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The Firm in a Free Economy

January 22, 2002

In a recent op-ed in the New York Times, economist Hal Varian, citing Noble economist Ronald Coase, argues, "What economists call firms . . . are essentially groups of activities for which it is more effective and less costly to use command and control than markets to have things done." This view of the firm leads him to believe that "(p)aradoxically, the primary unit of capitalism, on close inspection, looks a lot like central planning."  

Can it really be true that a key element in process of social cooperation and the division of labor that is so essential to human material well-being is, at its core, a socialist entity? Only if one does not properly distinguish between true social cooperation based on voluntary interaction and social interaction based on violence, threat of violence, and fraud--the true environment for "command and control" and central planning. 

Perhaps the confusion has developed because we tend to talk about the free market or the market as the key feature of what should more properly be referred to as the free economy or the free society. While market exchange is a key feature of the possible economic interactions between individuals in such a society, it is not the only means of social cooperation. A free economy is marked by the use of the economic means and the absence of the use of the political means, or interventionism, to satisfy human wants.1

Wants are met by the use of one's labor and other resources, used in cooperation with others to produce goods and services that can be used for (1) own use, (2) exchange with other producers/consumers, or (3) provision of a voluntary gift of valuable goods and services to others--true, old-fashioned compassion or charity. 

In such a system, decision makers use market prices to access and appraise the best potential methods for achieving various ends and objectives. Such choices in a free economy are not limited to just purely market choices--should I buy from person/firm A or person/firm B, should I purchase at price x or price y, what quality is required, etc.--but always include the option to self-produce rather than purchase from others. 

The formation of a firm is thus not an example of command and control properly understood. A firm thus "looks a lot like central planning" only if one mistakenly does not understand the true difference between central planning and planning by individuals based on calculation and appraisal in a free economy. 

No one forms a firm by acquiring resources for the firm at the point of a gun. No one becomes an employee of a firm through conscription or forced labor. Firms are formed and people join firms as part of a process of voluntary cooperation that we usually refer to as the market. Market conditions (including an appraisal of transaction costs) lead individuals to believe that their ends are best served by forming and/or joining a firm, just as households often choose to self-produce certain services--such as child care, food preparation, or yard upkeep--themselves rather than contract for these services though the market.

Firms are thus a key element of planning process by individuals, which we often call the market, that leads to prosperity and peace; they are not an element of the planned chaos and relative poverty of interventionism called central planning.

On the theory of the firm, see Firms, Strategies, and Resources: Contributions from Austrian Economics and Entrepreneurship and Corporate Governance.

  • 1. Rothbard, Murray N. 1977. Power and Market. Kansas City: Sheed Andrews, and McNeel, p. 1.

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