Editing Ronald Coase (section)

==="The Nature of the Firm"===
{{Main|The Nature of the Firm}}
In "The Nature of the Firm" (1937), a brief but highly influential essay, Coase attempts to explain why the economy features a number of [[corporation|business firms]] instead of consisting exclusively of a multitude of independent, self-employed people who contract with one another. Given that "production could be carried on without any organization [that is, firms] at all", Coase asks, why and under what conditions should we expect firms to emerge?

Since modern firms can only emerge when an entrepreneur of some sort begins to hire people, Coase's analysis proceeds by considering the conditions under which it makes sense for an entrepreneur to seek hired help instead of contracting out for some particular task.

The traditional economic theory of the time (in the tradition of [[Adam Smith]]) suggested that, because the market is "efficient" (that is, those who are best at providing each good or service most cheaply are already doing so), it should always be cheaper to contract out than to hire.

Coase noted, however, a number of [[transaction cost]]s involved in using the market; the cost of obtaining a good or service via the market actually exceeds the price of the good. Other costs, including search and information costs, bargaining costs, keeping [[trade secret]]s, and policing and enforcement costs, can all potentially add to the cost of procuring something from another party. This suggests that firms will arise which can internalise the production of goods and services required to deliver a product, thus avoiding these costs. This argument sets the stage for the later contributions by [[Oliver Williamson]]: markets and hierarchies are alternative co-ordination mechanisms for economic transactions.<ref>Hein Schreuder, "Coase, Hayek and Hierarchy", In: S. Lindenberg & [[Hein Schreuder]], editors, Interdisciplinary Perspectives on Organization Studies, Pergamon Press</ref><ref>{{Cite book|last=Knight|first=Jack|url=https://books.google.com/books?id=VeoKtu_22q0C|title=Institutions and Social Conflict|date=1992|publisher=Cambridge University Press|isbn=978-0-521-42189-8|page=12|language=en}}</ref>

There is a natural limit to what a firm can produce internally, however. Coase notices "decreasing returns to the entrepreneur function", including increasing [[overhead expenses|overhead costs]] and increasing propensity for an overwhelmed manager to make mistakes in resource allocation. These factors become countervailing costs to the use of the firm.

Coase argues that the size of a firm (as measured by how many contractual relations are "internal" to the firm and how many "external") is a result of finding an optimal balance between the competing tendencies of the costs outlined above. In general, making the firm larger will initially be advantageous, but the decreasing returns indicated above will eventually kick in, preventing the firm from growing indefinitely.

Other things being equal, therefore, a firm will tend to be larger:
* the lower the costs of organising and the slower these costs rise with an increase in the number of transactions organised
* the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organised
* the greater the lowering (or the smaller the rise) in the supply price of factors of production to firms of larger size

The first two costs will increase with the spatial distribution of the transactions organised and the dissimilarity of the transactions. This explains why firms tend to either be in different geographic locations or to perform different functions. Additionally, technology changes that mitigate the cost of organising transactions across space may allow firms to become larger – the advent of the telephone and of cheap air travel, for example, would be expected to increase the size of firms.

A further exploration of the dichotomy between markets and hierarchies as co-ordination mechanisms for economic transactions derived a third alternative way called [[Commons based peer production]], in which individuals successfully collaborate on large-scale projects following a diverse cluster of motivational drives and social signals.