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2010-12-21 12:09:07
Ronald Coase, the author of The Nature of the Firm (1937), turns 100 on
December 29th
Schumpeter
Dec 16th 2010 | from PRINT EDITION
FOR philosophers the great existential question is: Why is there something
rather than nothing? For management theorists the more mundane equivalent is:
Why do firms exist? Why isn t everything done by the market?
Today most people live in a market economy, and central planning is remembered
as the greatest economic disaster of the 20th century. Yet most people also
spend their working lives in centrally planned bureaucracies called firms. They
stick with the same employer for years, rather than regularly returning to the
jobs market. They labour to fulfil the strategic plans of their corporate
commissars. John Jacob Astor s American Fur Company made him the richest man in
America in the 1840s. But it never consisted of more than a handful of people.
Today Astor s company would not register as a blip on the corporate horizon.
Firms routinely employ thousands of workers and move billions of dollars-worth
of goods and services within their borders.
Why have these islands of conscious power survived in the surrounding ocean
of unconscious co-operation , to borrow a phrase from D.H. Robertson, an
economist? Classical economics had little to say about this question. Adam
Smith opened The Wealth of Nations with a wonderful description of the
division of labour in a pin factory, but he said nothing about the bosses who
hired the pin-makers or the managers who organised them. Smith s successors
said even less, either ignoring the pin factory entirely or treating it as a
tedious black box. They preferred to focus on the sea rather than the islands.
Who knows the secret of the black box?
The man who restored the pin factory to its rightful place at the heart of
economic theory celebrates his 100th birthday on December 29th. The economics
profession was slow to recognise Ronald Coase s genius. He first expounded his
thinking about the firm in a lecture in Dundee in 1932, when he was just 21
years old. Nobody much listened. He published The Nature of the Firm five
years later. It went largely unread.
But Mr Coase laboured on regardless: a second seminal article on The Problem
of Social Cost laid the intellectual foundations of the deregulation
revolution of the 1980s. Eventually, Mr Coase acquired an army of followers,
such as Oliver Williamson, who fleshed out his ideas. In 1991, aged 80, he was
awarded a Nobel prize. Far from resting on his laurels, Mr Coase will publish a
new book in 2011, with Ning Wang of Arizona State University, on How China
Became Capitalist .
His central insight was that firms exist because going to the market all the
time can impose heavy transaction costs. You need to hire workers, negotiate
prices and enforce contracts, to name but three time-consuming activities. A
firm is essentially a device for creating long-term contracts when short-term
contracts are too bothersome. But if markets are so inefficient, why don t
firms go on getting bigger for ever? Mr Coase also pointed out that these
little planned societies impose transaction costs of their own, which tend to
rise as they grow bigger. The proper balance between hierarchies and markets is
constantly recalibrated by the forces of competition: entrepreneurs may choose
to lower transaction costs by forming firms but giant firms eventually become
sluggish and uncompetitive.
How much light does The Nature of the Firm throw on today s corporate
landscape? The young Mr Coase first grew interested in the workings of firms
when he travelled around America s industrial heartland on a scholarship in
1931-32. He abandoned his textbooks and asked businessmen why they did what
they did. He has long chided his fellow economists for scrawling hieroglyphics
on blackboards rather than looking at what it actually takes to run a business.
So it seems reasonable to test his ideas by the same empirical standards.
Mr Coase s theory continues to explain some of the most puzzling problems in
modern business. Take the rise of vast and highly diversified business groups
in the emerging world, such as India s Tata group and Turkey s Koc Holding.
Many Western observers dismiss these as relics of a primitive form of
capitalism. But they make perfect sense when you consider the transaction costs
of going to the market. Where trust in established institutions is scarce, it
makes sense for companies to stretch their brands over many industries. And
where capital and labour markets are inefficient, it makes equal sense for
companies to allocate their own capital and train their own loyalists.
But Mr Coase s narrow focus on transaction costs nevertheless provides only a
partial explanation of the power of firms. The rise of the neo-Coasian school
of economists has led to a fierce backlash among management theorists who
champion the resource-based theory of the firm. They argue that activities
are conducted within firms not only because markets fail, but also because
firms succeed: they can marshal a wide range of resources particularly nebulous
ones such as corporate culture and collective knowledge that markets cannot
access. Companies can organise production and create knowledge in unique ways.
They can also make long-term bets on innovations that will redefine markets
rather than merely satisfy demand. Mr Coase s theory of market failure needs
to be complemented by a theory of organisational advantages .
All this undoubtedly complicates The Nature of the Firm . But it also
vindicates the twin decisions that Mr Coase made all those years ago as a young
student at the London School of Economics: to look inside the black box rather
than simply ignoring it, and to examine businesses, not just fiddle with
theories. Is it too much to hope that other practitioners of the dismal science
will follow his example and study the real world?