Confidential - for classroom use only
Why do Business Organizations Exist?
Per Ronald Coase (b. 1910),
Why is there a business firm at all?
Why is not all production organized in one large firm?
What determines the boundaries of the firm?
It is the essential nature of the firm to replace the inherent equality among market participants with hierarchic, authority relations
Firms are an efficient response to the impossibility of foreseeing and contracting on what tasks will need to be undertaken
“The Nature of the Firm”
The Nature of the Firm
was a brief but highly influential essay in which Coase tries to explain why the economy is populated by a number of
business firms, instead of consisting exclusively of a multitude of independent, self-employed people who contract with one
another. Given that "production could be carried on without any organization [that is, firms] at all", Coase asks, why and under what
conditions should we expect firms to emerge?
Since modern firms can only emerge when an entrepreneur of some sort begins to hire people, Coase's analysis proceeds by considering
the conditions under which it makes sense for an entrepreneur to seek hired help instead of contracting out for some particular
The traditional economic theory of the time suggested that, because the market is "efficient" (that is, those who are best at providing each
good or service most cheaply are already doing so), it should always be cheaper to contract out than to hire.
Coase noted, however, that there are a number of transaction costs to using the market; the cost of obtaining a good or service via the
market is actually more than just the price of the good. Other costs, including search and information costs, bargaining costs,
keeping trade secrets, and policing and enforcement costs, can all potentially add to the cost of procuring something with a firm.
This suggests that firms will arise when they can arrange to produce what they need internally and somehow avoid these costs.
There is a natural limit to what can be produced internally, however. Coase notices a "decreasing returns to the entrepreneur function",
including increasing overhead costs and increasing propensity for an overwhelmed manager to make mistakes in resource
allocation. This is a countervailing cost to the use of the firm.
Coase argues that the size of a firm (as measured by how many contractual relations are "internal" to the firm and how many "external") is
a result of finding an optimal balance between the competing tendencies of the costs outlined above. In general, making the firm
larger will initially be advantageous, but the decreasing returns indicated above will eventually kick in, preventing the firm from
Other things being equal, therefore, a firm will tend to be larger: