Ronald Coase, the eminent British economist and University of Chicago professor emeritus, turned 100 on December 29. In 1937, Professor Coase published a seminal paper: The Nature of the Firm, which along with many other achievements earned him the 1991 Nobel Prize in economics.
The Economist marked Professor Coase’s 100th birthday with an article, Why Do Firms Exist?, that reviews his major accomplishments. I like its edgy first paragraph:
“For philosophers the great existential question is: ‘Why is there something rather than nothing?’ For management theorists the more mundane equivalent is: ‘Why do firms exist? Why isn’t everything done by the market?’”
Professor Coase’s work provides simple answers to to these questions. He explained that, in principle, a firm should be able to find the cheapest, most productive goods and services by contracting them out in an efficient, open marketplace. However, markets are not perfectly fluid. Transaction costs are incurred in obtaining goods and services outside the firm, such as searching for the right people, negotiating a contract, coordinating the work, managing intellectual property and so on. Thus, firms came into being to make it easier and less costly to get work done.
A firm will keep expanding and adding people as long as doing so is less expensive than securing the additional services in the marketplace. But, there are limits to what can be produced efficiently within the firm, as well as to how big a firm can get and still remain competitive against faster moving companies. All that growth generally leads to ever larger, multi-layered hierarchical organizations. The additional layers of management and staff can cause the organization to become bureaucratic, significantly impacting its ability to quickly embrace new ideas and technologies when market conditions change. A well managed company strives to achieve an optimal balance between what work gets done within and outside its boundaries.
As The Economist article points out, market frictions and transaction costs are not the only reason why firms exist. There are actual organizational advantages to firms, such as the ability to marshal a wide range of resources to address very complex problems. This is particularly important at a time when new technologies are opening up all kinds of opportunities to improve productivity and grow revenues. Many of these business benefits will accrue to startups that are able to translate the disruptive technologies into innovative new companies. But a large portion of the benefits can be also be realized by those larger and more mature companies that are able to leverage the disruptive innovations to proper themselves into the future.
The article mentions that in the past couple of decades, a neo-Coasian school of economists and management experts has developed what is called the Resource-based View (RBV) of the firm as a way of framing the inherent organizational advantages of firms over markets. I particularly like the simpler version of the Resource-based View used in chapter seven of The Innovator’s Solution by Clayton Christensen and Michael Raynor. I used The Innovator’s Solution in courses and seminars and consider it one of the best management books I have come across.
Chapter seven is titled: Is your organization capable of disruptive growth? It poses key management questions: “How can we predict precisely what an organization unit is capable and incapable of accomplishing?,” and “How can we create new capabilities?”
Capabilities are the key factors that define what an organization is able to accomplish. Christensen and Raynor classify organizational capabilities into three main categories: resources, processes and values. Resources include people, equipment, technology, product designs, brands, information and cash, as well as the relationships the firm has with suppliers, distributors and customers. They are the most tangible capabilities, and the easiest to acquire, lose and replace. People can be hired and fired; technology and products can be bought and sold; assets can be acquired and disposed.
Processes are the patterns of interactions, coordination and communications that enable companies to get their work done efficiently and consistently, time after time. Some processes are explicitly defined and written down. Others are more informal, consisting of routines and ways of working that people have embraced over time. When processes have been effective for a long time, people follow them without thinking and over time they become part of the culture of the organization.
The third major class of organizational capabilities are its values. Christensen and Raynor have in mind a broader definition of values beyond its ethical connotations. Values are the standards that employees use to make decisions, set priorities and evaluate ideas. They embody the strategic directions and business model of the company. Value shape the culture of the organization, defining what it does as well as the boundaries beyond which it will generally not go.
Resources are the most important organizational capability in the early stages of a business, or when launching a new initiative within an existing company. You need to bring together the right people and provide them the proper support so they can develop and bring to market a new product or service. But, as people work together and the business grows over time, the key organizational capabilities begin to shift toward processes and values. Processes are put in place as people learn how to improve the productivity and quality of their work. And, as the strategic direction of the company takes shape, values begin to coalesce around the decisions and priorities that keep the company moving in the right direction.
Over time, the culture of the organization takes shape. Christensen and Raynor write:
“As successful companies mature, employees gradually come to assume that the priorities they have learned to accept, and the ways of doing things and methods of making decisions that they have employed so successfully, are the right ways to work. Once members of the organization begin to adopt ways of working and criteria for making decisions by assumption, rather than by conscious decisions, then those processes and values come to constitute the organization’s culture.”
“As companies grow from a few employees to hundreds and thousands, the challenge of getting all employees to agree on what needs to be done and how it should be done so that the right jobs are done repeatedly and consistently can be daunting for even the best managers. Culture is a powerful management tools in these situations. Culture enables employees to act autonomously and causes them to act consistently.”
A firm thus becomes a lot more than the sum of its people and resources. Successful firms build up powerful capabilities- processes, values and culture in particular, - that become the essence of its organizational capital. These capabilities enable large, global companies to succesfully manage complex projects that would be much more difficult to coordinate in an open, distributed marketplace.
But, these invaluable organizational capabilities can become major liabilities and endanger the very existence of the firm. For example, when dealing with well understand, standard, commoditized products and services, many of the bureaucratic and managements costs inherent in a large firm may provide little value and make it very difficult to compete in price with smaller and leaner companies.
The biggest danger to a large mature company takes place when a new disruptive innovation significantly transforms markets and business models. Getting new people and other resources to start a new initiative or launch a new entrepreneurial venture is relatively simple. But, when a company has developed a strong set of processes and values, and in particular, when it has a very strong culture, change can become extraordinarily difficult.
This is the world of creative destruction, where the disruptive innovation transforms markets, and companies that once dominated their industries have trouble moving fast enough to embrace the new designs, manufacturing processes and business models. The same capabilities that once enabled them to become successful make change very difficult, often fatally so.
Let me conclude by getting back to Ronald Coase. In addition to reviewing his seminal work on the nature of the firm, The Economist article also celebrates the personal qualities that led to his accomplishments.
“The young Mr Coase first grew interested in the workings of firms when he travelled around America’s industrial heartland on a scholarship in 1931-32. He abandoned his textbooks and asked businessmen why they did what they did. He has long chided his fellow economists for scrawling hieroglyphics on blackboards rather than looking at what it actually takes to run a business.”
As our understanding of why firms exist continues to evolve, the article points out that Professor Coase’s original narrow focus on transaction costs and market failures needs to be complemented by taking into account the value of organizational capabilities to the firm. But, it urges us to do so by attacking the problems as Ronald Coase would have:
“All this undoubtedly complicates “The Nature of the Firm”. But it also vindicates the twin decisions that Mr Coase made all those years ago as a young student at the London School of Economics: to look inside the black box [i.e., actual, working firms] rather than simply ignoring it, and to examine businesses, not just fiddle with theories. Is it too much to hope that other practitioners of the dismal science will follow his example and study the real world?”