the price mechanism”. But a firm does not completely neglect the price mechanism. You have fiat power but decisions are also based on price mechanism. So, an economic system where means of production are owned by big private firms is far from socialism.
(ii) You may agree that “socialism” is a more broad concept and what most people understand or what come first at Wikipedia is: […] socio-economic system in which property and the distribution of wealth are subject to control by the community (Encyclopedia Britannica. 2006) for the purposes of increasing social and economic equality and cooperation. […] As an economic system, socialism is often characterized by socialized (state or community) ownership of the means of production. According to this definition, socialism it not just refer to how production is coordinated but who control the means of production.
Response to Mario Mondelli.
I’m afraid it isn’t possible to both accept and reject the endowment effect as an explanation to managerial decisions. The effect, as it is discussed, is a result of people’s psychology and thus ultimately an effect of what it is to be a human being. If we accept the endowment effect as a psychological propensity it works the same way as the assumption that people are rational: they may be rational to differing degrees, but there is no such thing as irrational people. It simply isn’t possible do away with one’s psychological propensities and so the “limits” of such propensities cannot be overcome.
This does not mean your argument is utterly useless – it may very well be that competition in the market place works in a way so that the endowment effect is minimized. I believe that you are right in this statement to some degree, but you are exaggerating the applicability of the argument. If there is an endowment effect, which you seem to accept initially, then there is a human psychological propensity to “overvalue” that which is owned and “undervalue” that which is not (I’m here using the terminology of objective values theories to make the point very clear). And if markets tend to, through competition, minimize costs then overly excited owners of property (here: entrepreneurs or managers of firms) will face costs they will not be able to bear in the competitive market. But it does not follow from this that the endowment effect will be forced to ZERO! There is no such thing as a psychological propensity that people choose to do away with and that due to market forces “vanishes.”
You are also rather ambivalent in your argument. The endowment effect might very well be an explanation for firm-building and internalizing, but I have nowhere claimed it is the main or even among the main explanations. I have simply claimed that if there is an endowment effect it should cause, individually or together with other “effects,” a tardiness or a general bias towards property and control rather than free contracts. This is the main point in this blog post, and a point you seem to have disregarded.
Yet you accept the fact that there is a psychological propensity and that it might explain SOME managers’ decisions. Well, if it is truly a psychological propensity it should be among the explanatory variables for ALL managers and all their decisions, but perhaps to varying degrees. You have to either accept the endowment effect or reject it – it isn’t possible to do both.