R. H. COASE
Economic theory has suffered in the past from a failure to state clearly its assumption.
Economists in building up a theory have often omitted to examine the foundations on
which it was erected. This examination is, however, essential not only to prevent the
misunderstanding and needles controversy which arise from a lack of knowledge of the
assumptions on which a theory is based, but also because of the extreme importance for
economics of good judgment in choosing between rival sets of assumptions. For instance, it
is suggested that the use of the word “firm” in economics may be different from the use of
the term by the “plain man.”' Since there is apparently a trend in economic theory towards
starting analysis with the individual firm and not with the industry,2 it is ail the more
necessary not only that a clear definition of the word "firm" should be given but that its
difference from a firm in the "real world," if it aists, should be made clear. Mrs. Robinson
has said that "the two questions to be asked of a set of assumptions in economics are: Are
they tractable? and: Do they correspond with the real world?"3 Though, as Mrs. Robinson
points out, "More often one set will be manageable and the other realistic," yet there may
well be branches of theory where assumptions may be both manageable and realistic. It is
hoped to show in the following paper that a definition of a firm may be obtained which is
not only realistic in that it corresponds to what is meant by a firm in the real world, but is
tractable by two of the most powerful instruments of economic analysis developed by
Marshall, the idea of the margin and that of substitution, together giving the idea of
substitution at the margin.4 Our definition must, of course, "relate to formal relations which
are capable of being conceived exactly."5
It is convenient if, in searching for a definition of a firm, we first consider the economic
system as it is normally treated by the economist. Let us consider the description of the
economic system given by Sir Arthur Salter6. “The normal economic system works itself.
For its current operation it is under no central control, it needs no central survey. Over the
whole range of human activity and human need, supply is adjusted to demand, and
production to consumption, by a process that is automatic, elastic and responsive.” An
economist thinks of the economic system as being co-ordinated by the price mechanism
and society becomes not an organization but an organism.7 The economic system “works
itself. This does not mean that there is no planning by individuals. These exercise foresight
and choose between alternatives. This is necessarily so if there is to be order in the system
But this theory assumes that the direction of resources is dependent directly on the price
mechanism. Indeed, it is often considered to be an objection to economic planning that it
merely tries to do what is already done by the price mechanism.8 Sir Arthur Salter's
description, however, gives a very incomplete picture of our economic system. Within a
firm, the description does not fit at all. For instance, in economic theory we find that the
allocation of factors of production between different uses is determined by the price
mechanism. The price of factor A becomes higher in X than in Y. As a result, A moves from
Y to X until the difference between the prices in X and Y, except if 50 far as it compensates
for other differential advantages, disappears. Yet in the real world, we find that there are
many areas where this does not apply. If a workman moves from department Y to
department X, he does not go because of a change in relative prices, but because he is
ordered to do 50. Those who object to economic planning on the grounds that the problem
is solved by price movements can be answered by pointing out that there is planning within
our economic system which is quite different from the individual planning mentioned above
and which is akin to what is normally called economic planning. The example given above
is typical of a large sphere in our modem economic system. 0f course, this fact has not been
ignored by economists. Marshall introduces organization as a fourth factor of production;
J.B. Clark gives the co-ordinating function to the entrepreneur; Professor Knight introduces
managers who co-ordinate. As D. H. Robertson points out, we find "islands of conscious
power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of
buttermilk.”9 But in view of the fact that it is usually argued that co-ordination will be done
by the price mechanism, why is such organization necessary? Why are there these "islands
of conscious power"? Outside the firm, price movements direct production, which is coordinated
through a series of exchange transactions on the market. Within a firm, these
markets transactions are eliminated and in place of the complicated market structure with
exchange transactions is substituted the entrepreneurco-ordinator, who directs production.10
It is clear that these are alternative methods of co-ordinating production. Yet, having
regard to the fact that if production is regulated by price movements, production could be
carried on without any organization at all, well might we ask, why is there any
0f course, the degree to which the price mechanism is superseded varies greatly. In a
department store, the allocation of the different sections to the various locations in the
building may be done by the controlling authority or it may be the result of competitive
price bidding for space. In the Lancashire cotton industry, a weaver can rent power and
shop-room and can obtain looms and yarn on credit.11
This co-ordination of the various factors of production is, however, normally carried out
without the intervention of the price mechanism. As is evident, the amount of “vertical”
integration, involving as it does the supersession of the price mechanism, varies greatly
from industry to industry and from firm to firm.
It can, I think, be assumed that the distinguishing mark of the firm is the supersession of the
price mechanism. It is, of course, as Professor Robbins points out, “related to an outside
network of relative prices and costs,”
12 but it is important to discover the exact nature of
this relationship. This distinction between the allocation of resources in a firm and the
allocation in the economic system has been very vividly described by Mr. Maurice Dobb
when discussing Adam Smith's conception of the capitalist: “It began to be seen that there
was something more important than the relations inside each factory or unit captained by
an undertaker; there were the relations of the undertaker with the rest of the economic
world outside his immediate sphere... the undertaker busies himself with the division of
labour inside each firm and he plans and organises consciously,” but “he is related to the
much larger economic specialisation, of which he himself is merely one specialised unit.
Here, he plays his part as a single ceIl in a larger organism, mainly unconscious of the wider
rôle he fills.”13
In view of the fact that while economists treat the price mechanism as a coordinating
instrument, the? also admit the co-ordinating function of the “entrepreneur,” it is surely
important to enquire why co-ordination is the work of the price mechanism in one case and
of the entrepreneur in another. The purpose of this paper is to bridge what appears to be a
gap in economic theory between the assumption (made for some purposes) that resources
are allocated by means of the price mechanism and the assumption (made for other
purposes) that this allocation is dependent on the entrepreneur-co-ordinator. We have to
explain the basis on which, in practice, this choice between alternatives is effected.14
Our task is to attempt to discover why a firm emerges at ah in a specialized exchange
economy. The price mechanism (considered purely from the side of the direction of
resources) might be superseded if the relationship which replaced it was desired for its own
sake. This would be the case, for example, if some people preferred to work under the
direction of some other person. Such individuals would accept less in order to work under
someone, and firms would arise naturally from this. But it would appear that this cannot be
a very important reason, for it would rather seem that the opposite tendency is operating if
one judges from the stress normally laid on the advantage of “being one's own master;”15 0f
course, if the desire was not to be controlled but to control, to exercise power over others,
then people might be willing to give Up something in order to direct others; that is, they
would be willing to pay others more than they could get under the price mechanism in order
to be able to direct them. But this implies that those who direct pay in order to be able to do
this and are not paid to direct, which is clearly not true in the majority of cases.16 Firms
might also exist if purchasers preferred commodities which are produced by firms to those
not 50 produced; but even in spheres where one would expect such preferences (if they
exist) to be of negligible importance, firms are to be found in the real world.17 Therefore
there must be other elements involved.
The main reason why it is profitable to establish a firm would seem to be that there is a cost
of using the price mechanism. The most obvious cost of “organizing” production through
the price mechanism is that of discovering what the relevant prices are.18 This cost may be
reduced but it will not be eliminated by the emergence of specialists who will sell this
information. The costs of negotiating and concluding a separate contract for each exchange
transaction which takes place on a market must also be taken into account.19 Again, in
certain markets, e.g., produce ex-changes, a technique is devised for minimizing these
contract costs; but they are not eliminated. It is true that contracts are not eliminated when
there is a firm but they are greatly reduced. A factor of production (or the owner thereof)
does not have to make a series of contracts with the factors with whom he is co-operating
within the firm, as would be necessary, of course, if this co-operation were as a direct result
of the working of the price mechanism. For this series of contracts is substituted one. At
this stage, it is important to note the character of the contract into which a factor enters
that is employed within a firm. The contract is one whereby the factor, for a certain
remuneration (which may be fixed or fluctuating), agrees to obey the directions of an
entrepreneur within certain limits.20 The essence of the contract is that it should only state
the limits to the powers of the entrepreneur; Within these limits, he can therefore direct
the other factors of production.
There are, however, other disadvantages - or costs - of using the price mechanism. It may
be desired to make a long-term contract for the supply of some article or service. This may
be due to the fact that if one contract is made for a longer period, instead of several shorter
ones, then certain costs of making each contract will be avoided. Or, owing to the risk
attitude of the people concerned, they may prefer to make a long rather than a short-term
contract. Now, owing to the difficulty of forecasting, the longer the period of the contract
is for the supply of the commodity or service, the less possible, and indeed, the less desirable
it is for the person purchasing to specify what the other contracting party is expected to
do. It may well be a matter of indifference to the person supplying the service or commodity
which of several courses of action is taken, but not to the purchaser of that service
or commodity. But the purchaser will not know which of these several courses he will want
the supplier to take. Therefore, the service which is being provided is expressed in general
terms, the exact details being left until a later date. All that is stated in the contract is the
limits to what the persons supplying the commodity or service is expected to do. The
details of what the supplier is expected to do is not stated in the contract but is decided later
by the purchaser. When the direction of resources (within the limits of the contract)
becomes dependent on the buyer in this way, that relationship which I term a "firm" may be
obtained.21 A firm is likely therefore to emerge in those cases where a very short-term
contract would be unsatisfactory. It is obviously of more importance in the case of services
-labor-than it is in the case of the buying of commodities. In the case of commodities, the
main items can be stated in advance and the details which will be decided later will be of
We may sum Up this section of the argument by saying that the operation of a market
costs something and by forming an organization and allowing some authority (an
"entrepreneur") to direct the resources, certain marketing costs are saved. The entrepreneur
has to carry out his function at less cost, taking into account the fact that he may get
factors of production at a lower price than the market transactions which he supersedes,
because it is always possible to revert to the open market if he fails to do this.
The question of uncertainty is one which is often considered to be very relevant to the
study of the equilibrium of the firm. It seems improbable that a firm would emerge without
the existence of uncertainty. But those, for instance, Professor Knight, who make the
mode of payment the distinguishing mark of the firm - fixed incomes being guaranteed to
some of those engaged in production by a person who takes the residual, and fluctuating,
income-would appear to be introducing a point which is irrelevant to the problem we are
considering. One entrepreneur may sell his services to another for a certain sum of money,
while the payment to his employees may be mainly or wholly a share in profits.22 The
significant question would appear to be why the allocation of resources is not done directly
by the price mechanism.
Another factor that should be noted is that exchange transactions on a market and the same
transactions organized within a firm are often treated differently by Governments or other
bodies with regulatory powers. If we consider the operation of a sales tax, it is clear that it is
a tax on market transactions and not on the same transactions organized within the firm.
Now since these are alternative methods of organization"-by the price mechanism or by the
entrepreneur-such a regulation would bring into existence firms which otherwise would have
no raison d'être. It would furnish a reason for the emergence of a firm in a specialized
exchange economy. 0f course, to the extent that firms already exist, such a measure as a
sales tax would merely tend to make them larger than they would otherwise be. Similarly,
quota schemes, and methods of price control which imply that there is rationing, and which
do not apply to firms producing such products for themselves, by allowing advantages to
those who organize within the firm and flot through the market, necessarily encourage the
growth of firms. But it is difficult to believe that it is measures such as have been mentioned
in this paragraph which have brought firms into existence. Such measures would, however,
tend to have this result if they did not exist for other reasons.
These, then, are the reasons why organizations such as firms exist in a specialized exchange
economy in which it is generally assumed that the distribution of resources is "organized" by
the price mechanism. A firm, therefore, consists of the system of relationships which
comes into existence when the direction of resources is dependent on an entrepreneur;
The approach which has just been sketched would appear to offer an advantage in that it is
possible to give a scientific meaning to what is meant by saying that a firm gets larger or
smaller A firm becomes larger as additional transactions (which could be exchange
transactions co-ordinated through the price mechanism) are organized by the entrepreneur
and becomes smaller as he abandons the organization of such transactions. The question
which arises is whether it is possible to study the forces which determine the size of the
firm. Why does the entrepreneur not organize one less transaction or one more? It is
interesting to note that Professor Knight considers that:
the relation between efficiency and size is one of the most serious problems of theory,
being, in contrast with the relation for a plant, largely a matter of personality and
historical accident rather than of intelligible general principles.
But the question is peculiarly vital because the possibility of monopoly gain offers a
powerful incentive to continuous and unlimited expansion of the firm, which force
must be offset by some decreased efficiency (in the production of money income) with
growth in size, if even boundary competition is to exist.23equally powerful one
Professor Knight would appear to consider that it is impossible to treat scientifically the
determinants of the size of the firm. On the basis of the concept of the firm developed
above, this task will now be attempted.
It was suggested that the introduction of the firm was due primarily to the existence of
marketing costs. A pertinent question to ask would appear to be (quite apart from the
monopoly considerations raised by Professor Knight), why, if by organizing one can
eliminate certain costs and in fact reduce the cost of production, are there any market
transactions at all?24 Why is not ah production carried on by one big firm? There would
appear to be certain possible explanations.
First, as a firm gets larger, there may be decreasing returns to the entrepreneur function,
that is, the costs of organizing additional transactions within the firm may rise.25
Naturally, a point must be reached where the costs of organizing an extra transaction within
the firm are equal to the costs involved in carrying out the transaction in the open market,
or; to the costs of organizing by another entrepreneur. Secondly, it may be that as the
transactions which are organized increase, the entrepreneur fails to place the factors of
production in the uses where their value is greatest, that is, fails to make the best use of the
factors of production. Again, a point must be reached where the loss through the waste of
resources is equal to the marketing costs of the exchange transaction in the open market or
to the loss if the transaction was organized by another entrepreneur. Finally, the supply
price of one or more of the factors of production may rise, because the "other advantages"
of a small firm are greater than those of a large firm.26 0f course, the actual point where
the expansion of the firm ceases might be determined by a combination of the factors
mentioned above. The first two reasons given most probably correspond to the economists'
phrase of "diminishing returns to management."27
The point has been made in the previous paragraph that a firm will tend to expand until the
costs of organizing an extra transaction within the firm become equal to the costs of
carrying out the same transaction by means of an exchange on the open market or the
costs of organizing in another firm. But if the firm stops its expansion at a point below the
costs of marketing in the open market and at a point equal to the costs of organizing in
another firm, in most cases (excluding the case of "combination"28), this will imply that
there is a market transaction between these two procedures, each of whom could organize it
at less than the actual marketing costs. How is the paradox to be resolved? If we consider an
example the reason for this will become clear. Suppose A is buying a product from B and
that both A and B could organize this marketing transaction at less than its present cost. B,
we can assume, is not organizing one process or stage of production, but several. If A
therefore wishes to avoid a market transaction, he will have to take over all the processes
of production controlled by B. Unless A takes over ail the processes of production, a market
transaction will still remain, although it is a different product that is bought. But we have
previously assumed that as each producer expands he becomes less efficient; the additional
costs of organizing extra transactions increase. It is probable that A's cost of organizing the
transactions previously organized by B will be greater than B's costs of doing the same
thing. A therefore will take over the whole of B's organization only if his cost of organizing
B's work is not greater than B's cost by an amount equal to the costs of carrying out an
exchange transaction on the open market. But once it becomes economical to have a
market transaction, it also pays to divide production in such a way that the cost of
organizing an extra transaction in each firm is the same.
Up to now it has been assumed that the exchange transactions which take place through the
price mechanism are homogeneous. In fact, nothing could be more diverse than the actual
transactions which take place in our modem world. This would seem to imply that the costs
of carrying out exchange transactions through the price mechanism will vary considerably
as will also the costs of organizing these transactions within the firm. It seems therefore
possible that quite apart from the question of diminishing returns the costs of organizing
certain transactions within the firm may be greater than the costs of carrying out the
exchange transactions in the open market. This would necessarily imply that there were
exchange transactions carried out through the price mechanism, but would it mean that
there would have to be more than one firm? Clearly not, for all those areas in the economic
system where the direction of resources was not dependent directly on the price mechanism
could be organized within one firm. The factors which were discussed earlier would seem to
be the important ones, though it is difficult to say whether "diminishing returns to
management" or the rising supply price of factors is likely to be the more important.
Other things being equal, therefore, a firm will tend to be larger:
a. the less the costs of organizing and the slower these costs rise with an increase in the
b. the less likely the entrepreneur is to make mistakes and the smaller the increase in
mistakes with an increase in the transactions organized.
c. the greater the lowering (or the less the rise) in the supply price of factors of production
to firms of larger size.
Apart from variations in the supply price of factors of production to firms of different
sizes, it would appear that the costs of organizing and the losses through mistakes will
increase with an increase in the spatial distribution of the transactions organized, in the
dissimilarity of the transactions, and in the probability of changes in the relevant prices.29
As more transactions are organized by an entrepreneur, it would appçar that the
transactions would tend to be either different in kind or in different places. This furnishes
an additional reason why efficiency will tend to decrease as the firm gets larger. Inventions
which tend to bring factors of production nearer together, by lessening spatial distribution,
tend to increase the size of the firm.30 Changes like the telephone and the telegraph which
tend to reduce the cost of organizing spatially will tend to increase the size of the firm. All
changes which improve managerial technique will tend to increase the size of the firm.31/32
It should be noted that the definition of a firm which was given above can be used to give
more precise meanings to the terms "combination" and "integration."33 There is a
combination when transactions which were previously organized by two or more
entrepreneurs become organized by one. This becomes integration when it involves the
organization of transactions which were previously carried out between the entrepreneurs
on a market. A firm can expand in either or both of these two ways. The whole of the
"structure of competitive industry" becomes tractable by the ordinary technique of
The problem which has been investigated in the previous section has not been entirely
neglected by economists and it is now necessary to consider why the reasons given above
for the emergence of a firm in a specialized exchange economy are to be preferred to the
other explanations which have been offered.
It is sometimes said that the reason for the existence of a firm is to be found in the division
of labor This is the view of Professor Usher, a view which has been adopted and expanded
by Mr. Maurice Dobb. The firm becomes "the result of an increasing complexity of the
division of labour… The growth of this economic differentiation creates the need for some
integrating force without which differentiation would collapse into chaos; and it is as the
integrating force in a differentiated economy that industrial forms are chiefly
significant."34 The answer to this argument is an obvious one. The "integrating force in a
differentiated economy" already exists in the form of the price mechanism. It is perhaps
the main achievement of economic science that it has shown that there is no reason to
suppose that specialization must lead to chaos.35 The reason given by Mr. Maurice Dobb is
therefore inadmissible. What has to be explained is why one integrating force (the
entrepreneur) should be substituted for another integrating force (the price mechanism).
The most interesting reasons (and probably the most widely accepted) which have been
given to explain this fact are those to be found in Professor Knight's Risk, Uncertainty and
Profit. His views will be examined in some detail.
Professor Knight starts with a system in which there is no uncertainty:
acting as individuals under absolute freedom but without collusion men are supposed to
have organised economic life with the primary and secondary division of labour, the
use of capital, etc., developed to the point familiar in present-day America. The
principal fact which calls for the exercise of the imagination is the internal
organisation of the productive groups or establishments. With uncertainty entirely
absent, every individual being in possession of perfect knowledge of the situation,
there would be no occasion for anything of the nature of responsible management or
control of productive activity. Even marketing transactions in any realistic sense
would not be found. The flow of raw materials and productive services to the consumer
would be entirely automatic.36
Professor Knight says that we can imagine this adjustment as being "the result of a long
process of experimentation worked out by trial-and-error methods alone," while it is not
necessary "to imagine every worker doing exactly the right thing at the right time in a sort
of 'pre-established harmony' with the work of others. There might be managers,
superintendents, etc., for the purpose of co-ordinating the activities of individuals," though
these managers would be performing a purely routine function, "without responsibility of
Professor Knight then continues:
With the introduction of uncertainty-the fact of ignorance and the necessity of acting
upon opinion rather than knowledge-into this Eden-like situation, its character is
entirely changed. . . . With uncertainty present doing things, the actual execution of
activity, becomes in a real sense a secondary part of life; the primary problem or
function is deciding what to do and how to do
This fact of uncertainty brings about the two most important characteristics of social
In the first place, goods are produced for a market, on the basis of entirely impersonal
prediction of wants, not for the satisfaction of the wants of the producers themselves.
The producer takes the responsibility of forecasting the consumers' wants. In the
second place, the work of forecasting and at the same time a large part of the
technological direction and control of production are still further concentrated upon a
very narrow class of the producers, and we meet with a new economic functionary, the
entrepreneur. . . . When uncertainty is present and the task of deciding what to do and
how to do it takes the ascendancy over that of execution the internal organisation of
the productive groups is no longer a matter of indifference or a mechanical detail.
Centralisation of this deciding and controlling function is imperative, a process of
"cephalisation" is inevitable.39
The most fundamental change is:
the system under which the confident and venturesome assume the risk or insure the
doubtful and timid by guaranteeing to the latter a specified income in return for an
assignment of the actual results… With human nature as we know it it would be
impracticable or very unusual for one man to guarantee to another a definite result of
the latter's actions without being given power to direct his work. And on the other
hand the second party would not place himself under the direction of the first without
such a guarantee…The result of this manifold specialisation of function is the
enterprise and wage system of industry. Its existence in the world is the direct result
of the fact of uncertainty.40
These quotations give the essence of Professor Knight's theory. The fact of uncertainty
means that people have to forecast future wants. Therefore, you get a special class
springing Up who direct the activities of others to whom they give guaranteed wages. It acts
because good judgment is generally associated with confidence in one's judgment.41
Professor Knight would appear to leave himself open to criticism on several grounds. First
of all, as he himself points out, the fact that certain people have better judgment or better
knowledge does not mean that they can only get an income from it by themselves actively
taking part in production. They can sell advice or knowledge. Every business buys the
services of a host of advisers. We can imagine a system where ah advice or knowledge was
bought as required. Again, it is possible to get a reward from better knowledge or judgment
not by actively taking part in production but by making contracts with people who are
producing. A merchant buying for future delivery represents an example of this. But this
merely illustrates the point that it is quite possible to give a guaranteed reward providing
that certain acts are performed without directing the performance of those acts. Professor
Knight says that "with human nature as we know it, it would be impracticable or very
unusual for one man to guarantee to another a definite result of the latter's actions without
being given power to direct his work." This is surely incorrect. A large proportion of jobs
are done to contract, that is, the contractor is guaranteed a certain sum providing he
performs certain acts. But this does not involve any direction. It does mean, however, that
the system of relative prices has been changed and that there will be a new arrangement of
the factors of production.42 The fact that Professor Knight mentions that the "second
party would not place himself under the direction of the first without such a guarantee" is
irrelevant to the problem we are considering. Finally, it seems important to notice that
even in. the case of an economic system where there is no uncertainty Professor Knight
considers that there would be co-ordinators, though they would perform only a routine
function. He immediately adds that they would be "without responsibility of any sort,"
which raises the question by whom are they paid and why? It seems that nowhere does
Professor Knight give a reason why the price mechanism should be superseded.
It would seem important to examine one further point and that is to consider the relevance
of this discussion to the general question of the "cost-curve of the firm."
It has sometimes been assumed that a firm is limited in size under perfect competition if its
cost curve slopes upward,43 while under imperfect competition, it is limited in size because
it will not pay to produce more than the output at which marginal cost is equal to marginal
revenue.« But it is clear that a firm may produce more than one product and, therefore,
there appears to be no prima facie reason why this upward slope of the cost curve in the
case of perfect competition or the fact that marginal cost will not always be below marginal
revenue in the case of imperfect competition should limit the size of the firm.45 Mrs.
Robinson46 makes the simplifying assumption that only one product is being produced. But
it is clearly important to investigate how the number of products produced by a firm is
determined, while no theory which assumes that only one product is in fact produced can
have very great practical significance.
It might be replied that under perfect competition, since everything that is produced can be
sold at the prevailing price, then there is no need for any other product to be produced. But
this argument ignores the fact that there may be a point where it is less costly to organize
the exchange transactions of a new product than to organize further exchange transactions
of the old product. This point can be illustrated in the following way. Imagine, following
von Thunen, that there is a town, the consuming center, and that industries are located
around this central point in rings. These conditions are illustrated in the following diagram
in which A, B, and C represent different industries.
Imagine an entrepreneur who starts controlling exchange transactions from x. Now as he
extends his activities in the same product (B), the cost of organizing increases until at some
point it becomes equal to that of a dissimilar product which is nearer. As the firm expands,
it will therefore from this point include more than one product (A and C). This treatment
of the problem is obviously incomplete,47 but it is necessary to show that merely proving
that the cost curve turns upwards does not give a limitation to the size of the firm. So far
we have only considered the case of perfect competition; the case of imperfect competition
would appear to be obvious.
To determine the size of the firm, we have to consider the marketing costs (that is, the
costs of using the price mechanism), and the costs of organizing the different entrepreneurs
and then we can determine how many products will be produced by each firm and how much
of each it will produce. It would, therefore, appear that Mr. Shove48 in his article on
"Imperfect Competition" was asking questions which Mrs. Robinson's cost curve apparatus
cannot answer; The factors mentioned above would seem to be the relevant ones.
Only one task now remains; and that is, to see whether the concept of a firm which has
been developed fits in with that existing in the real world. We can best approach the
question of what constitutes a firm in practice by considering the legal relationship
normally called that of "master and servant" or "employer and employee."49 The
essentials of this relationship have been given as follows:
(1) the servant must be under the duty of rendering personal services to the master or
to others on behalf of the master, otherwise the contract is a con-tract for sale of
goods or the like.
(2) The master must have the right to control the servant's work, either
personally or by another servant or agent. It is this right of control or interference, of
being entitled to tell the servant when to work (within the hours of service) and when
not to work, and what work to do and how to do it (within the terms of such service)
which is the dominant characteristic in this relation and marks off the servant from an
independent contractor, or from one employed merely to give to his employer the
fruits of his labour. In the latter case, the contractor or performer is not under the
employer's control in doing the work or effecting the service; he has to shape and
manage his work 50 as to give the result he has contracted to effect.50
We thus see that it is the fact of direction which is the essence of the legal concept of
"employer and employee," just as it was in the economic concept which was developed
above. It is interesting to note that Professor Batt says further:
That which distinguishes an agent from a servant is not the absence or presence of a
fixed wage or the payment only of commission on business done, but rather the
freedom with which an agent may carry out his employment.51
We can therefore conclude that the definition we have given is one which approximates
closely to the firm as it is considered in the real world.
Our definition is, therefore, realistic. Is it manageable? This ought to be clear; When we are
considering how large a firm will be the principle of marginalism works smoothly. The
question always is, will it pay to bring an extra exchange transaction under the organizing
authority? At the margin, the costs of organizing within the firm will be equal either to the
costs of organizing in another firm or to the costs involved in leaving the transaction to be
"organized" by the price mechanism. Business men will be constantly experimenting,
controlling more or less, and in this way, equilibrium will be maintained. This gives the
position of equilibrium for static analysis. But it is clear that the dynamic factors are also of
considerable importance, and an investigation of the effect changes have on the cost of
organizing within the firm and on marketing costs generally will enable one to explain why
firms get larger and smaller; We thus have a theory of moving equilibrium. The above
analysis would also appear to have clarified the relationship between initiative or enterprise
and management. Initiative means forecasting and operates through the price mechanism
by the making of new contracts. Management proper merely reacts to price changes,
rearranging the factors of production under its control. That the business man normally
combines both functions is an obvious result of the marketing costs which were discussed
above. Finally, this analysis enables us to state more exactly what is meant by the "marginal
product" of the entrepreneur. But an elaboration of this point would take us far from our
comparatively simple task of definition and clarification.
1. Joan Robinson, Economics Is a Serious Subject (1932), 12.
2. See N. Kaldor, "The Equilibrium of the Firm," 44 The Economic Journal (1934), 60-76.
3. Op. cit., 6.
4. J M. Keynes, Essays in Biography (1933), 223-24.
5. L. Robbins, Nature and Significance of Economic Science (1935), 63.
6. This description is quoted with approval by D. H. Robenson, Control 0f Industry (1923),
85, and by Professor Arnold Plant, "Trends in Business Administration," 12 Economica
(1932) 45-62. It appears in Allied Shipping Control, pp. 16-17.
7. See F. A. Hayek, "The Trend of Economic Thinking," 13 Economica (1933)121-37.
8. See R A. Hayek, op. cit.
9. Op. cit., 85.
10. In the rest of this paper I shall use the term entrepreneur to refer to the person or
persons who, in a competitive system, take the place of the price mechanism in the
direction of resources.
11. Survey of Textile Industries, 26.
12. Op. cit., 71.
13. Capitalist Enterprise and Social Progress (1925), 20. Cf., also, Henderson, Supply and
Demand (1932), 3-5.
14. It is easy to see when the State takes over the direction of an industry that, in planning
it, it is doing something which was previously done by the price mechanism. What is usually
not realized is that any business man in organizing the relations between his departments is
also doing something which could be organized through the price mechanism. There is
therefore point in Mr. Durbin's answer to those who emphasize the problems involved in
economic planning that the same problems have to be solved by business men in the
competitive system. (Sec "Economic Calculus in a Planned Economy," 46 The Economic
Journal  676-90.> The important difference between these two cases is that
economic planning is imposed on industry while firms arise voluntarily because they
represent a more efficient method of organizing production. In a competitive system, there
is an "optimum" amount of planning!
15. Cf. Harry Dawes, "Labour Mobility in the Steel Industry," 44 The Economic Journal
(1934) 84-94, who instances "the trek to retail shopkeeping and insurance work by the
better paid of skilled men due to the desire (often the main aim in life of a worker> to be
16. None the less, this is not altogether fanciful. Some small shopkeepers are said to earn
less than their assistants.
17. G. F. Shove,, "The Imperfection of the Market: a Further Note," 44 The Economic
Journal (1933>113-24, n. 1, points out that such preferences may exist, although the
example he gives is almost the reverse of the instance given in the text.
18. According to N. Kaldor, "A Classificatory Note of thc Determinanteness of Equilibrium,"
I The Review 0f Economic Studies (1934)122-36, h is one of the assumptions of
static theory that "Ail the relevant prices are known to ail individuals." But this is clearly
not true of the real world.
19. This influence was noted by Professor Usher when discussing the development of
capitalism. He says: "The successive buying and selling of partly finished products were
sheer waste of energy." (Introduction to the Industrial History 0f England (1920), 13.) But
he does not develop the idea nor consider why it is that buying and selling operations still
20. It would be possible for no limits to the powers of thc entrepreneur to be fixed. This
would be voluntary slavery. According to Professor Batt, The Law o! Master and Servant
(1933), 18, such a contract would be void and unenforceable.
21. 0f course, it is not possible to draw a hard and fast line which determines whether there
is a firm or not. There may be more or less direction. It is similar to the legal question of
whether there is the relationship of master and servant or principal and agent. Sec the discussion
of this problem below.
22. The views of Professor Knight are examined below in more detail.
23. Risk, Uncertainty and Profit, Preface to the Re-issue, London School of Economics
Series of Reprints, No. 16 (1933).
24. There are certain marketing costs which could only be eliminated by the abolition of
"consumers' choice" and these arc the costs of retailing. It is conceivable that these costs
might be so high that people would bc willing to accept rations because the extra product
obtained was worth the loss of their choice.
25. This argument assumes that exchange transactions on a market can be considered as
homogeneous; which is clearly untrue in fact. This complication is taken into account
26. For a discussion of the variation of the supply price of factors and production to firms
of varying size, sec E. A. G. Robinson, The Structure of Competitive Industry (1932). It is
sometimes said that the supply price of organizing ability increases as the size of the firm
increases because men prefer to be the heads of small independent businesses rather than the
heads of departments in a large business. Sec Jones, The Trust Problem (1921), 531, and
Macgregor, Industrial Combination (1935), 63. This is a common argument of those who
advocate Rationalization. It is said that larger units would be more efficient, but owing to
the individualistic spirit of the smaller entrepreneurs, they prefer to remain independent,
apparently in spite of the higher income which their increased efficiency under
Rationalization makes possible.
27. This discussion is, of course, brief and incomplete. For a more thorough discussion of
this particular problem, see N. Kaldor, "The Equilibrium of the Firm," 44 The Economic
Journal (1934) 60-76, and E. A. G. Robinson, "The Problem of Management and the Size
of the Firm," 44 The Economic Journal (1934) 242-57.
28. A definition of this term is given below.
29. This aspect of the problem is emphasized by N. Kaldor, op. cit. Its importance in this
connection had been previously noted by E. A. G. Robinson, The Structure 0f Competitive
Industry (1932), 83-106. This assumes that an increase in the probability of price movements
increases the costs of organizing within a firm more than it increases the cost of
carrying out an exchange transaction on the market - which is probable.
30. This would appear to be the importance of the treatment of the technical unit by E. A.
G. Robinson, op. cit., 27-33. The larger the technical unit, the greater the concentration of
factors and therefore the firm is likely to be larger.
31. 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 on 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 h will have the effect of reducing the size of the firm.
32. An illustration of these dynamic forces is furnished by Maurice Dobb, Russian
Economic Development (1928), 68. "With the passing of bonded labour the factory, as an
establishment where work was organised under the whip of the overseer, lost its raison d'être
until this was restored to it with the introduction of power machinery after 1846." It seems
important to realize that the passage from the domestic system to the factory system is not
a mere historical accident, but is conditioned by economic forces. This is shown by the fact
that it is possible to move from the factory system to the domestic system, as in the
Russian example, as well as vice versa. It is the essence of serfdom that the price
mechanism is not allowed to operate. Therefore, there has to be direction from some
organizer. When, however, serfdom passed, the price mechanism was allowed to operate. It
was not until machinery drew workers into one locality that it paid to supersede the price
mechanism and the firm again emerged.
33. This is often called "vertical integration," combination being termed "lateral
34. Op. cit., 10. Professor Usher's views are to be found in his Introduction to the Industrial
History of England (1920), 1-18.
35. Cf. J.B. Clark, Distribution of Wealth (1899), 19, who speaks of the theory of exchange
as being the "theory of the organisation of industrial society."
36. Risk, Uncertainty and Profit, 267.
37. Op. cit., 267-68.
38. Op. cit., 268.
39. Op. cit., 268-95.
40. Op. cit., 269-70.
41. Op. cit.,270.
42. This shows that it is possible to have a private enterprise system without the existence
of firms. Though, in practice, the two functions of enterprise, which actually influences the
system of relative prices by forecasting wants and acting in accordance with such forecasts,
and management, which accepts the system of relative prices as being given, are normally
carried out by the same persons, yet it seems important to keep them separate in theory.
This point is further discussed below.
43. See Kaidor, op. cit., and Robinson, The Problem of Management and the Size of the
44. Mr. Robinson calls this the Imperfect Competition solution for the survival of the small
45. Mr. Robinson's conclusion, op. cit., 249, n. 1, would appear to be definitely wrong. He is
followed by Horace J. White, Jr, "Monopolistic and Perfect Competition," 26 The
American Economic Review (1936) 645, n. 27. Mr. White states "It is obvious that the size
of the firm is limited in conditions of monopolistic competition."
46. Economics Imperfect Competition (1934).
47. As has been shown above, location is only one of the factors influencing the cost of
48. G. F. Shove, "The Imperfection of the Market," 43 The Economic Journal (1933).
115. In connection with an increase in demand in the suburbs and the effect on the price
charged by suppliers, Mr. Shove asks “…why do not the old firms open branches in the
suburbs?" If the argument in the text is correct, this is a question which Mrs. Robinson's
apparatus cannot answer.
49. The legal concept of "employer and employee" and the economic concept of a firm are
not identical, in that the firm may imply control over another person's property as well as
over their labor But the identity of these two concepts is sufficiently close for an
examination of the legal concept to be of value in appraising the worth of the economic
50. Batt, The Law of Master and Servant, 6.
51. Op. cit., 7.