As first appearing in the September 30, 2013, print edition of The Weekly Standard:
Though I never met the man, I feel a debt of gratitude to Ronald Coase, the Nobel Prize-winning economist who died on Labor Day at age 102. Reading his “Nature of the Firm” – one of the most cited essays in all of economic literature – encouraged me to start my own business.
Two decades ago, I persuaded John McDonnell, the CEO of McDonnell Douglas, then the nation’s 23nd largest industrial company, to outsource the biggest part of my job (writing his speeches) back to me as an independent writer. I left the company with an annual contract that paid me no less money than I was making before and that allowed me to pursue other clients. But as I told John McDonnell, I also knew that I had to perform at a high level – being painfully aware of the fact that the company could cancel my contract at any time if I did less well as an independent contractor than I had as a “salary-man” (to use the Japanese expression) or employee.
Anyone familiar with Ronald Coase’s work will recognize that I had struck a classic “Coasian” bargain – finding an efficient free-market solution to a particular problem (my unhappiness with the corporate environment and desire for independence) that worked for both parties: The CEO accepted the notion that I would be a hyper-motivated non-employee, and I became my own boss.
Coase was the first to ask – and provide a plausible answer to – the question of why companies exist . . . and why a critical part of their success comes from getting large numbers of people to submit to a form of voluntary servitude – punching a time clock and giving employers the right to direct their performance in exchange for predetermined wages or salaries and protection from sudden or arbitrary dismissal.
His answer was that companies exist for the purpose of reducing “transactions costs” – meaning all the costs of trying to order economic activity through voluntary exchange. That includes the costs of searching out and evaluating other parties; negotiating contracts; maintaining communication; and policing and enforcing the terms of those contracts.
Imagine the extraordinary difficulty that a Henry Ford or a William Boeing would have faced in trying to contract out for every part and every task going into the assembly of a car or airplane. Hence the need for the visible hand of management in coordinating the allocation of resources.
At the same time, Coase fully appreciated the disciplines and rewards of free enterprise, and he was acutely aware of the tendency of corporate (or government) bureaucracies to stifle individual initiative and kill any sense of real ownership that people have over the quality of their own work. Within a large, publicly owned corporation, no one, including the CEO, is spending his own money.
Citing the picturesque words of another economist (D. H. Robertson), the British-born Coase, who spent most of his working life in the United States, described companies as “islands of conscious power” – or central planning – in an “ocean of unconscious (i.e., spontaneous free-market) cooperation . . . like lumps of butter in a pail of coagulating buttermilk.”
The “lump of butter” of which I was a part in the early 1990s was a shrinking rather than a growing mass: In just three years, the company shed more than 50,000 jobs, or 42 percent of the workforce. In the midst of all the downsizing, people were angry and confused – not knowing where the axe would fall next and bitterly resenting a sudden loss of the personal security that they had gained (and felt entitled to) through years of fealty to the same company. What they didn’t see was that a whole way of life was disappearing.
And now it is gone. Today, no one – not even someone graduating from a top business school – expects to spend his or her entire adult life with a single company. Everyone accepts that big companies really aren’t built to last. More like lumps of butter than castles of perpetual growth and stability, they may dissolve at any moment and disappear into the liquid churn.
One may think of the quarter of a century from 1955 (the first year of the Fortune 500) to 1980 as a golden age for big business in America. During that time, Fortune 500 companies ruled the roost – growing at about twice the rate of GDP growth and enjoying robust profitability from one year to the next – even during recessions. In 1975, the last year of the virulent recession touched off by the Arab oil embargo, only 15 Fortune 500 companies, or 3 percent of the total, reported losses, and all of the top 50 companies were solidly in the black.
Compare that to 1993 – which happened to be my last year as an employee at McDonnell Douglas. This was a brutal year for many big companies. Even though the 1990-91 recession was officially over, no fewer than 151 Fortune 500 companies – or just more than 30 percent – lost money in 1993, and that included 4 out of the top 10 (GM, Ford, IBM, and DuPont) and 22 out of the top 50 ranked by revenues.
To add just one more statistic gleaned from sifting through old issues of the Fortune annual survey, it is worth noting that Fortune 500 companies shed close to 3 million jobs in the 10-year period ending in 1993.
So what happened to bring the era of big business dominance to a close and set the stage for a new era of entrepreneurship and greater dispersal as opposed to centralization of economic activity?
We may turn to Ronald Coase for what I believe is the key insight. In his essay on the nature of the firm – published in 1937, when he was a young professor at the London School of Economics – he addressed the different ways in which technological advancements could affect the size of companies:
It should be noted that most inventions will change both the costs of organizing and the costs of using the price mechanism. In such cases, whether the invention tends to make firms larger or smaller will depend upon the relative effect on these two sets of costs. For instance, if the telephone reduces the costs of using the price mechanism more than it reduces the costs of organizing, then it will have the effect of reducing the size of the firm.
But of course, I thought, when I read those words for the first time. This was a year before John McDonnell and I struck our Coasian bargain. With his encouragement, I had agreed to take part in a research project by the Center for the Study of American Business at Washington University in St. Louis examining how U.S. firms (including McDonnell Douglas) were responding to the twin challenges of the information revolution and globalization . . . and to write sections of a book (The Dynamic American Firm) summarizing the findings.
Coase’s thinking loomed large in the book and in my own subsequent decision to go out on my own.
The mainframe computers that came into existence in the 1950s were so big and expensive that only the biggest companies could use them. With the help of these early computers in reducing the costs of organizing production and marketing, Fortune 500 companies became bigger and more prosperous throughout the sixties and seventies.
Then came the information revolution – which (even before the Internet) had the opposite effect of reducing the size of firms. It reduced the need for corporate bureaucracy. Still more, it caused many big companies to disassemble their carefully constructed vertical empires and to contract out for just about everything outside of their own core competencies. I knew that writing was not one McDonnell Douglas’s core competencies, and I reasoned that I should set a price for my work as an outside contractor that would be equal to the cost that the company would incur in having to hire a full-time speechwriter to replace me. Because the drafting of speeches and annual reports took maybe 50 percent of my time at McDonnell Douglas, I figured I would free up many hours that would go into serving other clients.
The Dynamic American Firm did not become a best-seller, but in re-reading some passages of the book, I can relive some of the excitement that I felt in pondering the next step in my own life:
Like “de-industrialization,” the rapid rise in business services and self-employment over the past several years has set alarm bells ringing in enlightened centers of thought. “In the future,” one displaced executive told Time magazine, “we are going to be moving from job to job in the same way that migrant workers move from crop to crop.”
Perhaps. But unlike the migrant worker, today’s corporate refugee, equipped with a personal computer, printer, copier and fax machine – all purchased for about $7,000 – can earn a good living toiling in the comfort of his, or her, home. That is so because the information revolution has greatly reduced transactions costs – for big firms and small contractors alike.
Coase may have done more to extend our understanding of business and commerce than any thinker since Adam Smith. But his influence did not stop there. He also had a profound influence in challenging the belief that government regulations, taxes, or subsidies were the best and, indeed, the only way of dealing with actions of business firms that have harmful effects on others, with a commonly cited example being the emission of sparks from a train that causes damage to a farmer’s crops along the railroad’s right-of-way.
In a “The Problem of Social Cost,” his second most famous essay, published in 1960, Coase argued that most disputes of this nature are best resolved by negotiation, rather than regulation or imposing strict penalties on the damaging party.
As Coase pointed out, both the railroad and the farmer would be better off if the latter agreed not to cultivate the vulnerable portion of his land in exchange for a payment that would equal or exceed the opportunity cost incurred in foregoing its cultivation. In other words, without regulation, the two sides could easily reach a mutually beneficial solution.
“The Problem of Social Cost” gave rise to a whole new body of literature in the field of “economics and the law.”
In awarding him the 1991 prize in economics, the Nobel committee observed that “Coase may be said to have identified a new set of ‘elementary particles’ in the economic systems.” Coase himself made no such claims, saying in a 2012 interview, “I’ve never done anything that wasn’t obvious and I didn’t know why other people didn’t do it.”
Andrew B. Wilson is a resident fellow and senior writer at the Show-Me Institute, which promotes market solutions for public policy in Missouri.