Thayer Watkins

The Transaction Cost Approach
to the Theory of the Firm

The transaction cost approach to the theory of the firm was created by Ronald Coase. Transaction cost refers to the cost of providing for some good or service through the market rather than having it provided from within the firm. Coase describes in his article "The Problem of Social Cost" the transaction costs he is concerned with:

In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on.

More succinctly transaction costs are:

Coase contends that without taking into account transaction costs it is impossible to understand properly the working of the economic system and have a sound basis for establishing economic policy.

Notes on: The Nature of the Firm (1937) by Ronald Coase

Coase observes that market prices govern the relationships between firms but within a firm decisions are made on a basis different from maximizing profit subject market prices. Within the firm decisions are made on through entrepreneurial coordination. Coase quotes D.H. Robertson on there being,

"Islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk."

There are a great variety of arrangements in producing goods. In agriculture often most of the labor force works on a day-to-day basis. In other industries the labor force may be permanent, tied to the firm with long-term contracts. Repair services in some firms may be supplied by an internal organization; in others it is provided by specialized firms from outside. A firm is a system of long-term contracts that emerge when short-term contracts are unsatisfactory.

The unsuitability of short term contracts arise from the costs collecting information and the costs of negotiating contracts. This leads to long term contracts in which the remuneration is specified for the contractee in return for obeying, within limits, the direction of the entrepreneur.

Coase notes that the economic theory of the production level of a plant in the short run and long run are well worked out, but the theory of the size of the firm is not well developed. This is clear in the matter of acquisition of companies by other companies.

Ronald Coase gives the origin of The Nature of the Firm as a course in the organization of the business unit which he taught in 1932. He noted that there are inconveniences of market transactions, but if transactions are not governed by the price system there has to be an organization. The object of an business organization is to reproduce the conditions of a competitive market for the factors of production within the firm at a lower cost than the actual market. But if an organization exists to reduce costs then why is there any market transactions at all? Coase gave two reasons:

Coase's career in economics came as a result of some odd circumstances. Here is what Coase himself says:

At my school ... it was possible to spend two additional years preparing for the external intermediate degree examinations of the University of London (the equivalent of the first year of university work). My inclination was to take a degree in history but having come to the school at age twelve rather than at the usual age of eleven, there was no question of my taking Latin at school. This lack of Latin barred me from taking an arts degree (or at any rate the one that I wanted to take). I therefore started to work for a science degree, with the intention of specializing in chemistry. However, I soon found that mathematics, a requirement for a science degree, was not to my taste, and I switched to the only alternative open to me at school, working for a commerce degree. This move was undoubably made easier by the fact that I was at that time a socialist and the interest in social problems that this implies made studying economics (a requirement for a commerce degree) attractive....In 1929, I went, aged eighteen, to the London School of Economics to continue work for a commerce degree.

In economics Coase single handedly pioneered a nonmathematical but deeply penetrating economic analysis. He examined questions that never occured to most economists. In the rare cases where others considered those questions they did not come to meaningful conclusions as did Coase. The uniqueness of his contribution was recognized with his being awarded the Nobel Prize in economics.

His contribution which is most widely known in economics is what George Stigler named the Coase Theorem. Coase never referred to this proposition as a theorem and its role in his article, "A Problem of Social Cost" is subsidiary to transaction cost approach. In presenting the "Coase Theorem" Coase was arguing that in the absence of transaction costs many surprising results hold. The Coase Theorem says that even in the presence of externalities (although he doesn't use that term) if there are no transactions costs to creating private agreements the levels of productions of goods will be the same no matter which party to an externality has legal right to compensation. This means that the intervention of the government in the case of externality doesn't affect production if there are no transaction costs. Intervention of the government in such cases does affect the distribution of income. The economics profession has focused upon the content of the proposition rather than the fact that significance of the presence or absence of transaction costs.

An illustration of Coase's Theorem

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