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Saturday, August 19, 2017

Coase’s theory of the firm

The first in a series on "Six big ideas" in economics at The Economist

"Throwing light on the magic of market co-ordination was a mainstay of the 'classical' economics of the late-18th and 19th centuries. Then, in 1937, a paper published by Ronald Coase, a British economist, pointed out a glaring omission. The standard model of economics did not fit with what goes on within companies. When an employee switches from one division to another, for instance, he does not do so in response to higher wages, but because he is ordered to. The question posed by Coase was profound, if awkward for economics: why are some activities directed by market forces and others by firms?

"His answer was that firms are a response to the high cost of using markets. It is often cheaper to direct tasks by fiat than to negotiate and enforce separate contracts for every transaction. Such 'exchange costs' are low in markets for standardised goods, wrote Coase. A well-defined task can easily be put out to the market, where a contractor is paid a fixed sum for doing it. The firm comes into its own when simple contracts of this kind will not suffice. Instead, an employee agrees to follow varied and changing instructions, up to agreed limits, for a fixed salary."
That paper, "The Nature of the Firm", was published at Economica.

He later wrote "The Problem of Social Cost", which was published at the Journal of Law and Economics. It is the most-cited law review article of all time, according to this essay by Fred R. Shapiro and Michelle Pearse at the Michigan Law Review.

#law #wealth

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