Coase’s goals are to both give a definition of a firm which is representative of the real world and also begin to explain why firms exist. Basic economic theory would suggest that economic production can efficiently take place with a collection of unrelated individuals interacting in their own self interest, without the need for any sort of coordinating mechanism. So why organizations?
At a basic level, Coase defines a firm as an organization in which the price mechanism is suppressed. He gives an example of a worker moving from one department to another not because his marginal product is higher in the new department (as the price mechanism would suggest) but because he is told to so by an entrepreneur-manager. Coase notes that the degree to which the price mechanism is suppressed varies across firms, and relates this suppression to the idea of vertical integration.
Coase explains that coordination can happen either through the price mechanism or through the actions of a coordinating entrepreneur, and notes that there must be something that drives firms in some cases and markets in others. He gives several potential explanations for why we might see firms, but then explains why they are not correct (p.390). One example is the proposition that people prefer to be managed, and Coase points out that this is contrary to the notion of people wanting to be their own bosses. The theory that Coase doesn’t reject is that there are costs to operating in the market, such as the cost of learning relevant prices and negotiating. There are costs involved in making contracts, and these costs can be reduced, though not necessarily eliminated, by establishing long-term contracts within a firm. In this case, a factor of production (eg. an employee) sells the right for the entrepreneur to tell it what to do, within certain boundaries. Therefore the entrepreneur is free to coordinate production within in the limits of the contracts.
There are costs to using the price mechanism above and beyond just having to learn about relevant prices. There can be increased contracting costs since long term contracts are not really possible, and repeated short term contracting may not be desirable. In a firm, a general long term contract can be developed, with the details left to be decided later (within reason). This provides the flexibility needed to mitigate the risk inherent in writing a long term contract. Therefore, firms are more likely to emerge when short term contracts are unsatisfactory. It is also improbable that firms would exist in the absence of uncertainty, since it is uncertainty that makes these long term general (employment) contracts appealing. firms could also exist for tax reasons, since a transaction cost would be present if a sales tax was placed on a purchased good but not an internally produced one.
Coase then embarks on the topic of firm size. What does it mean for a firm to be larger? It means that more transactions are conducted within the firm and organized by the entrepreneur. Given the presence of transaction costs, why do markets exist at all? Why not just one big firm? The other piece of the puzzle is that there are decreasing returns to entrepreneurship (which Demsetz later calls management cost). This is because, as a firm becomes large, there are additional levels of management, which come at a cost, and it gets more difficult to optimally assign people to jobs. This creates some "waste", which is a form of cost of internal organization. The firm will want to internalize transactions until the transaction cost equals the management cost.
Based on this logic, firms will be larger when:
-- management cost is low, or rows slowly
-- there are fewer mistakes in assigning jobs, and hence less waste
-- there are greater economies of scale, and large firms can acquire factors of production at a discount
