I remember how in the early days of my stay in Ulaanbaatar, interaction with local journalists would leave me both amused and bemused by their insistence on using the word Company or LLC after mentioning the name of a business firm, particularly if it was one of some size. On their part, they would find my reference to Rio Tinto or Ivanhoe Mines or Boroo Gold just like that as somewhat disrespectful. I rationalised that freed from the earlier suspicion of all corporate existence, my friends found it particularly satisfying to emphasise the emergence and presence of so many companies in their country, and would not deny them their due. The practice persists. MAK is preferred to Mongolyn Alt but the logic of acronymic advantage will not hold good in the overgenerous use of LLCs after other names.
There is, of course, nothing wrong in this, but the small detail came to my mind recently when I read about the death of centenarian Ronald H. Coase, whose insights about why companies work and when government regulation is unnecessary earned him a Nobel Prize in 1991. It was no accident that many of the obituaries described him primarily as the man who studied and explained why companies exist. His proposition, first presented in a lecture when he was a mere 21-year-old, became more widely known when, five years later in 1937, he published “The Nature of the Firm”. The raison d’etre for a company, he posited, was that it was cheaper and easier to coordinate activity within a centrally planned organisation than to spell out contract details covering the myriad steps in the process of production. Coase generated awareness of how companies make economic sense and, seen from there, the Mongolian is right to insist that a company be called such.
Obviously, this column cannot be about Mongolian habits of speech and writing, so what did Coase say in his long and productive life? I would restrict myself to just two of his many papers, both invariably counted among the most influential in modern economics. The first of these,the already mentioned “The Nature of the Firm”, revolutionised our understanding of why companies come to be set up and, once they are there, what then determines their size and scope.
Given that “production could be carried on without any organisation at all”, and also that “the price mechanism should give the most efficient result”, Coase said firms exist because they reduce transaction costs, such as search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs. A logical extension of this would bring up the question why firms should not then become ger and ger. Why should we not have one mega firm to carry on all world production? To this, Coase said, “First, as a firm gets larger, there may be decreasing returns to the entrepreneur function, that is, the costs of organising additional transactions within the firm may rise… Secondly…as the transactions which are organised increase, the entrepreneur…fails to make the best use of the factors of production.” At a certain point, the gains from economies of scale are defeated by the costs of bureaucracy.
Coase argued that the boundaries of the modern company were determined by the relative costs of market organisation and hierarchical direction. An assembly line demanded hierarchy because the costs of bargaining between each successive stage of production would be too great. A wheel fits only on an axle for which it has been designed: command and control is superior to markets in these idiosyncratic transactions. The ideas laid out in the paper explain why, in the first half of the 20th century, companies tended to become more vertically integrated (for example, Ford Motor building its own steel mills and buying its own rubber plantations rather than relying on suppliers), and why, more recently, companies have tended to do the opposite, aggressively outsourcing even basic functions like paying their employees.
The second of his ground-breaking papers came 23 years later, in 1960, when the post-war world called for a new look into practices permeating every facet of capitalism. “The Problem of Social Cost” challenged the idea that the only way to restrain people and companies from behaving in ways that harmed others was through government intervention. He argued that if there were no transaction costs, the affected parties could negotiate and settles conflicts privately to their mutual benefit, and that fostering such settlements might make more economic sense than pre-empting them with regulations.
The paper grew out of a study on how the U.S. Federal Communications Commission licensed broadcasters. Coase argued against the then prevalent practice of issuing more or less permanent licences for small fees to whoever applied first and met legal requirements. Better to treat them as property, auction them off and allow them to be freely transferred. Decades later, his ideas were used to raise billions of dollars for the U.S. Treasury when radio frequencies were assigned for cellular phone services.
The British-born Coase immigrated to the USA in 1951, and he was teaching at the University of Virginia when he submitted his essay about the F.C.C. to The Journal of Law and Economics, a new periodical at the University of Chicago. George J. Stigler later recalled how the faculty there had been puzzled by “how so fine an economist could make such an obvious mistake”. They invited Coase to explain his views to a group that included Milton Friedman and several others to become Nobel laureates. “In the course of two hours of argument, the vote went from 20 against and one for Coase, to 21 for Coase,” Stigler later wrote. No wonder the Royal Swedish Academy of Sciences wrote in announcing his prize in 1991, “Coase may be said to have identified a new set of ‘elementary particles’ in the economic system.”
It is not easy to pin down Coase to a fixed place in this system, though. As a conservatively inclined economist, he was instinctively sceptical of government regulations, but he was also an English empiricist who recognised that reality is complicated. He didn’t believe in laissez-faire, and freely admitted that his insights did not apply to many cases of pollution and other instances of what economists refer to as “negative externalities”, especially those that affect large numbers of people.
Indeed it was Stigler who coined the term “Coase theorem” as he elevated what Coase had described as “a merely useful mental exercise”, expressed in delightfully plain English, to the higher realm of theory. There was a rush to bowdlerise and distort Coase’s subtle reasoning to berate government. Coase had talked about a world in which the affected parties can come together, with all relevant information at hand, and reach a voluntary agreement at zero cost. “This is, of course, a very unrealistic assumption,” he admitted. In cases of industrial pollution, thousands of people, or even more, can be affected. Getting them together, and persuading them all to agree on a settlement, can be a monumental and very costly undertaking. Direct government regulation will not necessarily give better results than leaving the problem to be solved by the market or the firm. But equally there is no reason why, on occasion, such government administrative regulation should not lead to an improvement in economic efficiency. Whether its corporate identity is overly stressed or not, a company, in Mongolia or anywhere else, cannot put all its faith in brinksmanship.