The Nature of the Firm STOR R.H.Coase Economica,New Series,Volume 4,Issue 16 (Nov.,1937),386-405. Your use of the ISTOR archive indicates your acceptance of ISTOR's Terms and Conditions of Use,available at http://www.jstor.org/about/terms.html.JSTOR's Terms and Conditions of Use provides,in part,that unless you have obtained prior permission,you may not download an entire issue of a journal or multiple copies of articles,and you may use content in the ISTOR archive only for your personal,non-commercial use. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission Economica is published by The London School of Economics and Political Science.Please contact the publisher for further permissions regarding the use of this work.Publisher contact information may be obtained at http://www.jstor.org/journals/lonschool.htmI. Economica 1937 The London School of Economics and Political Science JSTOR and the JSTOR logo are trademarks of JSTOR,and are Registered in the U.S.Patent and Trademark Office. For more information on ISTOR contact jstor-info@umich.edu. ©2001 JSTOR http://www.jstor.org/ Tue0ct219:29:062001
NOVEMBER The Nature of the Firm By R.H.CoASE EcoNomrc theory has suffered in the past from a failure to state clearly its assumptions.Economists in building up a theory have often omitted to examine the foundations on which it was erected.This examination is,however, essential not only to prevent the misunderstanding and ncedless controversy which arise from a lack of knowledge of the assumptions on which a theory is based,but also because of the extreme importance for economics of good judgment in choosing between rival sets of assumptions. For instance,it is suggested that the use of the word "firm" in economics may be different from the use of the term by the plain man."Since there is apparently a trend in economic theory towards starting analysis with the individual firm and not with the industry,2 it is all the more necessary not only that a clear definition of the word "firm"should be given but that its difference from a firm in the "real world,"if it exists,should be made clear. Mrs.Robinson has said that "the two questions to be asked of a set of assumptions in economics are Are they tractable and Do they correspond with the real world ?a Though,as Mrs.Robinson points out,"more often one set will be manageable and.the other realistic,"yet there may well be branches of theory where assumptions may be both manageable and realistic.It is hoped to show in the following paper that a definition of a firm may be obtained which is not only realistic in that it corresponds to what is meant by a firm in the real world,but is tractable by two of the most powerful instruments of economic analysis developed by Marshall,the idea of the margin and that of substitution,together giving the idea of substitution at Joan Robinson,Economics is a Serious Subject p.12. 2 See N.Kaldor,"The Equilibrium of the Firm," Economnic Journal,Marcb,1934. 3 Op.cit.,p.6. 386
937] THE NATURE OF THE FIRM 387 the margin.Our definition must,of course,"relate to formal relations which are capable of being conceived exactly. I It is convenient if,in searching for a definition of a firm, we first consider the economic system as it is normally treated by the economist.Let us consider the description of the economic system given by Sir Arthur Salter."The normal economic system works itself.For its current operation it is under no central control,it needs no central survey.Over the whole range of human activity and human need,supply is adjusted to demand,and production to consumption,by a process that is automatic,elastic and responsive."An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organisation but an organism.The economic system "works itself."This does not mean that there is no planning by individuals.These exercise foresight and choose between alternatives.This is necessarily so if there is to be order in the system.But this theory assumes that the direction of resources is dependent directly on the price mechanism.Indeed,it is often considered to be an objection to economic planning that it merely tries to do what is already done by the price mechanism.5.Sir Arthur Salter's description,however,gives a very incomplete picture of our economic system.Within a firm,the description does not fit at all.For instance,in economic theory we find that the allocation of factors of production between different uses is determined by the price.mechanism.The price of factor becomes higher in X than in r.As a result, 4 moves from r to X until the difference between the. prices in X and r,except in so far as it 'compensates for other differential advantages,disappears.Yet in the real world,we find that there are many areas where this does not apply.If a workman moves from department r to department X,he does not go because of a change in relative prices,but because he is ordered to do so.Those who 【了.M.Keynes,Essays in Biography,Pp.223-4 L.Robbins,Narure and Significance of Economie Science,p.63. a This description is quoted with approval by D.H.Robertson,Comrol of Indusiry, p.85,and by Professor Arnold Plant,"Trends in Business Administration,"Ecoxomte: Februaty,1932.It appears in Allied Shipping Control,pp.16-17. See 'A.Hayek,The Trend of Econamic Thinking,"EcoxoNCA,3fay:1933. s See F.A.Hayek op.cit
388 ECONOMICA [NOVEMBER object to economic planning on the grounds that the problem is solved by price movements can be answered by pointing out that there is planning within our economic system which is quite different from the individual planning mentioned above and which is akin to what is normally called economic planning.The example given above is typical of a large sphere in our modern economic system. Of course,this fact has not been ignored by economists Marshall introduces organisation as a fourth factor of production;J.B.Clark gives the co-ordinating function to the entrepreneur;Professor Knight introduces managers who co-ordinate.As D.H.Robertson points out,we find "islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk."But in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organisation necessary Why are there these "islands of conscious power"?Outside the firm,price movements direct production,which is co-ordinated through a series of exchange transactions on the market.Within a firm,these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator, who directs production.?It is clear that these are alternative methods of co-ordinating production.Yet,having regard to the fact that if production is regulated by price movements, production could be carried on without any organisation at all,well might we ask,why is there any organisation Of course,the degree to which the price mechanism is superseded varies greatly.In a department store,the allocation of the different sections to the various locations in the building may.be done by the controlling authority or it may be the result of competitive price bidding for space.In the Lancashire cotton industry,a weaver can rent power and shop-room and can obtain looms and yarn on credit.This co-ordination of the various factors of production is,however,normally carried out without the intervention of the price mechanism.As is evident,the amount of "vertical"integration,involving as it does 1 Op.cit..p.85. In che rest of this paper I shall use the temmi entrepreneur to refer to the person or persons who,in a competitive ystem,take the place of theprice mechanism in the direction af花ources线. Surey of Temtile Indusriet,p.26
1937] THE NATURE OF THE FIRM 389 the supersession of the price mechanism,varies greatly from industry to industry and from firm to firm. It can,I think,be assumed that the distinguishing mark of the firm is the supersession of the price mechanism. It is,of course,as Professor Robbins points out,"related to an outside network of relative prices and costs,"1 but it is important to discover the exact nature of this relation- ship.This distinction between the allocation of resources in a firm and the allocation in the economic system has been very vividly described by Mr.Maurice Dobb when discussing Adam Smith's conception of the capitalist: "It began to be seen that there was something more important than the relations inside each factory or unit captained by an undertaker;there were the relations of the undertaker with the rest of the economic world outside his immediate sphere ...the undertaker busies himself with the division of labour inside each firm and he plans and organises consciously,"but."he is related to the much larger economic specialisation,of which he himself is metely one specialised unit.Here,he plays his part as a single cell in a larger organism,mainly unconscious of the wider role he fills." In view of the fact that while economists treat the price mechanism as a co-ordinating instrument,they also admit the co-ordinating function of the "entrepreneur,"it is surely important to enquire why co-ordination is the work of the price mechanism in one case and of the entrepreneur in another.The purpose of this paper is to bridge what appears to be a gap in economic theory between the assump- tion (made for some purposes)that resources are allocated by means of the price mechanism and the assumption (made for other purposes)that this allocation is dependent on the entrepreneur-co-ordinator.We have to explain the basis on which,in practice,this choice between alternatives is effected. Op.cit p 1. Capitalist Enterprise and Social Progress p.C Henderon,Supply and Demand ethState takes over the direction of industrythatiaplami it it is doing samething which was previously done by the price mechanism.What is usually not realised is that any business man in organising the relations between his depart- mencs is also dqing someching which could be organised through the price mechanism.Thece is therefore point in Mr.Durhin's answer to those who emphasise the probiems invalved in econdmic planaing that the same problems have to be solved by business men in the competitive systemm.(See "Econamie Caleulus in a Planned Econamy,"Ecaramic December,1936.)The important difference between theie two cases is that economic planning is imposed on industry while firms arise voluntarily because they represent a more effcienc method of organising produetion,In a competitive ay性trm、t止here is an“optimum" amount of planning【