(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 228

CHAPTER 6 • Production 203

Today we take firms for granted. It is hard for us to imagine the production
of automobiles without large companies like Ford and Toyota, the production
of oil and natural gas without companies like Exxon-Mobil and Shell, or even
the production of breakfast cereal without companies like Kellogg and General
Mills. But stop for a minute and ask yourself whether we really need firms to
produce the goods and services that we consume regularly. This was the question raised by Ronald Coase in a famous 1937 article: If markets work so well in
allocating resources, why do we need firms?2

Why Do Firms Exist?
Do we really need firms to produce cars? Why couldn’t cars be produced by
a collection of individuals who worked independently and contracted with
each other when appropriate, rather than being employed by General Motors?
Couldn’t some people design a car (for a fee), other people buy steel, rent the
equipment needed to stamp the steel into the shapes called for in the design,
and then do the stamping (also for negotiated fees), other people make steering
wheels and radiators, still other people assemble the various parts, and so on,
where again, every task would be performed for a negotiated fee?
Or take another example: We—the authors of this book—work for universities, which are essentially firms that provide educational services along with
research. We are paid monthly salaries and in return are expected to teach regularly (to students recruited by our “firms” and in classrooms the “firms” provide), do research and write (in the offices our “firms” give us), and carry out
administrative tasks. Couldn’t we simply bypass the universities and offer our
teaching services on an hourly basis in rented classrooms to students who show
up and pay us, and likewise do research on a paid piecemeal basis? Do we really
need colleges and universities with all their overhead costs?
In principle, cars could indeed be produced by a large number of independent workers, and an education could be produced by a number of independent
teachers. These independent workers would offer their services for negotiated
fees, and those fees would be determined by market supply and demand. It
shouldn’t take you long, however, to realize that such a system of production
would be extremely inefficient. Think about how difficult it would be for independent workers to decide who will do what to produce cars, and negotiate the
fees that each worker will charge for each task. And if there were any change in

the design of the car, all of these tasks and fees would have to be renegotiated.
For cars produced this way, the quality would likely be abysmal, and the cost
astronomical.
Firms offer a means of coordination that is extremely important and would be
sorely missing if workers operated independently. Firms eliminate the need for
every worker to negotiate every task that he or she will perform, and bargain
over the fees that will be paid for those tasks. Firms can avoid this kind of bargaining by having managers that direct the production of salaried workers—they
tell workers what to do and when to do it, and the workers (as well as the managers themselves) are simply paid a weekly or monthly salary.
There is no guarantee, of course, that a firm will operate efficiently, and there are
many examples of firms that operate very inefficiently. Managers cannot always
monitor what workers are doing, and managers themselves sometimes make

2
Ronald Coase, “The Nature of the Firm,” Economica (1937), Vol. 4: 386–405. Coase won a Nobel Prize
in Economics in 1991.