Coase’s theory of the firm

ONE morning, an economist went to buy a shirt. The one he chose was a marvel of global production. It was made in Malaysia using German machines. The cloth was woven from Indian cotton grown from seeds developed in America. The collar lining came from Brazil; the artificial fibre from Portugal. Millions of shirts of every size and colour are sold every day, writes Paul Seabright, the shirt-buying economist, in his 2004 book, “The Company of Strangers”. No authority is in charge. The firms that make up the many links in the chain that supplied his shirt had merely obeyed market prices.

Throwing light on the magic of market co-ordination was a mainstay of the “classical” economics of the late-18th and 19th centuries. Then, in 1937, a paper published by Ronald Coase, a British economist, pointed out a glaring omission. The standard model of economics did not fit with what goes on within companies. When an employee switches from one division to another, for instance, he does not do so in response to higher wages, but because he is ordered to. The question posed by Coase was profound, if awkward for economics: why are some activities directed by market forces and others by firms?