The economically rational consumer & the concept of the ‘firm’

The economically rational consumer & the concept of the ‘firm’

(An extract from ‘A semiotic interrogation of law & economics’ by Dr James Moylan)

The contemporary social discourse is crowded with economically rational consumers and providers. Banks, billionaires, moneylenders, corporations and even some local retail outlets are all perceived as being social actors who entertain and exhibit a similar ‘economically rational’ personality. Yet less than a century ago the concept of an ‘economically rational actor’ was little more than an academic abstraction.

The birth of the economically rational actor

‘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’. (Ronald Coase, ‘The Nature of the Firm’, 1937).[1]

While economists might quibble about the particular features ascribed to ‘a rational actor’ they are all debates regarding the precise form of much the same theoretical construct. The rationality of a ‘rational (choice) actor’ is not at all similar to that employed by just any individual thinking in ‘a thoughtful clear-headed manner’.[2] It is the proposition of a grossly delimited rationality where an actor, who always entertains a complete knowledge of all of the economic factors that might impact upon any decision, always strives to balance costs against profits to maximise their own personal commercial advantage.[3]

For most readers this concept of an ‘economically rational actor’ will either be familiar or immediately recognisable. So it is largely impossible to recover as a personal experience the sense of novelty that the originator of this concept must have entertained. Yet unlike most tropes of literature and thought, in this instance it is possible to identify not only who first described this concept but also why the description was fashioned. The ‘rational choice actor’ proposition is a theoretical abstraction that was first described and employed in an explicit fashion in an academic treatise in 1937, in an essay by Ronald Coase entitled The Nature of the Firm.[4]

Researchers are privy to far more information regarding the circumstances surrounding the generation of this essay than is usually the case. In a second essay published fifty-one years after the original, Coase provides a wealth of contextual information.[5] He makes this available because the original article had long since become a text ‘usually referred to with respect’.[6]

Nonetheless, throughout this latter essay an odd sense of ambivalence prevails. Even though Coase is obviously thrilled that this particular aspect of his theoretical work has come to be celebrated, it is also clear that he has some reservations regarding the nature and degree of this success. At one stage he even discretely describes The Nature of the Firm as being his ‘un succes d’estime’.[7].

At the commencement of this celebrated work, Coase gently castigates his fellow practitioners of economics for often failing to state clearly the assumptions which animate many of their propositions. Then he suggests that the manner in which a ‘plain man’[8] might use the word ‘firm’[9] would likely differ from the way that an economist would conceive of and employ the same. Before proposing that, in exploring and expanding on the definition attaching to the word ‘firm’, certain observations might be made which may be of utility to an economist.[10] In this manner, Coase declares right at the outset, that he is an economist using words in a way which is likely to be foreign to your average ‘plain man’.

In his re-defining of the word ‘firm’, Coase proposes that the validity of any assumptions must be testable. So he sets out the nature of a twofold test:

‘… 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? …. 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 … economic analysis. …. Our definition must, of course, “relate to formal relations which are capable of being conceived exactly”.’[11]

Regarding ‘the free-market’, Coase quotes the classical economist Sir Arthur Salter with approval:

‘Salter had observed ‘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’.’[12]

With these sentiments in mind, echoing the words of yet another colleague, Coase then proceeds to question why, in such ‘a free market’, would there be ‘islands of conscious power in this ocean of unconscious co-operation, like lumps of butter coagulating in a pail of buttermilk’.[13] Or in plainer terms – why does an entity like a ‘firm’ exist?

The economist at once proceeds to answer his own question, suggesting that the ‘distinguishing mark of the firm is the supersession of the price mechanism’[14] being occasioned by managers or entrepreneurs operating within ‘firms’.[15] With these entrepreneurs being the embodiment of the commercial dynamics that are ‘… related to the much larger economic specialisation, of which he himself is merely one specialised unit. Here, he plays his part as a single cell in a larger organism, mainly unconscious of the wider role he fills’.[16] Consequently, Coase reasoned, why not ascribe to a firm a distinct persona? A persona that is fully aware of all the particular economic dynamics that are currently operating in the marketplace that might relate to that particular ‘firm’?[17]

By thus conceiving of ‘a firm’ as a self-aware embodiment of the capitalistic free-market, on a smaller scale, the dynamics of the free market could then be extended to explain the internal dynamics of a firm (regardless of what it might be that the owners and managers of a firm might actually think they are doing). All that was needed was to attribute to every firm a persona that is endowed in analysis with a full knowledge of all the free-market conditions and transactions that might be implicated in any economic transaction.[18]

While these might seem like a series of simple and perfectly obvious propositions to any resident of the 21st century, when this ‘rational actor’ concept was first described it was appreciated by both academics and the public at large as being entirely novel.[19]

Coase’s newly coined definition of ‘a firm’ certainly did prove to be theoretically tractable. Much of the remainder of the article is devoted to an examination of the variety of ways in which this new formulation might be employed. Not only did it provide a seemingly plausible explanation for the ‘existence’ of firms, the model also seemed to explain the dynamics which serve to regulate the size of a firm. In the realm of economics this paper is best known for being the origin of this ‘theory of the firm’, a theory which proposes that when external transaction costs are higher than internal, a company will increase in size, and accordingly, when external transaction costs are lesser than internal, a company will outsource production and become smaller.[20]

Finally, having demonstrated that the formula under consideration was certainly of significant utility in economics, Coase then turns his attention to demonstrating that his definition also ‘corresponds to what is meant by a firm in the real world’.[21] Eventually determining that ‘[w]e 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”.’[22]

Making it obvious once again that Coase conceived of the ‘real world’ in a manner that is unlikely to correspond with the way in which any ‘plain man’ might. Which simply corresponds with his earlier observation that his definition of a ‘firm’ must ‘relate to formal relations which are capable of being conceived exactly’.[23] Thus Coase was not interested in historical particularity, social environment, cultural milieu, or the class or personal attributes attending to any of the players in his modelling. He was only concerned with those institutional and economic attributes that might be conceived of ‘exactly’.

Thus it is obvious that when Coase formulated his ‘theory of the firm’ he believed he was formulating an economic concept in pursuit of solving an economic puzzle. Yet less than a century later, these very same propositions of definition and explanation are now pervasive and seemingly ubiquitous.

References

[1] Ronald Coase, ‘The Nature of the Firm’ (1937) 4 (16) Economica, New Series 386-405, 388.

[2] As Friedman advises in Milton Friedman, ‘The role of monetary policy’ in Essential Readings in Economics, (Palgrave, London, 1995), 215-231, 215.

[3] Ibid.

[4] Coase (n 298).

[5] Ronald Coase, ‘The Nature of the Firm: Origin’ (1988) 4(1) Journal of Law, Economics, & Organization 3-17.

[6] Ibid 3.

[7] A French colloquialism referring to an important but largely unpopular success or achievement. Ibid.

[8] Ronald Coase, ‘The Nature of the Firm’ (1937) 4 (16) Economica, New Series 386-405, 388.

[9] Ibid.

[10] Ibid.

[11] Ibid 386-7.

[12] Ibid.

[13] Ibid 389.

[14] Ibid.

[15] Ibid.

[16] Ibid 389. Here Coase is quoting Maurice Dobb’s 1925 work, Capitalist Enterprise and Social Progress where the Dobb’s is discussing Adam Smith’s conception of a capitalist.

[17] Ibid.

[18] ‘We may sum up this section of the argument by saying that the operation of a market costs something and by forming an organisation 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’. Ibid 392.

[19] Ronald Coase, ‘The Nature of the Firm: Origin’ (1988) 4(1) Journal of Law, Economics, & Organization 3-17.3-4.

[20] Ibid 400-4.

[21] Ibid 386.

[22] Ibid 403-4.

[23] Ibid 387.