Chapter 4: Coase’s theory of the firm: the next steps
Ronald Coase’s (1937) treatment of the theory of the firm was a clear reconsideration of an emerging literature on the efficiency of the price system, which had been given a systematic exposition by A.C. Pigou (1920). This argued that, in the absence of increasing returns and externalities, an allocation is efficient if and only if it could be a competitive equilibrium at a suitable set of prices. As Coase observed, this point of view would imply that a firm seeking to maximize profits would use a price system to coordinate its departments and interfirm product flows. Yet, as he emphasized, the price system is not used within firms. Firms find it more profitable to use direct authority over employees, with instructions specified in quantity terms. Coase gives two reasons why firms make this choice. (1) The price system is costly in information terms. For example, even knowing what the prices are may be costly. Indeed, statisticians are accustomed to the idea that all information is costly. (2) Relying on individual decisions is costly because simply drawing up the specification of the rules of action (e.g., in the form of contracts) is difficult. It would be necessary to specify actions to be taken in circumstances that may occur rarely. It is easier for management to tell the employees what to do when the circumstances arise.
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