Sir Isaac Newton in 1666 sat under an apple tree and was hit by an apple. From that the world understood gravity and laws of mechanics, the basic building blocks of physics. Wilbur and Orville Wright in 1903 made and flew the first propeller powered aircraft or rather the first heavier than air aircraft. From that the world got the jumbo jet of today and made air travel a reality for all. Sir Alexander Fleming in 1928 found some mould in his bacteria dish and discovered that the mould(which he called Penicillin) could inhibit the growth of bacteria. From that the world got a powerful weapon to fight bacteria infections, changing the face of medicine forever. In very much the same way, something happened in 1937 that changed the way we see the firm today. From that the world got the discipline of Management and Business Administration and the basis of a huge pool of knowledge today.

Ronald Coase wrote his famous paper in 1937, entitled "The Nature of the Firm". Of course if anyone reads it today, it does not seem very impactful. But cast yourself back in time. How would you have felt being next to Newton when the apple dropped? Or in the same cockpit as the Wright brothers? Or standing next to Fleming when he cast his eyes on the mould? So really, if you can cast yourself back to 1937 and read the famous paper, you will certainly appreciate the momentous occasion in 1937.

A quick sidetrack: Coase won the 1991 Nobel Laureate in Economics for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy

Before Coase, the economic system as described by Sir Arthur Salter is thought to require no planning and functions by itself. "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."

Is it possible to have no economic planning and have everything handled by what is called the price mechanism? We know today that this does not happen in the real world. Companies try to estimate the demand of consumers and adjust their supply, but you do not see the price of something like bread move up and down when there is too little or too much bread respectively. The price mechanism works in perfectly competitive markets but that does not exist in the world today for various reasons. Similarly for a firm, where the entrepreneur controls and plans the use of factors of production based on his expectation of demand, the price mechanism has been superceded.

These ideas which are the reality of firms run by entrepreneurs create inherent disagreement with the concept of the price mechanism. And it is Coase’s paper in 1937 that cleared the air between price mechanism and the firm. It is also a very insightful paper in 1937, which should not be underestimated just because the ideas proposed are very common place today.

Today apples drop from trees and we know it is gravity. We fly in planes and take antibiotics when we are sick. The eureka feelings of Sir Newton, the Wright brothers and Sir Fleming are not experienced by people today. These have become so commonplace that apples dropping, air travel and medicine taking have become mundane or very much a part of everyday life. We also analyse companies and businesses daily with our knowledge of how firms work. But this is only because of the start that Coase’s 1937 paper, "The Nature of the Firm" has given us.

So allow me to indulge in this momentous development in Economics Theory, which I believe is the starting fundamentals of how we analyse companies and businesses today. In fact this fundamental has been so entrenched that we take it for granted.

Here are a few important ideas that were shared in this paper that I would like to point out.

Coase says in the paper that "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." He goes on to point out that these costs include among other costs, the cost of finding out prices of goods, marketing costs and contracting costs with factors of production. These costs are one reason why perfectly competitive markets do not exists. Thus the point of having a firm is because the firm can undertake these costs which individual factors would be unwilling to undertake. The costs of these can then be passed on to the consumers who otherwise would not be able to get the good if there were no firm to undertake these costs.

Coase says in the paper that it is not efficient for a factor of production (say skilled labour) to continuously make contracts with other factors within the firm. Thus, this contract is substituted by one contract and this "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." This forms the basis of the employer-employee relationship which we take very much for granted these days. This long term contract between the factor and entrepreneur(or employer) reduces the costs of continuously engaging in contracts between the factor and entrepreneur as well as other factors. This is a key reason for the existence of a firm.

Now Coase has pointed out the relationship between the employer and the employee. This seems to make sense from the employer or entrepreneur’s point of view as he has reduced costs and only needs to pay his employees a fixed remuneration. Why then does the employee want to be at the losing end of the equation, or is he? For the answer to this, Coase quotes Professor Frank Knight who says that "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 organization 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 "centralisation" is inevitable."

Professor Knight goes on to say that what works 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 specialization of function is the enterprise and wage system of industry. Its existence in the world is the direct result of the fact of uncertainty."

From that we developed the idea that the entrepreneur undertakes this risk or uncertainty for the reward of profit. And the employees give up their freedom to be controlled by the entrepreneur, in return for a fixed remuneration.

I am not sure if you share my joy in expounding these points but the development of the Theory of the Firm has indeed gone through much work with certain important concepts such as Agency Theory, Theory of Incomplete Contracts and Oliver Williamson’s Opportunism. But I will not be doing justice to the work done by trying to summarise it all in this article. Roger has covered Agency Theory in a previous article and we will continue to discuss these important theories.

Still I would like to leave you with a sense of start and today (Where we are today from what Ronald Coase started in 1937 is Management Theory today and how we model the firm). No models truly stand out today, but this is probably due to the fact that the understanding of the firm is quite commonplace today. Nonetheless, it does not hurt to use a model as an overarching framework. From this framework, we can then pinpoint the areas of the firm that we would like to address.

I have taken the liberty of using a model that we have developed at Oaktree. So here is the Oaktree Research Model of the Firm.

All firms have key managers or entrepreneur(s) running them. They form the basis of the firm as suggested by Coase and their relationships are with Shareholders, Customers, Factors of Production and Authorities.

The next diagram outlines the details of the relationships with these four groups.

The relationship between the Firm and its Shareholders is really Investor Relations and it covers equity, accounting, internal controls and audit /risk management. The relationship between the Firm and its Customers is really Marketing and it covers market segmentation, branding, logistics/distribution and competition. The relationship between the Firm and its Factors of Production is really Mobilisation and it covers labour, debt, raw materials and services. Lastly the relationship between the Firm and the Authorities is really Compliance and it covers taxation/subsidies, licensing, rule of law and listing requirements.

Finally just to add the finishing touch, the input of the Entreprenuers, that which I call the Strategy-Operations Axis which I described in an earlier article. 

This Strategy-Operations Axis covers leadership, corporate strategy, innovation and operational excellence. It is most critical in the company as it links up the various relationships the firm has and is in essence the Core Competence of the firm.

In conclusion, I am pretty sure most readers will not get the eureka feeling from reading all this. But in describing how it all started to how we understand the firm today, I hope you would appreciate the feeling of eureka that Ronald Coase probably felt in 1937. And in reflecting on it, I certainly hope you put this together with the falling apple, the first heavier than air airplane and the discovery of antibiotics. For I most certainly and definitely feel that "The Nature of the Firm" is in good company there.

Any opinions or comments ?