When Ronald Coase was a college student, he wondered why we needed firms when the prevailing wisdom was that prices alone could make the world go round and round. He looked in vain for a satisfactory answer in his books. So he boarded a ship in England and found his way to Detroit, Michigan. It was in the early 1930s. He got himself into car assembly plants and watched how people worked together. In 1937, he reported what he had learned in “The Nature of the Firm.”
Coase’s explanation of the firm is so simple that it can be boiled down to six words: Firms are better at managing relations. The explanation is extraordinary because everybody else thought the essence of a firm was production, not management. For that same reason, though, economists did not want to take his explanation seriously. Coase (1972) mused 35 years later: “What is curious about the treatment of the problems of industrial organization in economics is that it does not now exist.” Then, 16 more years later, Coase (1988, p. 62) again reviewed the impact of “The Nature of the Firm” and found the article to be “much cited but little used.” Macey (2008, p. 5), alarmed by economists’ willful blindness to Coase’s wisdom, issues a warning: “(I)f Coase is right … then everything is up for grabs—or up for negotiation—including the issue of what the basic objectives and purpose of the corporation should be.”
In this Appendix, I revisit Coase’s theory of the firm. I show that profit comes about from management, not production. It follows that the manager—not the owner—collects profit.
“A firm,” according to Coase (1937, p. 339), “consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.” Firms are an alternative resource-allocation mechanism to the price mechanism. Why do firms exist in the midst of the price mechanism? Coase’s explanation is simple: some of us think that we are better at allocating resources than the price mechanism.
Let’s consider a barber by the name of Joe. He does one hairdo a day. He has been thinking about an occupational choice: go solo or work for someone by the name of Mary. If he goes solo, he can charge and keep the competitive price p
. But then he must manage the relation with the grumpy and manipulative customer, thereby incurring a transaction cost τ
. His daily net income as a solo barber is
$$ \left(p-\tau \right) $$
If, alternatively, he works as an employee for Mary, who owns a barber shop, Mary pays him a fixed daily wage of w
. Also, Mary deals with all customer payment and complaints. All Joe needs to do is deal with Mary the boss. For that relation, Joe incurs a daily transaction cost θ
. In sum, Joe’s net daily income as an employee equals:
$$ \left(w-\theta \right) $$
Joe considers the two incomes. He chooses the higher income.
Let’s say that, unlike most other barbers, Joe turns out to be indifferent between working as a solo and working as an employee. His indifference may be expressed as the equality of the two net incomes above:
$$ \left(p-\tau \right)=\left(w-\theta \right) $$
$$ \left(p-w\right)=\left(\tau -\theta \right) $$
This equality says that Joe is indifferent because the extra net income as a solo is equal to the extra transaction cost as a solo.
This indifference equation turns out to be the link between the Coasian firm, founded on transaction costs and management, and the neoclassical firm, founded on prices and production. To show the link most directly, assume that Mary’s barber shop produces X haircuts a day by employing X barbers and dealing with X customers. Let its cost of administering these relations be A(X), which increases with X. Then Mary’s profit equals:
$$ \pi (X)= pX- wX-A(X) $$
$$ \pi (X)=\left(p-w\right)X-A(X) $$
By substitution from Eq. (2.4), Eq. (2.6) becomes
$$ \pi (X)=\left(\tau -\theta \right)X-A(X) $$
Mary’s profit, then, becomes a function of transaction costs entirely. Her profit is equal to the transaction cost that she can save by substituting herself for the price mechanism.
This pretty much captures the essence of Coase’s theory of the firm.