Essential Coase: Why Do Firms Exist?

Welcome to the essential ideas of Ronald Coase.

Some of Coase's most powerful  insights came from simple questions,

like “why do people join together to create  businesses instead of just working on their own?”

Coase's answer is that firms are  formed to minimize the costs that

people and businesses incur when  they exchange goods and services,

which are known as transaction costs. These  include the time it takes to find someone with

whom to exchange, the time and costs to negotiate  a deal, and the costs to resolve disputes.

Let's explore Coase's explanation of  why businesses exist with an example:

Jane is an avid cyclist who wants to create  her own brand of bikes. But how does she decide

whether to work alone or form a business? Jane could, for instance, work on her own

and contract with other people for the goods and  services she needs to make and sell her bikes.

This includes sourcing all the  materials and components needed,

hiring outside contractors to assemble the  bikes, working with wholesalers to sell her bike,

and using a warrantee company to  service the bikes after the sale.

But at every exchange, Jane and the other people  with whom she trades face transaction costs.

They have to find each other, research the others  services, negotiate terms of their contracts, pay

to have the contracts legally enforced, and so on. And so, given all the transaction costs,

Jane might discover that she can reduce those  costs and be more profitable if she hires someone

to assemble the bikes rather than contracting out. And Jane might discover that transaction costs are

further reduced if she sold her bikes directly  to bike stores by hiring her own salespeople

and perhaps Jane's mountain  bikes become so popular—and

the transaction costs associated with working with  bike shops become high enough—that she discovers

it's more profitable for her to open her own  chain of stores, and hire her own sales staff.

Jane's decision to create a business, instead  of working alone, and then when and how to

expand are all linked with reducing transaction  costs, which make her business more profitable.

And for Coase, that's why firms  exist—to minimize transaction costs.

Coase's insights into the nature of firms  sparked new research and created entirely

new fields of study in economics, business  management and even political science.

For more information on Ronald  Coase visit EssentialCoase.org,

and to learn about more essential  scholars, visit EssentialScholars.org