Ronald Coase’s ‘Nature of the Firm’ By Charlie Evans

EveryDay Economics by K Shah & Dr I St John

5 min readOct 8, 2021

Why are some activities directed by market forces and others by firms?

A perplexing question in economics is why firms exist at all. In a market economy, why are all goods and services not simply exchanged through the market? Why do workers enter firms where they agree, in return for a wage, to be directed and told what to do by their employer? Why does an employer establish and maintain an entire IT department rather than just pay for IT services as and when they need them? This question of why firms exist at all was first posed and answered by the British Economist Ronald Coase of the LSE and then Chicago. He won the Nobel Prize for his work. Charlie Evans provides a summary of his path breaking argument.

What makes a firm?

The definition of a firm is a business organisation that produces and sells goods and services with the aim of making profit. They would operate within a market system, which is a place where buyers and sellers can meet to exchange goods and services. By definition, classical economists suggest that markets will set the most efficient allocation of resources as set by the price mechanism, therefore a question has arisen as to why firms can operate, when markets would set the most efficient outcome.

Coase’s argument

Coase argued that whilst the market achieved the most efficient allocation of the goods and services that are available, it does not mean that the market is the most cost-effective method to do so. This is because he identified certain costs associated with coordinating economic activity, which he called “transaction costs”. These costs can include examples such as the cost of agreeing and drawing up contracts, searching for contractors, or changing plans. Therefore, Coase suggests that an alternative institutional arrangement, the firm, can coordinate these activities involved in production, at a lower cost.

Firms can achieve these lower costs because the employees of the firm have already negotiated contracts where they are given work and told to do it, in return for a salary. By this method the cost of agreeing a price for the work each time the employee is given a task is negated and the costs of producing the goods and services will be lower than out-sourcing the tasks every time it needs to be completed. Further costs that would otherwise be involved in a market, such as search-costs and co-ordination costs can also be negated by the firm, as they have the workers to do the tasks already, and don’t have to look for labour, and managers make it easier and more cost effective in regards to coordinating where resources are invested and which workers will complete what tasks. Therefore, the firm is able to be more efficient than the market because it is able to negate the unseen costs, or “transactional costs ‘’, of a market. The higher the value of the costs that a firm can avoid compared to the market, the larger the scope of the firm will be.

How his theory relates to modern day

Coase’s theory is just as relevant in the modern world as it was when he first wrote about it. The role of the internet has drastically changed the way the market handles “transaction costs”, making the world more connected and driving down the costs. Search and coordination costs have been cut significantly through access to things such as Google and the ability to search for labour much easier through online advertisement, while technological advances make communication, particularly between market forces, much easier than ever before. Analysts describe modern economic engines as internet-based clusters of businesses. We have entered an age where companies retain their own identity, but function amongst other companies to create a gigantic business ecosystem, where services can be shared and traded to create more profit than they ever would be able to individually.

While the technologies of the modern world have lowered “transaction costs”, meaning the scope of individual firms decreases, it has offered the opportunity for new corporations and business ecosystems to emerge, and take the place of any traditional marketplace. Examples such as Boeing (the aircraft company) have highlighted this point, because they use the much easier ability to outsource production to their advantage, contracting out multiple phases of the aircraft production, such as the construction of the engines.

Looked at one way, Amazon.com is a website with many employees that ships books. Looked at another way, however, Amazon is a vast ecosystem that includes authors, publishers, customers who write reviews for the site, delivery companies like UPS, and tens of thousands of affiliates that market products and arrange fulfilment through the Amazon network.

Overall, Coase’s theory of the firm is a text that has helped us to understand and describe the transition of the firm throughout history. The firm, as a profit maximising agent, had drastically changed since Coase’s work was published in 1937, but his theories still have a huge impact to this day.

Ronald Coase’s ‘Nature of the Firm’ By Charlie Evans

Written by EveryDay Economics by K Shah & Dr I St John