Firms

Diary Entry: February 11, 2025

I’m still spinning out about that “Coase was a socialist” comment from Calabresi. It just won’t leave my head. I decided to dig into his really early publications, back when he supposedly had these sympathies.

I found it: “The Nature of the Firm,” published in 1937.

And... wow. This is a huge piece of the puzzle.

The whole paper is about a question I’ve never even thought to ask: Why do firms exist?

I mean, if you really believe in Adam Smith’s system, firms shouldn’t exist. The economy should just be a giant, free market. If you need a service, you go to the market and contract for it. If you need a component, you buy it. The “price mechanism” should coordinate everything.

But that’s not what happens. Instead, we have these massive companies — these “islands of conscious power,” as Coase calls them. And inside those islands, the price mechanism completely disappears.

Coase points out that when an employee moves from one department to another, it’s not “because of a change in relative prices, but because he is ordered to do so”. The boss is an “entrepreneur-coordinator”. That’s just a nice word for a central planner.

So, why do firms exist? Coase’s answer is... market failure.

He says it’s because there are “transaction costs” to using the market. It costs money to find people, to negotiate, to “draw up the contract”. A firm, he argues, comes into existence when it becomes cheaper to just hire people and plan their activities than it is to constantly go out to the market and form endless contracts. The firm is the alternative to the market.

So, the great hero of free-market capitalism started his career by writing a paper on how the market fails and must be replaced by... little pockets of central planning?

This is not a paper about a “collection of contracts.” It’s a paper about how firms eliminate the need for those contracts.

This is... this is really weird. This is the exact opposite of what I thought this man stood for. What does this have to do with his 1960 paper?