The source of the gain from having a firm is that the organization of a market costs something and that, by forming an organization and allowing the allocation of resources to be determined administratively, these costs are saved.
-Ronald Coase, "Industrial Organization"
Whenever thinking about Ronald Coase's contributions, especially his theory of the firm, I always tend to associate it with Hayek's distinction between the micro- and macro-cosmos within The Fatal Conceit. For Hayek, even though the extended order, the macro-cosmos, is a complex system which receives its order from cooperation conditioned by abstract signals, that complex system was still constituted by many, often seemingly countless, microcosms of human cooperation.
Rather than receiving the source of their order from impersonal interactions like bidding on a stock market or spot transactions at a convenience store, microcosms receive their order from strategic, repeated interactions between unique individuals, often codified into long-term contracts. The microcosms, which can also be known as organizations, are thus, as Hayek titled a section of a chapter, the “elements of spontaneous orders.” The primary question that Coase tries to tackle in “The Nature of the Firm” is”to discover why a firm emerges at all in a specialized exchange economy” can thus be understood as an analysis as to what makes possible the existence of certain types of microcosms, or if you wish organizations, in society requiring different norms of cooperation than the extended order that nevertheless exist side-by-side to the extended order.1
After all, as Coase explains in the very same article, this is a topic of interest if the impersonal coordination within the macrocosm of Hayek's extended order lead to the most efficient utilization of resources. If this were the case, then why would other forms of social cooperation based on concretely planning the utilization of means of production towards the satisfaction of wants be needed? Have economists not shown that society can function without the need of any omniscient planner simply by the interactions of individuals within the decentralized markets of the extended order. If the extended order truly “works,” then why are there small islands of planning within it that maintain their coherence despite the efficiency of the market process?
Coase explains the emergence and continued existence of these microcosms otherwise known as firms because of the costs of interacting within the extended order. Yes, it can bring about human cooperation across the entire planet, can make possible an intensely specialized division of labor throughout that blue marble, can allocate means of production to satisfying the most urgent wants of consumers, and can bring about peaceful relations among human beings despite nation, race, and creed, but that doesn't mean that the extended order can exist without reference to the microcosms that constitute it. It would be a mistake to think that human cooperation within the extended order, even cooperation restricted to the economic, do-ut-des sphere, is universally atomistic with cooperation being spot transactions between impersonal agents. Instead, the interaction of human beings is also conditioned by other factors within the world that make possible for the emergence and the maintenance of microcosms like a firm.
Among the factors conditioning the evolutionary landscape of economic institutions are the costs Coase identifies with “using the price mechanism.”2 Two causes behind these costs include the effort behind searching for the lowest prices available, and the effort that goes into specifying and negotiating a complete contract to dictate the terms of the interaction. The existence of these microcosms within the extended order are thus conditional upon there being costs for a lone individual to simply get by with spot transactions and hammering out contracts with everyone else on their own. Firms are thus a type of social order that has emerged in the course of human beings dealing with a world in which there are costs to participating in the extended order. (One could follow conventional econ jargon and call these “transaction costs,” but I feel myself as it the concept has been drained of all meaning. Transaction costs are used by economists to explain everything and in doing so the concept has become completely amorphous.)
This consideration brings us to Coase's greatest contribution to the study of human society, his analysis that voluntary trades in property rights will result in the optimal allocation of resources for the amelioration of human uneasiness in the world in “The Problem of Social Costs.” Indeed, the Coase Theorem, as those following Stigler tend to call this result, seems to provide an extension of the First Welfare Theorem, which states that a complete market can reach an efficient allocation of resources, to the non-market world as long as there is efficient bargaining. However, there is really no Coase Theorem since “The Problem of Social Costs” is not intended to show that efficient allocations always exist in the world despite the existence of so-called frictions within social interactions. Instead, Coase's purpose was to provide a reason to believe that self interest could, contra Pigou's welfare economics, result in exchanges in property titles that could yield the best state of the world. In addition, Coase's narrative of people bargaining leading to the optimal allocation of resources provides a useful foil to studying real institutions in the real world.
Overall, Coase's contributions have helped enlarge our appreciation of how organizations, microcosms within the sea of the greater extended order, have emerged and survived throughout human history. In order to understand the nature of human cooperation, we have to understand it beyond the arena of perfect competition; instead, we must understand its institutional peculiarities in actual societies across the world. To understand how the extended order has grown over the centuries, we have to understand how the organizations that constitute the extended order function, and it is to this study that Ronald Coase has provided us with a monument for the ages in “The Nature of the Firm” and “The Problem of Social Costs” alone.
1 Ronald Coase, “The Nature of the Firm” in The Firm, the Market, and the Law (Chicago: Chicago University Press, 1988), 37.
2 Ibid, 38.