Government as Super Firm*

July 28, 2010

*Like Walmart, not like Tofu

I’m working on something important, but very slowly, because I don’t know how to begin. Well, what I’m working on is transaction cost economics, and that means I have to start with the man who started it all, Ronald Coase.

Coase is the guy you go to when, after hearing from economists over and over again about the virtues of the free market, you ask, “If markets are so great, why are there firms?” Within a firm, there are bosses and employees; you don’t go to work every day and start trying to sell your services to willing bidders. And when your boss asks you to make copies or write a report, you don’t negotiate your terms before you do it. Markets are supposed to work from the bottom up, with entrepreneurs using their special knowledge to find profit opportunities. Yet firms are centralized, top-down bureaucracies, where everyone is ordered around and expected to do what they’re told, under threat of firing. But firms are all over the place. If the unconscious, un-directed market works so well, why does the market environment contain all these islands of socialism?

The answer is that for all its great features, the price system isn’t free to use. As Coase wrote in his 1960 article, “The Problem of Social Cost,” “In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on.” The price system is great, but using it in its information-organizing capacity entails high costs. And the pricing mechanism is just one way of deciding how resources get allocated. Another way is by conscious control and direction, the kind you see when firms hire workers and proceed to order them to do certain tasks. It certainly happens that some of the tasks bosses order their workers to do are not the highest- valued uses for those workers, if you could somehow ignore the costs incurred in finding out what those highest-valued uses are, negotiating the conditions under which they will perform those tasks, etc. But these “transaction costs” are a fact of the process of resource allocation; they can’t be ignored.

It is in this context that Coase refers to the government as a “super-firm.” They can order around resources and people in ways that firms and individuals can’t. The government’s position has some advantages and disadvantages:

The government is, in a sense, a super-firm (but of a very special kind) since it is able to influence the use of factors of production by administrative decision. But the ordinary firm is subject to checks in its operations because of the competition of other firms, which might administer the same activities at lower cost and also because there is always the alternative of market transactions as against organisation within the firm if the administrative costs become too great. The government is able, if it wishes, to avoid the market altogether, which a firm can never do. The firm has to make market agreements with the owners of the factors of production that it uses. Just as the government can conscript or seize property, so it can decree that factors of production should only be used in such-and-such a way. Such authoritarian methods save a lot of trouble (for those doing the organising). Furthermore, the government has at its disposal the police and the other law enforcement agencies to make sure that its regulations are carried out.

It is clear that the government has powers which might enable it to get some things done at a lower cost than could a private organisation (or at any rate one without special governmental powers). But the governmental administrative machine is not itself costless. It can, in fact, on occasion be extremely costly. Furthermore, there is no reason to suppose that the restrictive and zoning regulations, made by a fallible administration subject to political pressures and operating without any competitive check, will necessarily always be those which increase the efficiency with which the economic system operates. Furthermore, such general regulations which must apply to a wide variety of cases will be enforced in some cases in which they are clearly inappropriate. From these considerations it follows that direct governmental 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 governmental administrative regulation should not lead to an improvement in economic efficiency. This would seem particularly likely when, as is normally the case with the smoke nuisance, a large number of people are involved and in which therefore the costs of handling the problem through the market or the firm may be high.

Perhaps Coase’s most important insight was that if transaction costs didn’t matter, then government wouldn’t matter, at least not from the perspective of economic efficiency. If the government sets the rules but individuals can negotiate freely with one another, then the pattern of resource utilization will be unaffected. If the government says I don’t have the right to play my music loud, but rather my neighbors have the right to a quiet neighborhood, they are free to rent me that right for a suitable fee. If I love music more than that money, I’ll play it whether I “own” the right or not.

But with large numbers of negotiators and complicated transactions, that analysis doesn’t mean a thing. The transaction costs are too high to make the transaction worthwhile. In those cases, what the government says has a real effect on economic efficiency.

That’s enough for one post. I have more to say, but I had to start with Coase.

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2 Responses to “Government as Super Firm*”

  1. Rrrobert! Says:

    This is an excellent post. Though keep in mind, in a democracy governments are subject to competition, even if it’s not the direct price competition faced by firms.


  2. […] again, as Coase taught us, the government is a giant transaction-cost reducing machine. If the reason there is no market in carbon emissions is because creating such a market is too […]


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