Causal-Realist Answers to the Coasean Question

0:00Okay, I guess this talk is going to be a little bit unique because it will not be philosophy like Mark's talk and it's not going to be any macroeconomics as well, like most people. It's going to be more business than cycle, you could say. I'm calling this talk the causal realist answers to the cosine question, the mission of labor and the firm. And I guess it needs a little bit of explaining. The cosine question, for instance, goes famously asked, if the price mechanism is efficient, then why are there firms? So that's really what I'm trying to answer here from an Austrian perspective.

0:45And also I call it answers. I, of course, have the answer. But there are many out there. So I'm going to try to touch on them a little bit. So for my talk, I divided this into three main parts. I'll go through the theory of the firm as it is in mainstream economics, neoclassical or new institutional economics, and then go through the Austrian perspective as it is, the answers, and then I'll take a step to the comprehensive firm in the market view, which is the answer, my answer, So, the theory of the firm. This is the firm to most people, I guess. It could be anything, but men wearing dark suits in a nice office in Manhattan. They make a lot of money and and that's a firm.

1:47This is the neoclassical theory of the firm. As you can see, you have marginal revenue. This is a perfectly competitive market, so it's just a straight line. And then you have the average variable cost, where it intersects the marginal revenue is where you have the shutdown point below that point. You lose money all the time. And up there you make profits. I mean it's all really a math problem. It's like any neoclassical economics problem. You just push it through a computer and then boom, there you go. That's the economic truth. Very easy actually. But within the neoclassical framework, you have a new institutionalism that is trying to look a little bit to institutions as well, not just the number crunching thing.

2:44So, that is what I'm going to focus on, since the theory of the firm in terms of three or four curves is pretty boring, it doesn't really tell us much, I'll go through the new institutional theory instead. And that's really what is now the mainstream view, because it actually does attempt to explain what a firm is and why there are firms and so forth. So, it's all based on Ronald Coase's famous work from 1937. You might recall that he got the Nobel Prize in Economics in the 80s, I believe. Now, his point of departure in this article is the specialized market economy, where everything is efficient because they use the price mechanism.

3:37And that's when he started thinking about this problem. If the price mechanism is really, truly efficient, why in the world do people group together in firms when they should just contract on the market? A lot easier. So, obviously there is some kind of problem here. And he realized then that maybe there is a cost of using the price mechanism. Hey, maybe there isn't perfect information, which really is what this means. So he invented the term transaction costs. They're costs of using the price mechanism. Exactly what transaction costs are kind of depends on who you ask. It could be search costs, searching for a partner to contract with, could be information costs, could be contracting costs, could be enforcement costs for the contract, could Now, his solution is not only that it's costly to trade in the marketplace, it is actually less costly to be a socialist, which is something I cover in another paper, but Coase is a socialist, just trust me on this one.

4:52So he identified, it's one of his assumptions, he identified the firm as, and he quotes someone else here, Robertson I think, as the islands of conscious power, as a firm, because what you have there is the manager and he directs labor like this, and he tries to reproduce market allocation, I think we've heard this before in the socialist calculation debate, that hey all you need to do is If we could actually reproduce what the market would do, then socialism works. That's actually what happens in the firm, according to this theory. They put it in a much nicer language, of course, but that's basically what they're talking about. Now, Coase's work was completely ignored for 30-35 years, until next Nobel laureate came along, last year's Nobel laureate, Oliver Williamson, And he bases his reasoning for the firm on Coase's identification of the firm as a hierarchical construct based on fiat power, really.

5:59And he has established a theoretical framework in the new institutional economics that he calls the transaction cost economics. Now, when you read Williamson and especially his conclusions, you realize that he doesn't really have the same assumptions as Coase, but he uses the Coasean concept. Instead, he seems to be thinking about the perfectly competitive model here. So if you have perfect competition, well, all production is actually done in the firms, so that there is a firm is not a problem. So the problem here is, if you have very specific assets, then a firm can hold up another firm, and then you have a problem.

6:49And because people are rational and they want to extract quasi-rents from other firms, then they will act opportunistically. And that may be a cause or a reason for integrating two firms into one big firm. One famous article by Josco talks about a railroad track. Imagine if you would invest in a railroad track to supply transportation for coalmine. Now, would you just invest in that railroad track to that coalmine? Well, that coal mining operation might not buy transportation from you later on, so they could force you to lower your prices really down to the level of your costs, right?

7:43And that kind of opportunistic behavior is the big problem for Williamson. So in this case, the coal mining operation and the transportation firm would do better integrating and then just bossing people around within the firm.

8:06So if you summarize this thing, ontologically, the firm is hierarchy, power, socialism. It's really the more labels you have, the better. Sometimes that is what you're thinking when you read this stuff. It has a single cost. It's due to transaction costs. Were it not for transaction costs, there would be no firm. According to Coase, it's because socialism, at least in small islands, is cheaper than the market, because you don't have these transaction costs. And since the manager, he assumes, can reproduce market allocation of resources without having these costs, it's a pretty good deal.

8:55And with two Williams and then you have a lower risk this opportunistic behavior, you don't have that within the firm because you can actually force them to do whatever you like. So, in conclusion, the firm according to the neoclassicals, is a solution to a single problem. I think we've seen this before. It's usually the case in neoclassical economics. You have one problem, one solution, and math, and then you solve it. But what is the Austrian theory of the firm, you might ask? There it is. There is no Austrian theory of the firm.

9:41Which is kind of interesting, because Austrians tend to analyze the market as it is, Let's analyze the market as it is, whereas neoclassicals tend to analyze their own models. And in the market there are a lot of firms. So why don't we study the firm? Let's see what some people have said. In 85, Driscoll and Rizzo said there is no Austrian theory of the firm. In 97, Foss said that he talked about the Austrian lack of interest in the firm. And last year, Foss and my advisor said that until recently the theory of the firm was an almost completely neglected area in Austrian economics. It's in the 2000s.

10:26That's 70 years plus after COSE. So, what do we have? Well, we have a bunch of approaches. I went through the literature and I found there are a lot of toward and Austrian theory or a basis for toward and Austrian theory. Now some Austrians base this on the knowledge problem and they talk about coordination of the knowledge within a firm. You have knowledge of how to produce something, you don't really want to let that knowledge So, you try to contract with these, all the factors and try to keep control of the information that you actually supply them.

11:19It's better to point them in the right direction than actually tell them what to do or how to do it. Then you have the production process view, which really focuses on the structure of production and it's about coordination of the production process. Now both of these are coordination of a certain thing, as you can see. One is coordination of the knowledge that you have as an entrepreneur when you establish a firm. The other is coordination of production. So you have different stages of production and you try to coordinate them so that you actually end up with the end product that you like. And you also have the coordinator of View, as I call it, just to use the word once more, which is really the entrepreneurial theory of the firm, some call it.

12:10Now here the entrepreneur is really the force that coordinates the whole firm, doesn't really matter if it's knowledge or production process or both or something third. And the fourth is uncertainty, so the firm is really some kind of calculation or planning to control uncertainty. These are the four basic kinds of Austrian approaches to the firm. Now, what does this tell us? Well, first of all, we don't really have a theory of the firm. And what we have are approaches focusing on just certain aspects of what is a firm and what is a market.

12:57So we just have these fragments, we have the knowledge theory of the firm, and we have the production process theory of the firm, and what about knowledge in the production process? Don't we have both in the firm? It should be pretty obvious that we do, but we have no comprehensive view, no firm in the market theory, as I call it, because these firms were trying to, or these theorists, I mean since I have the answer. They focus on these fragments, but they don't focus on the firm in the market and the interdependence and how things happen, what's going on in the market process. So what they're really lacking is the entrepreneur as the driving force behind the social creation of wealth, because that's really what has happened, what is going on here, right?

13:50What we're trying to explain is really the market process and why there are firms in the market process. So what I'm asking is for a firm in the market, of the market, by the market, and for the market. Why is that firm? So when I did this, I really started with our view of the market, in a totally free market. Coase does the same, he's talking about atomistic competition, but that view is quite neoclassical, or maybe classical even, a little bit. But what we do have is the specialized free market economy. What do we know about that?

14:38Well, there was this guy back in 1776, he talked about the division of labor, and we used that in Austrian economics as well, right? Mises talked about the division of labor, and he went a lot further than did Smith. I'm sorry for this beautiful PowerPoint slide here, but Mises said the division of labor Labor splits the various processes of production into minute tasks, many of which can be performed by mechanical devices. It is this fact that made the use of machinery possible and brought about the amazing improvements in technical methods of production. Mechanization is the fruit of division of labor, its most beneficial achievement, not its motive and fountain spring.

15:27Power-driven specialized machinery could be employed only in a social environment under the division of labor. Every step forward on the road toward the use of more specialized, more refined and more productive machines requires a further specialization of tasks. Now do you see something strange here? Suddenly specialization is not the problem, as it is with Coase and Williamson. Here specialization is the solution, that's the motive power of the economy. Let's go a little bit further. Division of labor, it's limited by the extent of the market, as Smith said. He talks about the pin factory, how labor, or how tasks are divided between labor factors within the firm.

16:17We have Marx, a little later, he talks about the closeness of factors. To really use the division of labor, you need the factors to be very close. And he really defined the firm as increased division of labor in the hands of the capitalist. And you had Durkheim four years before Coase, he talked about division of labor, you can use it to a higher degree when you have new technology in communication and transportation because that actually makes factors closer, in real way.

17:03So, let's have a look at this specialization view. Now, Mises, he talks about specialization as making the market productive and efficient. Coase, he kind of agrees with Mises on market efficiency, But he talks about the costs as well and of course the way to avoid those costs is socialism But this these costs the socialism is too costly when the factors are spread out Which is really what Durkheim was saying with New technology and transportation and communication because that brings the factors closer to each other at least subjectively closer and Williamson To him, the specialization is the problem. There's no perfect competition anymore. The firms are not exactly the same.

17:56So, specific assets must be integrated into firms. Here, I guess you could say that Coase is a little bit of a classical economist, whereas Williamson is more of a neoclassical. I don't need to define what Mises is, of course. The funny thing here is that all this is actually compatible, so Coulson-Williamson, they're both talking about specialization in different ways and they're compatible with Smith saying that specialization and division of labor is what drives the market. They're compatible with Marx who says that specialization in the firm is higher than in the market.

18:43Because that's basically what Williamson is saying, right, when he's saying that if you have very specific assets, you should have them integrated in the firm, because otherwise you have the risk of opportunism. That's what Marx said a hundred years earlier. And they're compatible with Durkheim, as I said before, and with Mises, which is very interesting. So what we have here is that the firm is a high density structure that really allows a greater level of specialization or division of labor than the market itself. So what I say here is that the firm is a super division of labor if you like.

19:32Now what does this lead us if we take this as a definition of the firm, as a way for the entrepreneur to actually create a higher density between factors to utilize division of labor to a higher degree than is possible in the market? Well, if we take these Austrian insights again, we have that the entrepreneur imagines a profit opportunity of some sort. This is the Cantillon-Night-Mises view of entrepreneurship, as Klein talks about. Now when he does that, he's really generating knowledge in his mind of a new type of structure of production, how to produce something new, if services are good or whatever, and of course he acts on this new profit opportunity, and he creates a firm leading them into specializing further than they could in the market and he teaches them how to work together to use this in a way that they could not do in the marketplace by themselves so the firm becomes a super efficient production structure because we know that division of labor makes you more efficient

20:48they're not dividing them, like switching between tasks all the time so let's have a short look I'm almost done at the firm versus atomistic competition, if we accept this definition well, we have a higher density within the firm which means we have a higher division of labor which means that we have higher efficiency and lower cost extra profits within the firm would cause increased competition in the marketplace because suddenly no one can compete with this firm that is organized. If everybody is self-employed, running around in the market trying to trade and someone establishes a firm where they can be more efficient, of course everybody else wants to establish a firm.

21:41It also means that you get specialization in administrative services. Suddenly within the firm, the entrepreneur can actually relieve these factors from all those extra services. Accounting, marketing, sales. If you're a carpenter, why don't you do carpentry? So you suddenly have specializations in these things as well. And you get new markets for these specialized labor factors. Both within production, where you specialize further than is possible in the market as self-employed, now you can go to other firms, because people would follow the lead of this entrepreneur.

22:29And also, suddenly you have a market for accountants, which would not exist before, possibly. Now the firm in the market, if you're self-employed, first of all you have to be compatible, you you have to be on the same level you can't produce something that is very very small that no one else can use you have to be basically the same level of specialization as all the others you must switch between tasks all the time you have to find customers, you have to find financing, you have to produce the stuff, you have to buy the stuff all these things you don't have to do that in the firm so it revolutionizes production and actually the firm like this explains why there is increased competition and it actually pushes the market towards an increased division of labor you will see the firm like this and it creates new markets for outsourcing imagine then the market takes another step in the division of labor and suddenly all firms have a marketing department.

23:42Well, why don't the marketing people suddenly go together, create a firm because they know what that is about and they sell these services in the market. So the entrepreneur says, okay, fine, I'll buy it on the market, that's more efficient. So in conclusion, this would be a holistic, comprehensive view through combining Austrian fragments and utilizing the strengths of the mainstream theory, both Coase and Williamson, just different degrees, I admit. Now the result is what I call a classical theory of the firm, because it's really following Smith and Marx and those people, so I'm totally skipping the neoclassicals, which feels good too. And to this classical theory of the firm, I add modern Austrian insights.

24:32And that's basically what I had.