1. Market Coordination:
Which goods and services a firm should produce is a significant decision a firm has to make and this decision relies on the market prices system that serves as a source of incentives and information network.
As relative market prices of goods or services change due to the changes in their demand and supply, the buyers or users will substitute the relatively cheaper goods or services for the expensive ones.
In response to the changes in demand for goods and guided by price signals, a firm will adjust the production of various goods produced by it.
Besides, changes in relative prices of goods create new profit opportunities for firms who can plan expanding production of goods which are in greater demand and have higher prices. All these adjustments in productive activity of the firms is accomplished through changes in market demand, supply and prices of goods without any central coordinating authority issuing commands to the firms to change their production structure.
2. Managerial Coordination or Command System:
There are many areas of firm’s activity which do not rely on market system and instead are coordinated by management hierarchy. That is, these activities are coordinated within a firm by various layers of management.
A senior manager issues commands or directions to their subordinates to do things in a way desired by him. Therefore, coordination by management within a firm is also called command system. At the top of managerial hierarchy within a firm is the Chief Executive Officer (CEO) who issues directions to the senior managers.
The senior managers in turn give instructions to the middle-level managers and then middle level managers directs the operation managers. The operation managers represent the lowest level of management that controls the workers who produce goods and services as directed by the managers. While commands or directions pass downward through top management to the lowest level of workers, information passes upward.
Managers at different levels of management hierarchy not only directs their subordinates but also collect and process information about the performance of the individuals under their control and supervision. They also ensure that the commands issued to their subordinates must be implemented properly and effectively.
In the modern corporate form of business organisation, there are many layers of management and coordination of activities and collecting information and monitoring the activities of workers by them have become quite complex. However, since the 1980s, with the invention of micro computers and information revolution that has accompanied it has made the task of collecting information and coordinating efforts within a firm relatively much easier than before.
It is important to note that despite the enormous efforts made by owners and top level management and the recent information revolution, top managers lack the necessary and complete information about what is happening at the lowest level of actual implementation of commands issued. This affects the efficient working of the firm. Therefore, large firms use incentive systems at various levels along with the command system to operate efficiently. There is a need for the use of incentives for efficient operation because firm’s owners and managers cannot have full information for efficient working of the firms.
The use of incentives is necessary because contribution made by managers at various levels and workers at the floor level is very difficult to measure directly. At the floor level, some workers are more efficient and hard-working but for owners and managers it is often difficult to know who is efficiently working and who is shirking work. It is due to the lack of adequate information on the part of owners and CEO that it is difficult to fix responsibility on the sales-force when sales of the firm decline.
The above factors induce the firms to devise incentive systems within the organisation so as to ensure that all including managers, workers and sales-force work efficiently for better performance of the firm. It is due to the lack of complete information that firms do not simply employ productive resources and pay for them certain prices as if they were buying tangible goods with well known qualities.
Instead they enter into contracts with managers of various levels, technical staff such as engineers, skilled labour and ordinary workers and pay them suitable compensation packages that give them adequate incentives so as to raise productivity. These contracts and incentive packages are known as agency relationship. These steps are adopted to solve what is called principal-agent problem.
The principal agent problem arises because managers and workers do not always work in the best interests of the owners of shareholders in case of corporate form of business organisation. Instead, managers and workers often attempt to pursue their own goals which may conflict with the efficient and profitable working of the firm.
To solve this principal-agent problem, suitable compensation packages that provide adequate incentives to the agents (i.e. managers and workers) to work in the interests of the principal (i.e. owners of the firm) are needed.
Boundaries of the Firm:
Coase whose views about the nature of the firm have been explained above mentioned the two coordinating principles that determine the boundaries of the firm:
(1) Market coordination principle,
(2) Managerial principle of coordination internally which is also called the command principle. What limits the boundaries of a firm can be explained with these two coordination principles. By boundaries of a firm we mean what parts of a product or what services a firm itself will produce and what parts or services it will get from outside using the market mechanism from other firms.
For example, if a firm requires some specific input such as a special component or a special service such as clearing the shop floor, it has two options; either it should do these itself inside the firm using command principle (that is, through managerial coordination and issuing commands to that effect) or it should buy them from other firms using market mechanism for that purpose.
However, the boundaries between what components or services the firm should produce or do internally and what it should buy from the market differ in case of different firms. Each firm tends to grow until the cost of organizing one extra task within the firm becomes equal to the cost of organizing the same task outside the firm through the market. It may be further noted that boundaries of a firm go on changing over time with technological changes.
Coase’s analysis of the boundaries of a firm is based on the concept of transaction costs. Transaction costs are those costs which are incurred by a firm when it buys a product or service from the market. For example, when a car manufacturing firm has to buy a component from outside the firm, it has to find the market in which that component is available and then to know the different quantities and qualities of the component are available in the market and at what prices. To collect all such information requires a lot of money expenditure which represents transaction costs.
On the other hand, when the firm decides to produce a component or provide any service within the firm itself, it opts for managerial coordination system. In this case using the command principle it can get produced a part or component of a product or provide any service internally of its desired specification and quality through issuing proper directions or commands to the managers at different levels of managerial hierarchy. It will also incur some extra costs of producing a component or service inside a firm.
However, in deciding to produce a component or service internally, the firm is able to avoid some transaction costs but it no longer takes advantage of buying the component or service in a competitive market.
As a firm expands its size and scale of production, it will face the inefficiencies of command system (that is, diseconomies of managing a large-sized firm) relative to the efficiencies involved in buying parts from the competitive markets.
It follows from above that the firms have to decide what components of a product it has to produce within the firm using managerial coordination system (that is, command principle) or get it from others through market mechanism.
Most firms use both the systems; they buy some components from other firms through market mechanism and produce some other components themselves within the firm. Coase’s view of the firm is that it is the institution that economises on transaction costs.
The use of market mechanism to get parts or components is efficient or economical when its transactions costs are relatively small. When transaction costs of getting components or services through market are relatively high, it produces them within the firm using internal managerial command system. Thus, Lipsey and Chrystal write, “Firms exist as an alternative to a pure market structure of transactions.
Inside a firm there is a command economy. Managers of firms have always to be asking what activities should be done inside the firm and what should be obtained in the market from other suppliers.”
It is important to note that changes in technologies often change the relative costs of some components and services through market mechanism or producing them inside the firm. For example, the recent revolution in information technology that involves the use of computers and internet has reduced the transaction costs of getting some services or components through the market as compared to producing them ‘in-house’.
As a result, many firms which used to provide certain services or produce some components internally now get them from others through market. Small firms that supply certain specific services or produce components often do these things more efficiently as they acquire specialisation in them.
As is now well-known many American firms are getting several services done through Call Centres located in India, China and other developing countries. They are getting some services done through what is called BPO (Business Processing Outsourcing) while earlier they provided for these services internally. In this way the large firms are able to concentrate on what are called ‘Core Competencies and contract out to get several other components produced and services done from other specialized firms. By doing so they are able to economise on transaction costs and increase their efficiency.