The Elgar Companion to Ronald H. Coase
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The Elgar Companion to Ronald H. Coase

Edited by Claude Ménard and Elodie Bertrand

Ronald H. Coase was one of the most innovative and provocative economists of the twentieth century. Besides his best known papers on ‘The Nature of the Firm’ and ‘The Problem of Social Cost’, he had a major role in the development of the field of law and economics, and made numerous influential contributions to topics including public utilities, regulation and the functioning of markets. In this comprehensive Companion, 31 leading economists, social scientists and legal scholars assess the impact of his work with particular reference to the research programs initiated, the influence on policymakers, and the challenge to conventional perspectives.
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Chapter 4: Coase’s theory of the firm: the next steps

Kenneth J. Arrow


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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