Wednesday, January 05, 2011

Spontaneous Market: Ronald Coase and The Firm

Last December 29, a known economist-theoretician, Ronald Coase, celebrated his 100th birthday. A columnist from The Economist wrote an article about him.

Why do firms exist?

Ronald Coase, the author of “The Nature of the Firm” (1937), turns 100 on December 29th Schumpeter The Economist, Dec 16th 2010

...The economics profession was slow to recognise Ronald Coase’s genius. He first expounded his thinking about the firm in a lecture in Dundee in 1932, when he was just 21 years old. Nobody much listened. He published “The Nature of the Firm” five years later. It went largely unread.

But Mr Coase laboured on regardless: a second seminal article on “The Problem of Social Cost” laid the intellectual foundations of the deregulation revolution of the 1980s. Eventually, Mr Coase acquired an army of followers, such as Oliver Williamson, who fleshed out his ideas. In 1991, aged 80, he was awarded a Nobel prize. Far from resting on his laurels, Mr Coase will publish a new book in 2011, with Ning Wang of Arizona State University, on “How China Became Capitalist”.

His central insight was that firms exist because going to the market all the time can impose heavy transaction costs. You need to hire workers, negotiate prices and enforce contracts, to name but three time-consuming activities. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. But if markets are so inefficient, why don’t firms go on getting bigger for ever? Mr Coase also pointed out that these little planned societies impose transaction costs of their own, which tend to rise as they grow bigger. The proper balance between hierarchies and markets is constantly recalibrated by the forces of competition: entrepreneurs may choose to lower transaction costs by forming firms but giant firms eventually become sluggish and uncompetitive.

In microeconomics, firms competing with each other -- like so many shops and retailers of clothing, food, carparts, etc. -- are termed as "monopolistic competition" and not as "perfect market competition". A pizza house is a food shop but its product is different from other food shops that sell pasta, hamburger, sea foods, kare-kare and crispy pata, etc. There are "mini-monopolies" among dozens or hundreds of different food shops in one big mall or one big city.

So why do firms exist? Because of specialization among entrepreneurs. A good pizza shop does not mean that it will also be a good puto-bibingka food shop. The same way that a good pharma company producing anti-cancer drugs does not mean that it will also be good in producing anti-malaria or anti-hypertension drugs.

The article made a good point regarding contracts. People want long-term contracts with their suppliers, with their markets and buyers. Toyota and Ford will need long-term contract with their suppliers of steel, tires, electrical wires, paints, glasses, headlights, etc. It is impossible for them to have different suppliers with different product quality at different prices at different product guaranty terms.

A friend from another yahoogroups commented,

Ronald Coase's most significant contribution to Economics was to explain the rationale for firms - if individuals, acting in their best self-interest as economic agents, can negotiate their way toward the efficient solution (as explained by Adam Smith's "invisible hand"), why then does the economy require firms - companies where labor and other factors of production are on long-term "contracts", and an authority (the "entrepreneur" - the owner, management or board of the corporation) co-ordinates and organizes production....

The authority-entrepreneur in the firm is only an "authority" over his/her workers. But that same authority-entrepreneur is just a follower to a much higher authority -- the consumers.

Let McDonald's be as lousy as it can be, the authority-entrepreneurs who own Mcdo have command over their workers anyway. Then what? Mcdo collapses, consumers shift to Jollibee, or Burger King, or Mang Donald, or to other fastfood chains. Nothing is permanent except endless competition and change.

Firm central planning is different from government central planning. If a firm does not plan its moves, its competitors, existing or upcoming, will simply gobble it. When owners and managers of Victory bus line miscalculate their moves and become complacent, they will soon be gobbled by Five Star bus, Dagupan bus, North Luzon bus, even by Ceres bus liner.

Compare that with government central planning. If those state central planners make major mistakes and succeed in burying an economy into deep public debt crisis, who will gobble those planners? No one except bacteria when they die.

Free markets simply means free individuals. All markets are composed of individuals -- buyers and sellers, producers and consumers, young and old, rich and poor, men and women. If I am a banker and I want to hire a person's services at X pesos per month and that person says, "Nope, I want X plus 15 percent", then no contract can happen between us. He has the freedom to find another employer who will give him good terms, I have the freedom to find other analysts at a price that my firm can only afford. Zero coercion, zero taxation, everyone is free to enter certain contracts or not. The price system -- wages, bonuses, interest rates, exchange rate, rental, etc. -- is the main mechanism where voluntary exchange and contract between and among parties and individuals can occur.

All the mini-central planning, mini-monopolies in a monopolistic competition market structure, by firms and individuals, are consistent with free markets and the price system.

Governments usually enter to destroy such freedom of voluntary exchange and contract between employers and potential employees, between buyers and potential suppliers and producers. Government policies like price control, rent control, fare control, exchange control, minimum wage law, mandatory social security contributions, etc., partially destroys the real price system to force highly regulated and a politically-manipulated, artificial price system.

Firms fix or set their prices as most firms -- and individuals -- act on a "monopolistic competition" and not "perfect market competition". There will always be product differentiation, or service differentiation. Each different product would be considered as something "unique" with its corresponding unique price that is different from the price of other products in the same generic category.

Example 1, Tomatoes. (a) round-small-green tomatoes are different from (b) round-small-red, (c) oblong-small-red, (d) huge-green, (e) huge-red-flattened, (f) cherry-red, ... In the eyes and valuation of some tomato sellers and buyers, they are all different and would command different pricing.

Example 1. UP economists. All of them are professional, academic economists. But they are not really "the same". A trade economist is different from a health economist, agri economist, labor economist, monetary economist, public finance economist, etc.

Just one differentiation in specialization already constitutes a "mini-monopoly" of one professional economist from another.

The same can be said of lawyers, physicians, engineers and all other major professions. A criminal lawyer is different from an election lawyer, from a commercial lawyer, from an IPR lawyer, etc. A rice farmer is different from a corn farmer, from mango farmer, from livestock farmer, from tilapia farmer, etc.

So I go back to my earlier point -- firms (and individual consultants and entrepreneurs, etc.) exist because of specialization. Consumers and buyers of certain services want to consult or get the services of someone or some firm that is a specialist on something.

Implication -- there is endless opportunity for people and firms as there is endless specialization. Even among rice farmers for instance, there is endless specialization possible. One farmer will produce milgarosa rice, another will produce dinorado, another will produce thai jasmine rice, another will produce brown rice, malagkit rice,...

I am not sure if Coase's definition of "market transaction costs" is similar to the need for specialization.

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