Ronald Coase, a renowned economist who taught at the University of Chicago, developed a theory of economics in the 1930s that addressed the purpose of business organizations. The theory was published by the London School of Economics in its publication Economica in November, 1937 in an essay entitled “The Nature of the Firm.” In this paper, Coase argued that the efficiencies of the market are best taken advantage of by organized firms as opposed to individuals.

The importance of Coase’s work in The Nature of the Firm set forth a powerful argument for business organizations and their control of economic processes, such as the pricing mechanism. Firms, well positioned to assume a master role in the economy, are better able to influence and control pricing than an individual, who has comparatively little influence. The essay explained why individuals choose to cluster in groups (firms) when trading through markets, as opposed to acting as independent agents.

Underlying Theory Within The Nature of the Firm  

The underlying theory of Coase’s work deals with the choice individuals make to create firms to transact business as opposed to operating as self-employed individuals. Coase argues that the existence of firms is driven by costs, basic supply and demand, as well as production considerations. Economic activity ultimately rests on the ability of individuals to provide their services to a firm and to, as a collective body, produce goods and services.

Firms versus Individuals

Coase’s seminal essay was written when he was twenty-six years old and a newly minted economist from the London School of Economics. He seized upon Adam Smith’s The Wealth of Nations and its discussion about the division of labor, choosing to focus his work on the division of management and management decisions.

The organization a firm provides can help save on the transactional costs associated with doing business. A firm can hire employees, manage their workload, enter into price negotiations, and bring about the enforcement of contracts much more efficiently than an individual. Individuals who are self-employed can technically complete those operations as well, but usually at a cost far too expensive or cumbersome to maintain a profitable enterprise.

The Cost Efficiency of Organized Firms 

The firm, through its collective power and organizational efficiency, is a more efficient cost mechanism for a business than a self-employed individual. The danger, however, with organized firms is that organizational costs, if not properly maintained, can swell to a point where the company becomes too large to manage effectively. Much of this cost control falls upon the management expertise and decision making skills of those in charge and their ability to hold costs as low as possibly while meeting desired outcomes.

There is a subset of economics that has been created based on Coase’s focus on the existence of transactional costs as justification for firms. Coase sets forth, as an argument for the firm in The Nature of the Firm that, “[t]he most obvious cost of ‘organizing’ production through the price mechanism is that of discovering what the relevant prices are.” Coase further argues that firms have an inherent ability to control costs because the negotiation process does not take place endlessly, and they are able to set prices for a relatively long period of time.

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Justin Kaiser is a freelance writer who concentrates on law, finance, law & economics, business, banking and other associated topics; those interested in joining the world of finance should consider the financial analyst jobs with moneyjobs.com.

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