Seeing the World through Transactions

STORY OF RONALD COASE

Dr. Ronald H. Coase was born in England in 1910. During the academic year of
1931 to 1932, he came to the U.S. on a traveling scholarship to study the structure
of American industries. Coase was a socialist at the time and sought to understand
capitalism. He visited Ford and General Motors. Coase came up with a puzzle: how
could economists say that Lenin was wrong in thinking the Russian economy could
be run like one big factory, when some very large firms in the U.S. seemed to be
run very well?

What came out of his enquiries was not a complete theory answering the
questions he initially sought, but the introduction of a new concept into economic
analysis:
transaction costs.

Coase used transaction costs to explain why there are
firms. Coase wrote firms were smaller versions of the socialist approach of centrally
planned economies, but they existed because of people’s choices. Coase asked, why
do people make these choices? The answer, wrote Coase, is “marketing costs.”
(Economists now use the term “transaction costs.”)
Coase theorized that, if markets
were costless to use, firms would not exist.
Instead, individuals would make personal,
arm-length transactions. But because markets are costly to use, the most
efficient production process often takes place in a firm. Coase’s explanation of why
firms exist birthed a body of literature on the transaction analysis. These ideas
became the basis for his article “The Nature of the Firm,” published in 1937 and
cited by the Royal Swedish Academy of Sciences in awarding him the 1991 Alfred
Nobel Memorial Prize in Economic Sciences.

What Coase observed at Ford and General Motors were very large and vertically
integrated manufacturing firms. Less than a generation before, Henry Ford had
changed manufacturing forever by the invention of the assembly line, complete with
repetitive tasks, interchangeable parts, interchangeable workers, and a product priced
so the workers themselves could afford to buy it. Since Ford initiated this type of
large manufacturing operation, there were not many supply sources his firm could rely on to produce parts in the quantity he needed. Part of the vertical integration
resulted from necessity: no other source of large quantity supply.
Another factor supporting the monolithic, vertically integrated structure was the
limited transportation and communication infrastructure. The concentrated growth
of Detroit as an automotive industry center was in no small way attributable to the
need for suppliers to be in close proximity to the end producer. Once suppliers of
sufficient size and quality were located in the region, Ford and other growing
competitors, like General Motors, began to have choices for their component supplies.
They could either make the part themselves or buy it elsewhere. The firm
began the evolution from a monolith to a network of suppliers. The primary driver
was the cost of the part.