Existence of Firm is Rational!

Classical and neoclassical theories stressed the primacy of the markets for transactions. To theorist of both the schools, the invisible hand manifesting through the price mechanism, resolves the imbalances that exist arising of the mismatch of demand and supply. Yet the ground realities suggested a sort of paradox. Of the total transactions that were observed in real life, the market based transactions occupied a smaller share. Most transactions seem to be occurring internally within an organization. The presence of the firm could not satisfactorily be explained by the early theorists. Profit maximization and utility maximization the key drivers of the neoclassical revolution seem to find limits to this power. The paradox was resolved by Ronald Coase who laid the foundations for transaction cost theory.

To Coase, “market prices govern the relationships between firms but within a firm decisions are made on a basis different from maximizing profit subject market prices. Within the firm decisions are made on through entrepreneurial coordination “

Implied in the Coasian assertion was the presence of transaction costs. Coase identified search and information costs, bargaining and decision costs and policing and enforcement costs that deter the market transactions across board and instead lead to the emergence of the firm. By entering long term contractual arrangements with suppliers of labour, capital, land, technology etc, the demanders of these resources will save on these costs. This provides the rationale for the existence of firms. The firm therefore is a rational outcome of the barriers to market decision making encountered by the firm.

A distinction between neoclassical models and transaction models were captured by Oliver Williamson. He distinguishes transaction cost theories with evolutionary cost theories on six different points as tabulated below

Attirbutes	Neoclassical theories	Transaction economics
Behavioral dimensions	Rationality	Bounded rationality
Unit of analysis	Composite goods and services	Transaction
Governance structure	Technological construct (production function)	Organizational construct
Property rights and contracts	Delineated clearly; negligible costs of enforcement	Enforcement costs high; contract renegotiation difficult;
Structural analysis	Marginal analysis	Basic structure analysis; improvement of existing structure
Remedies	Profit maximization; cost minimization	No optimal solution; satisficing

Source: Oliver Williamson, “The Mechanisms of Governance”, 1996

For Williamson, uncertainty, frequency and asset specificity were key ingredients in determining transaction costs.  Asset specificity refers to the value premium placed on an investment in a specific transaction as compared to its redeployment elsewhere.  The assumption of opportunism in transactions is inherent element in Williamson’s analysis.  While neo-classical analysis is robust in explaining low asset specificity situations, greater the asset specificity, the transactions start to assume a bilateral character resulting in the need for long term partnership. The need to preserve long term relationships results in the movement towards complex governance structures. Thus internal organization will enjoy progressive governance cost advantage with reference to market based governance mechanisms. Apart from the governance costs, firms also face a differential costs in terms of incentives and bureaucratic mechanisms (management excesses etc).

Behavioral attributes anchor in rational actions on the part of the actors in the neoclassical school. Rationality implies absence of information asymmetry and the individual entity in a position to evaluate in toto the cost benefit analysis. Yet to every individual or an organization, there are cognitive constraints that limit the ability to gather, grasp and analyze the information essential for perfectly rational move. In other words, rationality has a frontier which Herbert Simon termed as bounded rationality. In consumer or firm behavior, it is bounded rationality that is at work in daily life and thus the foundation for transaction cost economics.

There is a difference in treatment of units of analysis. Markets being primary in the neoclassical school, the unit of analysis centered on the composite goods and services. Yet composite goods and services were to be generalized to handle the specific vagaries of individual transactions. Hence each transaction would have to be factored as unit of analysis. Therefore right to use goods and services than goods and services themselves were to be foundation in Coasian models.

Production function describes the relation between inputs and outputs. It is independent of the organization. However, to Coasians, rather than mere establishment of mere technological relationship between input and output, it is essential to understand the structure of the firm and governance mechanisms that accompany it. Organizational governance underlined input output relationships and thus they are not independent of organizations. This distinction between technological construct and organizational construct would give insights to organizational priorities.

Neoclassicals assumed property rights to be well defined. The assumption would work subject to clear delineated assignment of rights and the transaction costs associated with exchange of such rights being zero. Yet that was hardly a case in reality. The question of who owned the rights first was paramount and added to the transaction costs in terms of bargaining, exchange and enforcement. Therefore the very view of property rights and their assignment in neoclassical was subject to limits and needed to be factored into practice. Therefore the very assumption of rationality mandated organizations find solutions to these rights and created the firm.  It was not absence of rationality in transaction cost school but the very fact of being rational made producers, consumers alike to adopt solutions to accommodate for the shortcomings in real life.

Marginal thinking underlines economic actions. Yet marginal analysis would be away from reality if divorced from structures. Transaction school favors improvement of structures, yet the structural improvements are n itself an outcome of cost benefit analysis wherein marginal costs would overpower marginal benefits. The essential nature of the firm would be to center around the organizational marginal analysis than analysis of goods and services.

Rationality as discussed above is associated with cognitive costs and hence bounded,. So bounded rationality would lead to an outcome of certain sense of satisfaction being derived to suffice for the existent requirements. It is not an ideal utility maximization or profit maximization in absence of information asymmetry but information asymmetry acting as constraints. The law of equimarginal utility posits income constraints. What transaction cost school seeks to build is information constraints. Least cost production is not merely constrained by isocost line premised in input costs, but isocost line premised by informational constraints. Isocost line is further premised by transaction cost constraints which add up to the input costs. The final input costs are sum total of explicit input costs, bargaining costs, enforcement costs, contractual costs, informational costs etc which acts as final constraint for least cost production. Hence satisficing, the primary element of analysis in Coasian school itself is a rational outcome in presence of informational constraints.

Therefore, rather being mutually exclusive, Coasian models are an outcome of rational action accounting for new constraints hitherto unaccounted by the neoclassicalists.