Home > The Economics Profession > Coase, uncertainty, and the firm

Coase, uncertainty, and the firm

from Peter Radford

The Economist notes Ronald Coase’s one hundredth birthday. I should not allow this to go uncommented upon. To me Coase asked one of the most simple yet subversive questions of all time in economics: why do firms exist?

To regular people outside the wonderland of orthodox economic theory, this question usually induces something between an indifferent yawn, and a totally indifferent shrug. Business firms are such a huge factor in our daily lives that we take them for granted.  Most people work in one, or know plenty of others who do. So why ask such a dull and, frankly, obvious question? Surely economists have that one covered. 

Umm, no.

I know this, because the “theory of the firm” was my entry point back into economics a decade or so ago. Having spent years in the business world I simply assumed that somewhere in the literature, maybe hidden from view, was a great deal of theorizing about the firm. I wanted to delve into it because I was convinced that said theory would guide me towards an answer to my own question, which was far more parochial: what will happen to the structure of the firm once information technology is fully embraced?

I came across Coase early in this search, and was happy to see he first posed his sly little enquiry in 1937. My search was immediately stalled. Hie question elicited no response. Economists were, and largely still are, totally uninterested in the firm and in the actual operations of business. Indeed in one paper two luminaries, Alchian and Demsetz, argued it was of no consequence, although I am happy to report they have backtracked subsequently.

How can this be?

Wonderland admits no organization other than the magic of markets. Ergo: no firms. If markets are so magical that they solve all the world’s economic coordination problems, which is what orthodox economists believe, then firms are an anomaly. Worse, they are an embarrassment.

I have a vague recollection of a character in Dickens called Podsnap, a bureaucrat who solves the unsolvable by waving his hand and dismissing the issue as a minor nuisance beneath his august attention. Maybe he was an economist because this is the standard method they adopt towards business. It is a mucky black box unworthy of their higher and more rarified examination.

That the black box is where stuff gets done is of no matter. Only business school people deal with earthly things like firms. True economists soar above, and grapple with important issues like revealed preferences, utility, marginal costs, Pareto efficiency, convex curves – how we love those – and other features of proper, albeit not real, economies. They leave real things to peons. The ugly paradox here is that business schools teach orthodox economics, apparently oblivious to the implied contradiction. No wonder business people hold economists in such low regard.

So Coase was ignored.

Of course I simplify, but the story is largely true.

Much later, only in the last two decades or so, has a true attempt been made to deal with the firm. Oliver Williamson, and his ilk, have developed the Coasian idea of transaction costs to allow the firm to be retrofitted onto orthodoxy without upending the entire sorry mess. The idea being that firms exist because there are costs of coordination that create efficacy in active, rather than passive, management. Remember the whole point of market worship is that its magic allows economies to be passively coordinated thus rendering the heavy, and altogether active, coordination of a government mute at best and harmful at worst. So active management simply doesn’t fit the orthodox narrative. It is a distinct no no.

Personally I reject Williamson as being an attempt to avoid answering the question correctly. The real answer, for me at any rate, is that firms exist because of uncertainty. And uncertainty is a dirty word in the lexicon of economics. A really bad, bad, dirty word.

You see, if uncertainty exists out there in the real world, then all that elegant math stuff economists rely upon to prove, yes prove, that markets possess magical powers, immune even to kryptonite, then uncertainty cannot be. It just cannot be.

So they don’t talk about it.

True, economists have spent vast amounts of energy trying to weasel a different view of what uncertainty is. Sometimes they call it risk. As in risk modeling. As in the financial crisis and risk management. Which turned out to be more risk than they could manage. That’s because they muddle risk and uncertainty. Risk is something we know enough about to mitigate. Uncertainty is something we simply don’t know. It is an ontological rather than epistemological problem. Not that learning doesn’t help.

Regular people are faced with uncertainty all the time. So they execute various strategies to fend off its consequences. They cooperate. They search to extend their known landscape. They move about. They listen and try to parse out meaning from noise. They organize. They build walls to protect themselves. They invent technologies so they can peer deeper into the dark. They design elaborate rituals to appease the spirits of gods. They speculate.

And they start business firms.

Firms themselves do many of these things too. Above all else they plan. They are centrally planned economies. They execute against a plan, which is an alternative reality they hope approximates the actual reality as it unfolds. If their plan and the real world are close enough, as history plays out, then the firm survives. No plan is ever accurate, but the point is that be accurate enough. Efficiency is not required. Sufficiency is. Perfection unnecessary, survival paramount. Redundancy is an virtue. Exactitude a luxury. Having some spare capacity to guard against forecasting error is useful. Having latitude and degrees of freedom are vital. Being supremely fit and lean are nice, but only if you know what’s going to happen. If you don’t, then its better to be a bit flabby, but versatile.

In other words it’s all about being able to hypothesize a direction, and being able to adapt as information flows in.

This is what firms do. It all sounds so utterly non-scientific and ordinary.

Firms are, in the words of Loasby, hedges against uncertainty.

They are thus a constant dagger pointed at the heart of orthodox economic theory. No wonder Coase went unanswered.

On a lighter note, here’s a neat question to pose all your CEO, MBA, and fervent right wing business friends: “Do you believe in free market theory?”. Probable answer: a resounding yes. Follow up question: “Then why is your company organized as a centrally planned economy a la the Soviet Union?”. Probable answer: blabbering, murmuring, and a change of topics.

There is not one CEO of a large business firm, that I know of, who truly believes in the magic of free markets. Otherwise one of them would have organized his or her firm to conform to that theory. So don’t listen to them. Further, since an enormous proportion of all economic activity in every country on earth takes place within the safe and centrally planned confines of a business firm, it is equally safe to say that the evidence is in. Markets suck at coordination. Planning rocks.

Now how we teach this basic economic reality to economists is another question.

Coase: you devil. Stop asking awkward questions!

  1. s h a r o n
    December 21, 2010 at 1:12 pm

    Beautiful.

  2. December 21, 2010 at 1:59 pm

    Hi Peter
    Revealing, amusing and frustrating all in one, thanks. It kind of reminds me of the current state of physics. Here you have 2 grand ideas of the unfathomably big and the stupidly small. One behaves like a ballerina, the other like a schizophrenic punk on roller skates. Economists have till now adored the ballet, while business people have dealt with planing for a breakdown. How they come together might just be in a stringy mess, sending them eventually one back to the ballet, one to the subway. Question is the fundamentals, as a lot of physicists who got caught up in string now recognise. What is time? What is the firm?

    I like you sub question too and will follow it up if I can: what is the firm of the future? What is the firm as represented on the iPad, the iFirm? There are enough people pulling apart what it means to lead, to manage, to measure and report, to employ and produce, to play by the rules that made the firm what it is, that made a firm a shell for all of the above to take place.

  3. December 21, 2010 at 2:16 pm

    Is the orthodox field really that oblivious? I thought that once upon a time, economists who’d been involved one way or another with coordinating production during WW II (so between firms) turned their attention to coordination WITHIN firms – Koopmans? Galbraithe? No?

    The “rhetorical” point is well put. A world in which every transaction would be subject to negotiation, and then renegotiation upon any party’s newly acquired data or situation, would make a lot of noise but not get much done.

    Gonna write anything re Coase’s other seminal contribution re efficiency and negative externalities and solutions in the absence of (or presence of minimal) transaction costs with no state to enforce the agreement? That’s the one that makes my head spin…

  4. Keith Wilde
    December 21, 2010 at 3:57 pm

    Three cheers! Blazing clarity.

  5. Derek
    December 21, 2010 at 5:12 pm

    While I agree with most everything here, I do not think we can say “Markets suck at coordination. Planning rocks.” The rise of the modern corporation took place in a particular historical and institutional framework, which was primarily shaped by state policy. Furthermore, just because the large corporation exists and is the dominant form of firm organization does not mean that planning works well relative to markets. We would have to consider, again, the role of state policy and its effects on the costs and uncertainty associated with firms before making any judgment in this regard.

  6. December 22, 2010 at 12:59 am

    Thanks Peter, confirms more of my suspicions.

    And notes the obvious paradox – BP, Microsoft et al. are centrally planned (and they don’t practice free trade across their borders, especially of intellectual property).

    Derek makes a fair point, that the internal planning is not necessarily very efficient. However note that the current set of institutions and rules, allegedly fostering free markets, has only allowed centralised firms to grow bigger and more dominant.

  7. Peter Radford
    December 22, 2010 at 1:26 am

    Derek and Geoff:

    I agree with Derek’s assertion with regard to history and institutional framework, but I am not sure we can pin too much on state policy. The modern corporation is more a response to the growth in complexity of production processes, which in turn are a consequence of the growth in technology. The state may shape the playing field, but it does not alter the basic fact that modern production takes place through extensive time and space and is thus exposed to levels of uncertainty that require intense coordination to offset. It also requires dedicated machinery, research, support and other features that an open market can only provide under extraordinary circumstances. So extraordinary that they don’t exist in a real world setting. Further, I think much of state policy is an effort to catch up with the emergence of the modern firm and to control it, rather than an a priori effort to establish a framework.

    Plus, it is not necessary that internal planning be efficient in an absolute sense, it merely has to be more efficient than that available in a decentralized setting such as a market. The interesting question is what changes are necessary in the decentralized setting to wrest the initiative back. Is it possible? Or is bureaucracy a superior coordination device across the board for all complex processes?

    In any case, uncertainty is the key. Economics needs to develop a full account and not avoid the issue by making utopian or heroic assumptions, or, even worse, by ignoring the firm as integral to a real economy.

  8. RRR
    December 22, 2010 at 7:32 am

    And to think that some of the larger “centrally-planned” firms reach turnover figures that are higher than the GDP of a middle-sized “free market” economy…

  9. Peter T
    December 22, 2010 at 7:37 am

    As a few economic historians (Pomerantz, Wallerstein and others) have pointed out, corporations started as long-distance armed trading ventures – that is, as small states (eg Dutch, British and French East Indies companies). Because of the large uncertainties, multiple relationships and long periods involved. They only became common in the late 19th century.

    But associations to deal with uncertainty (manors, fraternities, clerical orders, clan associations and much else) have a long history. It’s not new that markets are good for some things, but not for others. Even now, some simple arithmetic tells us that around two-thirds of economic activity in western countries is “off-market”, in households, inside companies, in government or in the not-for-profit sector. I have never seen much formal economic consideration of this.

  10. Alice
    December 22, 2010 at 9:41 am

    Another amazing observation on the hypocrisy (and falsehoods) of free markets.
    OH please – can it just be consigned to the dustbin now before any more academics and economists embarras themselves by having to admit they spent their whole lives chasing a flat earth view?

  11. Hannes
    December 25, 2010 at 6:33 pm

    Weird that people here comment about the clarity of this article. After all, in the whole (relatively) long text your write it’s hard to find out what a firm is and it’s even harder to find out why it exists. There is not even a hint why inefficient firms celebrating redundancy are likelier to survive in an environment of uncertainty. That’s just a statement with nothing similar to a proof supporting it.

  12. Danny L. McDaniel
    December 27, 2010 at 5:48 am

    Good post! There is a difference between the “invisible hand” and “the holy spirit.” But what is it?

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.