My (novice) highest-level summary of the argument in this paper: firms emerge as a result of transaction costs between people. By being in a firm together, people build shared structures, and as a result can reduce these transaction costs. A firm is like a ball of low transaction costs, pretty much.
This paper is the first economics paper I ever read (a long time ago, excuse my if my summary is awful lol), and still one of the most thought-provoking and interesting papers I've encountered.
The fun-to-think-about questions that it leads me to:
1. What sort of transaction costs between people today are _practically_ the most important to leading to a creation of a firm?
2. What if we built technology that reduced those transaction costs to near zero? E.g. what would it mean for there to be less incentives for a firm to form?
3. How does questions of transaction costs relate to market structure and monopoly?
I guess mostly this paper is amazing b/c it made me realize I never really thought to ask the question "why companies in the first place?"
> What sort of transaction costs between people today are _practically_ the most important to leading to a creation of a firm?
Discovery of services (what can I help you with? what can you do for me) and trust (can I trust you to do task <x>? Can you trust me to pay you) are two of the biggest person to person transaction costs I see nowadays.
Yes. The transaction cost includes both trust for this transaction, and trust for future transactions. Supply chain issues are much more of a concern today than two years ago.
On (2), here's something I've been wondering. Shouldn't the explosion of SaaS and remote work tools close the gap between internal/external transaction costs, and lead to a decrease in firm size? Because we've been seeing the opposite. [0]
Maybe this just hasn't shown up in the numbers yet, because there's a delayed effect? Or do SaaS and remote work tools benefit firms internally just as much, or more, than someone contracting out work on the open market?
Having taught this paper a couple times, the best way to think about it is a binary. Why is there 1 (a firm) and not 0 (the market)? This way shifts the internal/external viewpoint slightly. The resting state should be 0 (the market), we need to understand why we get 1 (the firm).
All of that being said, SaaS and remote work tools should reduce the cost of transactions in the firm, which means expanded control of capital and more productive monitoring systems. In effect this means that the company can coordinate restrictions on output, monitor agents, and curb the costs imposed by the agents on the firm.
Theory is ambiguous when it comes to markups, what the company charges versus the price that consumers pay. This might go up or go down. There is a lot of current debate on this. But the theory does suggest that markets should get more monopolized.
Let me know if you need more. This is one of my research foci.
I think you are right but underestimating the sheer number of small SaaS companies out there.
Just rode through a startup and acquisition in a space I’d never thought much about (way underserved but all kinds of money sliding around) until I worked there with a smaller than I would have thought possible team.
> 1. What sort of transaction costs between people today are _practically_ the most important to leading to a creation of a firm?
My take on this :
I have skill-a , you have skill-b. Skill-a plus skill-b would make a device that would solve a big problem in the world. Company solves the transaction cost of finding two people with complementary skills.
> What if we built technology that reduced those transaction costs to near zero? E.g. what would it mean for there to be less incentives for a firm to form?
Costs of organization can also drop, making firms more competitive compared to individual contracting.
In a way, an "organization" is just a very complex smart market or mechanism that we don't bother to analyze the incentive structures of. Organizational arrangements also involve transaction costs, and these can be quite high especially as size grows, personal loyalties decrease and inside politicking dynamics become prevalent. "The Nature of the Firm" is more about exploring the contrast of these different ways of arranging cooperation among agents than asserting one as consistently better than the other.
Just to make it explicit: the woah-effect of the idea is that the firm, a concept rather central to our experience of capitalism, contradicts a (common conception of a) central idea of capitalism, namely that competition assures efficiency.
This also has implications when we discuss workers who want to "work from home." I reference Coase in "What work can be done from home? What work needs to be done at an office?" While I think this piece is carefully researched, it is easily the least popular thing I've ever written. I'm surprised at how angry people get around this subject. I don't fully understand what is going, but I've never written anything else that drew such angry reactions from people. Simply pointing out the limits of the work-from-home movement seems to leave some people on edge, defensive, wary, and emotional. I'm not sure why. Obviously there must be some limit to work-from-home.
To me, it's pretty clear: A lot of people like working from home, and are wary that they will be forced back into the office, along with the long commutes and sometimes-frustrating social interactions that go along with it. They see arguments like yours as a real threat to their quality of life.
Also, you make a lot of assertions in your post without substantiating them. This generally contributes to outcry when the assertions don't line up with people's personal experience.
In terms of making assertions from personal experience, I do emphasize that what I've seen is limited to New York City. If you live some place else, your experiences might be very different. Perhaps I should repeat this point.
I was thinking about this topic just recently, as someone who got to spend the first ~10 years of my career in workplaces with private offices, now working remotely.
I came to the conclusion that open offices really did ruin everything. “On edge, wary, defensive, and emotional” is a pretty accurate description how I felt every day at work after everything changed to open offices.
People seem to just have these drastic reactions to everything now. Knee jerk reaction wants to blame it on social media. While the socials might not be THE reason, they definitely amplify it. A large portion of society seems to think that if you have a differing opinion/thought/belief on a given topic you are against them in a way that must be vigorously defended against without any consideration of the differing opinion/thought/belief.
It's so bad that when I hear something I WANT to believe, but merely ask why they think that particular thing or what are they basing that (unjustified) conclusion on, they immediately start assuming I believe in the contrary position and leveling personal attacks at me.
Like fuck me for wanting more information and to base my beliefs on sound conclusions.
The issue is that many people view inquisitiveness now as a dog whistle due to its increasing use in bad faith by extremists. It's called "sealioning": https://en.wikipedia.org/wiki/Sealioning
I mean, who are YOU to question them in the first place. /s
I have always had the "Asks why way too much" problem. Most people are defensive at first as if I had the gall the question them, but the ones I've learned the most from are the ones that realize the "why" isn't questioning them as it is questioning the process for better understanding.
"Defensive" is a great managerial term. It implies that the lower status person argues against the great managerial deliberations in a helpless and futile manner.
It turns any discussion automatically into a status contest, with a first mover advantage. I've never seen an intelligent person use it.
Environmental activist: we must cut back on the use of fossil fuels, or climate change will be catastrophic
CEO of Shell Oil: What? Why? What is wrong with fossil fuel? Why are you attacking me? What evidence do you have that lets you use words like "catastrophic"? And, uh, what about the economy? The workers?
----------------------
Moral of the story: sometimes very high status people get defensive.
Yours is one of the reasoned and illuminating takes on the WFH debate. I am going to share it with my team and one of my senior engineers who is extremely reluctant to come to the office, which in the long term will hurt his prospects.
As for meltdowns, I think it is because you are poking at something irrational namely "the urge to work from home". WFH has been a "freebie" for most folks - to use your example jobs that should pay $110k are paying $250k.
When you poke at this irrationality, like questioning the provenance of stolen goods, people get defensive and have emotional reactions. Deep down folks know that they have to accept the inevitability of going back or take a pay cut and neither option sits well.
The reason for waiting is that there's a sharp dropoff in interestingness along the repetition curve, and a few weeks is long enough to flush the hivemind caches.
Do you also consider the limits of working from the office? I’m thinking of things like lost productivity from open office floor plans, for instance.
I wonder how many firms arise simply to feed the ego of the people who start it? Certainly you must address this part of WFH? That fact was brought sharply into focus by the pandemic, no?
This is an interesting viewpoint and as an advocate of wfh, a good one for me to read.
However I would say that a lot of your argument seems to be based on the fact that senior leaders / top performers like to meet in person, so therefore there must be benefits. Have you considered the possibility that the causality is reversed here? The current generation of senior leaders came up before working from home was really possible, therefore are by definition going to be the people who thrive in face to face environment. Conversely people who work more effectively from home (including all the intangibles) are much less likely to currently have reached senior positions. But now working from home is so much more convenient, is there a reason to think that there couldn't be a rebalancing here?
I work with a lot of startups. I was recently working with PairEyewear.com, founded by 2 people who were 26 years old, and who are now 28 years old. They go to the office 4 days a week. I do not see a generational shift, I see leaders of all ages going to the office.
I didn't mean generation in terms of age. Maybe "current cohort" would have been better phrasing.
Many people will have already decided before they are 26 that they aren't cut out for leadership because they don't fit the prevailing idea of what a leader is/does.
Great idea! It never occurred to me to use Coase's perspective to look at working from home. Thinking about it in this way makes it much easier to reason about. Thanks.
I actually am a member of a sort of 3 man firm that on paper exists at 3 separate companies. We keep our intra-firm transactions operating on basically market principles. "Can you do this part of job x consisting of this rigorously defined scope for y dollars?" Prices set themselves pretty fairly that way. If a job of a particular type starts to become more tedious, complex or time-consuming, the price adjusts naturally and continuously at an equilibrium.
We're able to handle larger projects, offer greater breadth of services and service more clients than we would on our own, but we use one outward facing name so that clients feel they are interacting with one entity. We each have sub-speciallizations and clients are better served by the greater breadth of expertise. We almost always beat everyone on price too.
Clients are often, but not always, shared.
We each buy our own equipment, but we share it when needed and we share expertise. We each pitch in a 1/3 share for an office space to meet with clients.
In practice it works wonderfully.
But boy, 'the man' does not like that arrangement. They can't possibly fathom that there's an equal power dynamic, or that we really are separate entities, each with our own clients and business infrastructure. We just work together in only the ways each person finds mutually beneficial.
This is very interesting. Similar to a path I almost went down with some partners, but it fizzled due to too many unknowns and lack of energy to research them. Would you be willing to expound on your arrangement? Either here or privately. In particular…
What legal structure are you each using? sole proprietorships, llcs, s-corps? (Assuming you’re US based)
Are there any tax benefits/costs to this arrangement?
Has the government hassled you regarding the arrangement? (It sounds like it has, but…how exactly and how did you respond?)
Have counterparties hassled you or been scared off? Do they even “know” of the arrangement?
Are there significant legal/transaction costs between the three of you? If not, is that simply because you have strong trust in each other?
>What legal structure are you each using? sole proprietorships, llcs, s-corps? (Assuming you’re US based)
We've used a mix of ALL of the above. Right now, it's two s-corps and an LLC.
That's the nice thing, there's flexibility in how YOU want to structure YOUR stuff and do so optimally. UNFORTUNATELY, we're all California based, so sole proprietorships are probably out now.
>Are there any tax benefits/costs to this arrangement?
Yeah, so you lose out on economies of scale that would come by having ONE set of books, ONE accountant, an HR department, etc. However, that gets offset a bit by having total control and flexibility in how you structure your tax write-offs. On balance, I think I come out ahead this way, but it's a bit more unbillable work.
>Has the government hassled you regarding the arrangement? (It sounds like it has, but…how exactly and how did you respond?)
Yes, the CA EDD was kind of a nightmare to deal with over this issue during an audit which was for the year or two BEFORE the ABC test came into affect. It all mostly worked out but they just could NOT get it. We kind of lucked out there.
>Have counterparties hassled you or been scared off? Do they even “know” of the arrangement?
Basically, no, but they don't really know the arrangement. We have a sort of sub-contractor agreement that spells out who carries insurance liability for a particular job, and some other details. (I'm fuzzy on the details, it's been a while).
>Are there significant legal/transaction costs between the three of you? If not, is that simply because you have strong trust in each other?
Transaction costs are very minimal. We have contracts specifying the nature of payment and negotiations, and a clearly defined structure for who "owns" particular clients. That said, trust is paradoxically very high despite what I'd say is in some ways a very low-trust structure. The essence of the idea was to take all the stuff that would normally have to involve an army of lawyers and whatnot and convert it to something that can be managed as a free market.
Beyond our core team, we have several people that form a loose coalition of professionals we occasionally rope in on projects as well. This lets us grow or shrink out team in a really quick-to-adapt way without really making anyone feel responsible for anyone else's livelihood. Since we're regular partners on projects, typical transaction costs and negotiations are very minimal.
So if you share equipment, share an office, publicly use the same name, frequently work jointly on projects...
How is this fundamentally different from a single company with 3 departments? What advantages are you garnering? Are there purely tax advantages to this?
Yeah so the biggest difference is, all expectations are financial. If you want to just leave for a month and input zero labor, we have no issues with that. You just still have to pay your share of rent.
If we were partners, we'd basically have to have some sort of salary or profit-sharing agreement which would likely require all manner of careful management of expectations. So, for example, say we split profit 1/3, 1/3, 1/3. Well, how do you handle the situation where one partner is not putting out? What if they become less efficient for several months because of personal issues? What if one wants to just go travel for a month? What if one partner wants to be more lenient on their tax write-offs than others are comfortable with? Rather than hash out some complicated agreement with lawyers and all that, we just operate internally as independent companies.
This way, problems are much more contained. If one partner starts fucking off, the others just stop sharing work. There is no "milking their hours" situation because that is reflected in the pre-work price negotiations. There's no unfairness in expectations, because we treat each other as separate entities and let the 'market' figure it out.
Also, everyone has complete skin in the game on their own projects and own clients.
I wouldn't say there are any inherent tax advantages except that you have complete flexibility to make it work for your own person.
This is one of the most seminal papers in Economics and the only to win a Nobel that does not have a single equation in it :)
In general, Coase's transaction cost framework is very useful in the Internet era - Amazon EC2 can be viewed as a way for firms to lower transaction costs of scaling up and down to zero, something that not even large firms could manage, some time ago.
Shopify is a way for small merchants to access costs per transaction that were only available to large ecommerce giants and so on and so forth.
Transaction costs are just a model, and just like all models, the transaction cost model is imperfect and not always right, but often useful.
What transaction costs in the modern economy are ripe to be pared down?
- Suing a powerful adversary if you are in the right
- democratically changing a law (and abolishing old laws) to adapt to changed technologies
- patents and copyright as a way to motivate innovation (those are transaction costs introduced with a noble intention, but I think they can be improved by e.g. just paying people to
- land speculation (georgism ho!)
- borders and restrictions on free movement
- moralistic bans on drugs and prostitution instead of regulation to make those transactions safe and cut down on externalities
The book "radical markets", while not 100% aligned with my politics gives a more detailed overview on some of these
I think #1 is in the process of being unbundled. We _just_ need a coordination platform which brings lead plaintiffs, backers and lawyers together on a platform. Perhaps you mean something else by it?
Abolishing old laws already happens in some states but it needs to be lower transaction cost event. This would be a fun platform to build and something that can bring manifold benefit to society. Changing laws is a special and more complex case of creating new laws and has too much complexity maybe 10x harder than repealing old laws.
The last two evoke too many beliefs about ideology, moralism and nativist beliefs so I won't go there.
I meant things like the current Twitter debacle where it might be costlier for Twitter to enforce a legally binding contract than for them to go along with Musk wanting to renegotiate, or the cost and risk of a patent litigation making it exceedingly rare for invalid patents to get nullified, or people not routinely suing big companies for losing their data or breaking their services. Litigation costs money, the risks are asymmetrical and hedged towards large players, which makes the game nudged towards large players, heirs and monopolists.
Land speculation is the general Georgist critique of natural monopolies like land allowing people to make profits without labor or risk, creating rents which suck up the efficiency gains of the wider economy.
That was back when it was much easier to make contributions to the sciences. Now you need 50+ page paper with 2-4 authors full of stats and regression to get maybe published in a mid tier journal.
Charles Perrow, Complex organizations : a critical essay, 1972, 1985. pp. 186--187 looks at the firm and intra- and inter-firm dynamics from a sociological perspective. It's in large part a review of the literature to the time of its writing, beginning with Weber and including serveral economists, though Coase only merits one mention. There's considerable attention paid to Herbert Simon and James March, among many others.
There's two articles related to this that I really like. One is Herbert Simon's paper from 1991 on the topic of organizations and markets with a great passage
"A mythical visitor from Mars, not having been apprised of the centrality of markets and contracts, might find the new institutional economics rather astonishing. Suppose that it (the visitor I’ll avoid the question of its sex) approaches the Earth from space, equipped with a telescope that reveals social structures. The firms reveal themselves, say, as solid green areas with faint interior contours marking out divisions and departments. Market transactions show as red lines connecting firms, forming a network in the spaces between them. Within firms (and perhaps even between them) the approaching visitor also sees pale blue lines, the lines of authority connecting bosses with various levels of workers. As our visitor looked more carefully at the scene beneath, it might see one of the green masses divide, as a firm divested itself of one of its divisions. Or it might see one green object gobble up another. At this distance, the departing golden parachutes would probably not be visible. No matter whether our visitor approached the United States or the Soviet Union, urban China or the European Community, the greater part of the space below it would be within the green areas, for almost all of the inhabitants would be employees, hence inside the firm boundaries. Organizations would be the dominant feature of the landscape. A message sent back home, describing the scene, would speak of “large green areas interconnected by red lines.” It would not likely speak of “a network of red lines connecting green spots.”
That is itself referenced in the second piece which ties this into compuational complexity and socialist planning, by Cosma Shalizi.
