The Nature of the Firm

Author: Ronald H. Coase

Economica Vol. 4 (November 1937)
pp. 386-405

Presented by Danielle Jones

 Background
• Born in 1910 in London, England
• On faculty at London School of Economics when
The Nature of the Firm was published
• “Father” of transaction costs economics
• Currently Professor Emeritus of Economics at
University of Chicago Law School
• Nobel Memorial Prize in Economics in 1991
• Still alive and conducting research
 Problem
• Economic theory fails to clearly state its
assumptions

• Economic analysis tends to begin with the

individual firm

• Economists and people in the “real world” have

different definitions of a firm
 Purpose
• Definition and clarification of the firm

• To provide a definition that is realistic and

tractable (manageable)

• To clarify when resources are allocated by the

price mechanism (the market) and when they are
allocated by the entrepreneur (firm)
 Why does the firm exist?
• There are market (transaction) costs associated with
using the price mechanism to organize production
– Price discovery costs
– Contract and negotiation costs
– Regulation costs (taxes)
– Uncertainty costs

• A firm (under the authority of an entrepreneur) can

coordinate resources and minimize transaction costs
 Definition of firm

“…the system of relationships which

comes into existence when the direction
of resources is dependent on an
entrepreneur” (p. 393).
 What determines firm size?
• Amount of transactions

• Mistakes
– Failure to utilize factors of production properly
– Waste of resources

• Supply price of factors of production

 Cost curve of the firm
• As firm gets larger, there may be
decreasing returns to the
entrepreneur
– Loss in efficiency

• The firm will engage in the

number of transactions where
the costs of doing so in the firm
are equal to the transaction
costs in the market or to the
costs of organizing by another
entrepreneur

• Also determines number of

products produced by the firm
(Washington, 2013)
 Application of the firm to the “real world”

• Looks at legal relationships of master and servant

(employer and employee)

• Servant must be under the duty of rendering

personal services to the master

• Master must have the right to control the

servant’s work
 Tractability (manageability) of the firm
• The principal of marginal returns works
“smoothly” with determining firm size

• At the margin, the costs of organizing within the

firm will be equal either to the costs of organizing
in another firm or to the costs involved in leaving
the transaction to be organized by the price
mechanism