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Anyone who cares about capitalism and economics should mourn the death of
Ronald Coase
THE job of clever people is to ask difficult questions. The job of very clever
people is to ask deceptively simple ones. Eighty years ago a young British
economist wondered: why do companies exist? The answer that he gave remains as
fascinating today as it was back then.
Ronald Coase lived an extraordinarily long and productive life (see Free
exchange). In awarding him the Nobel prize for economics in 1991 the Swedish
Academy singled out two papers for particular praise, one published in 1937 and
based on a lecture which he gave in 1932 when he was only 21 years old, and one
published in 1961. He published his last book, How China Became Capitalist ,
last year at the age of 101. Not bad for a London boy whose parents both left
school at 12 and who was consigned to a special-needs school because he wore
leg braces (it was only the timely intervention of a phrenologist who detected
considerable mental vigour in the bumps on his head that redirected him to
grammar school and thence to the London School of Economics).
But it is his work on the firm that marked him out for greatness. Most
economists had been content to treat firms as black boxes. Mr Coase wondered
what the black boxes were doing there in the first place. He used a scholarship
that he won as an undergraduate to visit leading American firms such as Ford
and General Motors. He summed up his thinking in his 1937 essay, The Nature of
the Firm , which at first attracted no attention whatsoever, but continues to
be cited to this day.
Mr Coase argued that firms make economic sense because they can reduce or
eliminate the transaction cost of going to the market by doing things
in-house. It is easier to co-ordinate decisions. At the time, when
communications were poor and economies of scale could be vast, this justified
keeping a lot of things inside a big firm, so carmakers often owned
engine-makers and other suppliers.
Coase is dead, long live the firm
Mr Coase s theory of the firm would suggest that firms ought to be in retreat
at the moment, because technology is lowering transaction costs: why go to the
bother of organising things under one roof when the internet lowers the cost of
going to the market? And it is true that companies are rising and falling at a
faster rate than ever. Back in 1958, companies in the S&P 500 had typically
stayed in the index for 61 years; today the average is just 18 years. Nokia
produced a quarter of the world s handsets in 2000. This week it decided to
focus on making telecoms equipment and sold its handset business to Microsoft,
which is also a shadow of its former self (see article).
But far from bringing an end to big companies, the internet is producing
Goliaths of its own. Google accounts for about 40% of the world s internet
traffic, and Amazon is experimenting with vertical integration by investing in
content as well as distribution. That could be because transaction costs,
although lower than they used to be, are still a significant part of doing
business: it is still easier to work on complex ideas, designs, deals and
projects face to face.
Or it could be because firms do other jobs that Mr Coase did not acknowledge:
they can develop intellectual resources, for instance, from company-specific
knowledge to specialised skills that cannot be developed by individuals acting
on their own or working through the market. That even applies to the murky arts
of journalism. For instance, 170 years ago this week, a newspaper appeared,
often written largely by one man, James Wilson. To the relief of its now
slightly larger but obviously no less industrious workforce, The Economist
survives.
Whatever happens to this particular transaction-costs-reduction device, Mr
Coase s work should remain close to the heart of anyone who cares about
capitalism. He taught economists that they should not just pore over numbers
but look inside the organisations that produce wealth. And he set a test that
every boss still has to answer: what does their firm do that cannot be done
more efficiently elsewhere?