pn: Coase 1937 II: Substitution based on Transaction cost

Coase, 1937, Part II, p390

The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.

The most obvious cost of " organising" production through the price mechanism is that of discovering what the relevant prices are. This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information. The costs of negotiating and

Naturally, a point must be reached where the costsof organising an extra transaction within the firm are equal to the costs involved in carrying out the transaction inthe open market, or, to the costs of organising by anotherentrepreneur.

Secondly, it may be that as the transactionswhich are organised increase, the entrepreneur fails to place the factors of production in the uses where their value is greatest, that is, fails to make the best use of the factors of production. Again, a point must be reached wlhere the loss through the waste of resources is equal to the marketingcosts of the exchange transaction in the open market orto the loss if the transaction was organised by anotherentrepreneur.

Finally, the supply price of one or more of the factors of production may rise, because the " otheradvantages " of a small firm are greater than those of alarge firm.' Of course, the actual point where the expansionof the firm ceases might be determined by a combination of the factors mentioned above. The first two reasons given most probably correspond to the economists' phrase of " diminishing returns to management."

The point has been made in the previous paragraph thata firm will tend to expand until the costs of organising anextra transactioni within the firm become equal to the costsof carrying out the same transaction by means of an exchangeon the open market or the costs of organising in anotherfirm. But if the firm stops its expansion at a point below