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Ronald Coase (Part II: Firms vs. Socialism)

[Editor note: The efficacy of decentralized markets relative to government planning is a staple of modern social-science thought. This two-part series (see yesterday) concludes by comparing and contrasting the 'central planning' of the firm with governmental planning in the economy.]

Firms have traditionally been thought of as socialism writ small. Ronald Coase in The Nature of the Firm (1937) quoted Dennis Robertson, who described firms as “islands of conscious power in [an] ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk.” [1]

At first blush, firms are hierarchical and centrally planned, terms commonly associated with the socialist economy. Frederick Taylor’s The Principles of Scientific Management (1911), the business bible of its day, saw greater industrial efficiency in tighter managerial control over employees:

The work of every workman is fully planned out by the management at least one day in advance, and each man receives in most cases complete written instructions, describing in detail the task which he is to accomplish, as well as the means to be used in doing the work. [2]

“The task idea,” or blueprint management, which Taylor called “perhaps the most prominent single element in modern scientific management,” was certainly akin to command-and-control for the whole economy. [3]

However, the planned firm and planned economy are quite different. Market economies work only because inefficient firms go bankrupt, an outcome that cannot happen with “the economy.”

But the analogy between the firm and socialism fails for deeper reasons. Fundamentally, the firm is a nexus of voluntary contracts that are ultimately shaped by consumer decisions to buy or not buy. The socialist economy is based on coercion. The free-market firm is an infinitesimal part of the overall economy; socialism is the economy.

Moreover, there are incentives under capitalism for firms to demote command-and-control and rigid hierarchies where greater profits can be won. Profit centers deep in the organization create, in effect, firms within firms. Libertarian entrepreneur and business theorist Charles Koch has noted:

Identifying and efficiently creating profit centers at the lowest practical level can provide a substantial competitive advantage. Ideally, each plant should be a profit center and, if it makes more than one product, the profitability of each product should be tracked.  [4]

Such internal markets allow subsets of a firm to employ arm’s length transactions and keep “scorecards” to determine profitability and also the opportunity cost (next best opportunity) of the resource, such as outsourcing or selling a unit. [5]

Ultimately, there is still the single firm that is virtually always trying to expand to further internalize markets. The higher the transaction costs, the bigger the firm, other things the same. In any case, modern management theory and modern Coasian economics have elucidated the limits of central planning and value of decentralized knowledge and decision-making within each firm.

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[1] Coase, Ronald. “The Nature of the Firm.” 1937. In The Economic Nature of the Firm: A Reader, edited by Louis Putterman and Randall Kroszner, 89–104. Cambridge: Cambridge University Press, 1996, pp. 90–91.

[2] Taylor, Frederick. The Principles of Scientific Management. 1911. Reprint, Mineola, NY: Dover Publications, 1998, p. 17.

[3] Ibid.

[4] Koch, Charles. The Science of Success. Hoboken, NJ: John Wiley & Sons, 2007, p. 111.

[5] Ibid., pp. 43, 111.

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