The haggling theory of the firm

In “The Nature of the Firm,” Ronald Coase asks why islands of conscious power (companies) take form in an ocean of unconscious co-operation (markets).

We take companies for granted — how else would things like cars or iPhones get made? But in a free economy where prices coordinate most activity, their very existence is a puzzle. Why not outsource everything — design, assembly, shipping — and let the invisible hand of markets coordinate all the transactions that requires?

The answer, of course, is that outsourcing everything is a royal pain — you’d be constantly haggling over who does what, when, and on what terms. 

“A firm is likely therefore to emerge in those cases where a very short term contract would be unsatisfactory,” Coase wrote.

Blockworks, for example, employs a full-time newsletter writer because it would be annoying, expensive, and time-consuming to agree terms with a new one every morning. The “haggling cost” of discovering prices and negotiating contracts five times a week are greater than the cost of having a full-time writer on the payroll. (I hope.)

This seems obvious enough. But Coase’s observation was considered “breathtakingly simple and original,” as one economist later put it. Before his “theory of the firm,” no one thought of companies in these terms.

After Coase, it became the textbook explanation for why companies exist, and also the limits to how big they might get.

“A firm will tend to expand,” Coase explained, “until the costs of organising an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market.” 

No one pushed internal coordination further than Henry Ford. The complex he built at River Rouge, Michigan, in 1928 was his Coasean masterpiece: a vast, vertically integrated complex designed to avoid the frictions of the market. Ford dredged the Rouge River to build his own shipping docks and built hundreds of miles of railroad tracks, a dedicated electricity plant, and a steel mill onsite.

Thus Ford internalized virtually every transaction other than raw materials: With everything all in one place, River Rouge turned raw materials into cars. 

The immense complexity of that process inspired the Detroit Industry Murals, considered some of the most intricate examples of American painting:

An economist might see in these a depiction of market transactions brought inside a firm.

“​​Within a firm, these market transactions are eliminated,” Coase writes, “and in place of the complicated […] exchange transactions is substituted the entrepreneur-co-ordinator, who directs production.”

With River Rouge, Henry Ford became the ultimate entrepreneur-co-ordinator.

Ford pushed the limits of internal coordination even further with Fordlândia — a fully functional American-style town Ford built in the Amazon to avoid the cost and uncertainty of haggling for rubber on the open market.

It was an internalization too far. For an American car company, it turns out that growing your own rubber in a jungle is more expensive than simply buying it. 

Fordlândia failed before it produced any rubber at all. Founded in 1927, the site was abandoned by 1934, with the hospital, church, school, golf course, and housing Ford built for employees left to rot in the festering humidity of the Amazon. Ford’s grandson sold the property back to the government of Brazil in 1945 at a steep loss.

It was an expensive lesson in Coasean expansion: “A firm will continue to expand until the internal costs of organizing an additional transaction equal the costs of performing that same transaction on the open market,” Coase explains.

Fordlândia was well beyond that logical limit.

Fortunately, the “verticalization” at River Rouge was far more successful. But even there, the cost of internal coordination eventually exceeded the cost of just using the market: As markets got more efficient — through specialization, the highway system, standardized shipping containers, just-in-time manufacturing — Ford’s vision of turning raw materials into cars at a single site no longer made sense.

River Rouge is still active — F-150s are made there. But they’re made from parts sourced from suppliers located all over the world. The parts are transported to River Rouge by dedicated trucking companies. The onsite steel mill was sold in 1989. The dedicated power plant exploded in 1999, never to be rebuilt. 

Today, the trucks that roll out of River Rouge are only really assembled there.

By Cosean logic, you might think that would make Ford a smaller company. “A firm becomes larger as additional transactions are organised by the entrepreneur [instead of the market],” Coase says, “and becomes smaller as he abandons the organisation of such transactions.”

In practice, it’s more complicated than that. 

The two largest costs of “organizing production through the price mechanism,” Coase explains, are discovering prices and negotiating contracts  — “haggling costs,” as later economists called them. 

Haggling has become progressively less costly in recent decades: Price discovery happens much faster with the World Wide Web, for example, and contracts are executed faster with DocuSign.

But the cost of internal coordination has fallen, too: Email, Slack, and Zoom make it easier than ever for the entrepreneur-coordinator to bring transactions in-house.

By Coase’s logic, companies will get smaller only to the degree that external coordination costs fall faster than internal ones.

Both have fallen — at seemingly similar rates — causing companies to become more modular, but also, sometimes, bigger.

On the one hand, the falling cost of external coordination has enabled Ford Motors to produce more vehicles with fewer employees. On the other hand, the falling cost of internal coordination has enabled a grocery store like Walmart to employ 2.1 million people worldwide.

But what if the cost of external coordination fell so far it effectively rounded to zero? Could companies then have zero employees?

Cosean theory suggests they could.

Excitingly, that theory will soon be put to the test with AI agents.

Even more excitingly, this sets up the first-ever cliffhanger in Breakdown newsletter history!

Tune in tomorrow for The Cosean Singularity — or how the combination of AI and crypto will push Coase’s “theory of the firm” to its limits.

— Byron Gilliam

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