Coase's Economic Theory

In the article The Nature of the Firm by R. H. Coase, Coase posed the question why do firms exist. He set out to define the difference in an economy that is influenced by a firm and that which is influenced by the price mechanism therefore explaining why firms emerge.

Coase starts by out by attempting to define a firm that was both tractable and realistic in definition. He states that a “distinguishing mark of the firm is the supersession of the price mechanism.” This means that he believed that a firm could replace the price mechanism as the coordinating instrument to reduce cost and organize production. He also believes that a firm consists of relationships which emerge when an entrepreneur directs resources.

Coase then asks under what condition would we expect a firm to develop? A firm will expand when an entrepreneur determines that the cost of a contract in the open market is more expensive than hiring a person that specializes in a particular function. This was a theory that was new for his time. The transactional cost associated with contracts on the market would need to be considered when procuring a good or service. These costs could possibly add to the cost of acquiring the good or service which would encourage the entrepreneur to expand the firm. Marketing cost would be another reason for firms to develop. Entrepreneurs would conglomerate to reduce their cost. Coase states that a firm will continue to grow with each transaction, but there is a natural limit.

A firm will reach a point of diminishing return when there is decreasing returns on the entrepreneur function. The entrepreneur could fail to optimally use the factors of production or the cost to organize the extra transaction is too high. When there are decreasing returns a firm will be prevented from growing. This is the point when it is no longer profitable for the entrepreneur to make another transition versus making a contract on the open market. Thus a firm would want to stop expanding prior to hitting that diminishing return. It would be below the open market cost and therefore would support the idea of the entrepreneur/firm.

Coase’s article The Nature of the Firm gives an explanation of how and why firms are developed and the benefits of a firm versus the price mechanism making transaction on the open market.

Coase’s