Striking the Right Balance
“Ronald Coase was the greatest of the many great University of Chicago economists.” So declared a Forbes article published in homage to the British economist who died a year ago this September. What made Ronald Coase deserving of such a headline?
Prolific throughout his long life, in 1991 he was awarded the Nobel Memorial Prize in Economics “for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.”
His 1937 article, “The Nature of the Firm,” sought to explain the existential purpose of companies. If markets are so good at allocating resources, then why do we need firms at all? The answer is simple: because market transactions come with associated costs – sometimes quite high ones – and firms will arise when they can avoid such costs by doing it more efficiently themselves.
Consider this scenario: I am a professor looking for students to teach. What if instead of belonging to an educational institution, I went straight to the market to seek out students interested in my knowledge? That would be extremely costly: figuring out who is interested in what and agreeing a price with each student, not to mention deciding where and when the classes would be held, and so on. If I had to do that before each and every class, I would end up spending more time negotiating than teaching. Coase argued that the costs are far lower if such decisions are made not by the marketplace but by the organization that steps in to serve those functions.
This raises another question: If organizations can achieve lower costs, then why doesn’t a single company handle everything? Actually, this is essentially what the Soviet Union tried to do.
Once again, the answer is simple: because company transactions also have costs and, as they start to balloon, organizational costs rise, sometimes making it better to separate out certain activities and let the market intervene.
As such, managers need to learn how to strike the right balance; discerning when we need markets and when we need organizations, depending on which costs are higher. These questions strike at the heart of everyday realities, whether it’s deciding whether it’s cheaper to contract out than to hire, or whether governments or free markets are better at solving social ills such as pollution.
If these ideas seem simple, it’s because they are. Coase himself believed that some of the most important things we can learn from economics are simple truths, which all too often go ignored. But as Coase reminds us, the most obvious mistake a manager can make is to overlook the obvious. Don’t reject ideas for being simple; accept them for being simply true.
Read the full version of this article in IESE Insight magazine.