Has the distinction of helping me clearly understand a concept I was previously fuzzy on:
Munger: Coase asked this really great question in 1937: If markets are so great, why are there firms?
And his answer was... transaction costs.
Roberts: Explain the question first, though. Because a lot of people would say, "What kind of a question is that?"
Munger: Economists brag about the ability of prices to organize decentralized distributed activities – transactions – among people that don't know each other.
So, Friedrich Hayek in 1945 gives the example of tin: If the price of tin goes up, I don't need to know why. I just know that I need to economize.
People who produce tin don't need to know why. They'll just make more tin.
Entrepreneurs don't need to know why. They'll just figure out a way to make substitutes.
So, the price system directs people to do what they would do if they had perfect information. And that's a great savings. So, prices are really wonderful. Prices organize the economic system.
Coase said, "Well, if prices are so great, why are these little command economies that we call firms embedded in [the market]?"
Because, if I work for Ford motor company, I don't put a bolt into the chassis of the Ford car and then go on e-Bay and auction it off and find the highest price, deliver it to them, and then they put on the fender. Instead, the next guy in the line just puts on the fender. Price is not operating here: I'm being ordered to do this by an entrepreneur...
Most people, when you ask, "Who tells you what to do?" they don't say, "Prices." They say, "My boss."
So, bosses do a lot more ordering around than prices.
Coase's question was: "Where is the margin?" And firms call this the make-or-buy decision.
So, firms make some things, but they buy other things. So, maybe for a while Ford Motor Company considered going out and making its own steel for cars, but they never grew the wheat for the sandwiches in the employee cafeteria. They always bought some things.
So, that line between make or buy, Coase claimed, was based on transaction costs. It was the cost of using the market versus the cost of organizing this transaction within the company.
I think that if Coase were alive today, he might ask a question: "Why is it that we own instead of share?"
And the answer is still: transaction costs. The margin between owning and sharing will be determined by transaction costs.
The thing is that Coase recognized that there was a dynamic component to this. That is, the size of firms, both in terms of the scope of products and the amount of products that they produce, will be determined over time by transaction cost. If it's cheaper to buy things in the market, then firms will shrink.