How the Existence of Firms Shows That There Are Imperfections in the Market Essay

Introduction In 1776 moral philosopher and father of modern economy published his book â€Å"The Wealth of Nations† which singlehandedly changed the way we looked at political economy. The book, which was Adam Smith’s essay originally explaining why some nations are wealthier and more flourished than others, featured a few key insights. One of the most important ideas of the book was what he mentioned as the â€Å"invisible hand† of the economy, stating that market mechanism is perfect and there is no need for an outside intervention for it to function effectively. In his 1982 article â€Å"No need for morality: The Case of Competitive Market†, David Gauthier states that in a â€Å"perfect† market outside intervention will in turn adversely affect the market. However, to contradict this idea, Ronald Coase, in his influential essay â€Å"The Nature of the Firm†, suggested the idea that the existence of firm itself proves that the market mechanism is not perfect. In this paper, I am going to describe what Gauthier meant by a â€Å"perfect† market, how the existence of firm proves that there are imperfections in the market and an evaluation of both the theories. What is Gauthier’s idea of a â€Å"perfect† market? In his paper article â€Å"No need for morality: The Case of Competitive Market†, Gauthier describes the perfect market as having the following criteria: 1. Individual Endowment and Private Goods In the perfect market, the market is comprised of individual buyers and sellers, and they are all seeking to maximize their own utility. Goods are privately owned, hence ownership is fairly simple and direct. 2. Free market activity, mutual unconcern and the absence of externalities Individual buyers and sellers are free to make their own decisions and they will try to maximize their utility, regardless of the other party or parties’ concern. There are no external factors that can affect the market mechanism 3. Market is perfectly competitive and operating at an equilibrium This means that in the market after a transaction individual gain is assured, in that each can do as well as he/she can, given the other parties actions. Also, in an equilibrium, no one can be better off without someone else being worse off. (Gauthier 1982) Gauthier states that the buyers and sellers in a perfectly competitive market are rational and utility maximizing. Individuals are fully capable of maximizing gain and welfare through the market mechanism without the existence of firms or regulatory bodies. Imagine a rice market where individual sellers set up stalls for individual buyers to buy without the requirement of an outside intervention, that would be a perfectly competitive market. How does the existence of firms prove that the market is not perfect? In his paper Nature of the Firm, Ronald Coase addresses questions such as â€Å"Why do firms exist?† and â€Å"Why isn’t everything done by the market?† In his article he states how imperfections in the market lead individuals to form companies rather than trading bilaterally through short term contracts in the market. The central premise of his theory was that firms exist simply because transactions are cheaper when carried out internally (i.e. within a firm) rather than externally (Coase, 1937). He states that trading bilaterally in the market can impose a great deal of transaction costs, such as hiring workers, negotiating prices and forming short term contracts. Therefore a firm is a device or a nexus of long term contracts under a manager/entrepreneur who brings all the resources together under one roof. The main contrast between Gauthier’s market mechanism and Coase’s firms is that, individuals find is cheaper and more effective work in a hierarchical structure by forming a firm, rather than trading directly in the market. Ronald Coase quotes D.H. Robertson to provide an analogy for the existence of firms: â€Å"Islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk.† Here, firms are the islands of conscious power, and the market is the ocean of unconscious co-operation, provides a good comparison for the two different mechanism. According to Gauthier’s, the utility maximizing buyers and sellers can individually profit more through operating directly through the market without the need for a hierarchical firm. In reality, the market is imperfect (i.e. utility cannot be maximized individually) and firms are the answer to these imperfections. Evaluation Gauthier’s view was not to prove that the market is perfect, but that if there was such a perfect market there would be no need for regulatory bodies or moral constraints. â€Å"Our concern is to show that morality has no place in an ideal context of interaction, not to claim that this ideal has direct practical application†, writes Gauthier. So his paper states the needlessness of morality in a perfectly competitive market, which does not exist in reality. Modern market is comprised of large corporations, which in turn disproves the idea that the market is not as perfect as Smith thought it to be. Adam Smith’s approach was to provide a simplistic answer to inefficient government intervention and bureaucracies, and to this day globalization, free market and specialization have been key to the success of our economy. Both Adam Smith’s and Ronald Coase’s literature have been put to question throughout, and their theories have been refined to meet the expectations of modern economics. However, their theories lay the fundamental groundwork for modern economic theory. The 2008 financial market crash is a great example of a situation where Smith’s â€Å"invisible hand† failed to protect the society’s welfare, where a handful of Wall Street investment firms fraudulently sold billions of dollars of worth securities to its clients, that lost its value overnight. The need for morality and external regulatory bodies, the existence of firms and modern corporate culture disproves the idea that the market is perfect. Bibliography Coase, Ronald. 1937. â€Å"The Nature of the Firm,† Economica, 4: 386-405 Gauthier, David. 1982. â€Å"No Need for Morality: The Case of the Competitive Market†. Philosophic Exchange, 3: 41-54