The Changing Determinants of Economic Performance in the World Economy
Chapter 16: Theoretical framework
Ronald Coase has made two highly influential contributions to economic theory which provide the basis for our theoretical framework (Coase 1937, 1960). In his 1937 paper, Coase set out to discover why there were firms even when economists argued that economic activities were efficiently organized by the market mechanism. He answered this question by arguing that firms exist and grow because there are ‘costs of using the price mechanism’, such as ‘discovering what the relevant prices are’ and ‘negotiating and concluding a separate contract for each exchange transaction’. Firms can avoid these (and other) transaction costs by internalizing the costly transactions into their hierarchies (Coase 1937). The benefits of hierarchical organization led Coase to another fundamental question: ‘why . . . are there any market transactions at all? Why is not all production carried on by one big firm?’ To answer this question Coase referred to Kaldor (1934) and Robinson (1934) to argue that the hierarchical growth of firms is limited by the ‘diminishing returns to management’. He then went on to propose that the economic system can reach an organizational equilibrium when ‘the costs of organizing an extra transaction within the firm are equal to the costs involved in carrying out the transaction in the open market, or, to the costs of organizing by another entrepreneur’. Coase suggested that the organizational equilibrium would evolve over time as a result of changing transaction and ‘organizing’ costs (Coase 1937). In the famous 1960 paper, Coase extended his comparative organizational analysis to study negative...
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