Firm Government

The relevance of Professor Coase’s The Nature of the Firm to the Indian governance system.

Ronald H Coase, who died recently at the age of 102 had an extraordinarily productive life. He wrote his last book, How China became Capitalist, in 2012, when he was a hundred years old. His first significant work was The Nature of the Firm, published in 1937, when he was 27.

firm government

In that paper, Mr Coase dealt with the question of why firms exist in spite of the clear advantages that markets offer over central planning. Most of us have tipped waiters at restaurants, and justified the transaction on grounds that it gave the waiters an incentive to provide better service. Having come to that conclusion, we rarely proceed to ask why the rest of the restaurant is still organised as a centrally planned entity, with the proprietor making decisions in a command and control fashion.

We may envisage the Market Restaurant, that contrasts with the Command and Control Restaurant, as follows: In this restaurant, the employees—the waiters, chefs and other staff, instead of being appointed to their jobs, have to buy their positions. They will then have to recoup their costs by freely transacting in the restaurant business. The waiters make their revenues by selling food and service to customers at the price they set. They have to negotiate table-cleaning services from the cleaning staff and to buy the food from the chefs, who in turn have to buy the ingredients from the purchasing staff. Everyone has to pay rent for the space they occupy.

Such a restaurant would of course thrive with the dynamism that anything that relies on the market mechanism would be expected to depict. The perceptive reader may point out that the Market Restaurant is not as fanciful as it seems—an approximation of it would be found at food courts of malls, for instance. But the question that The Nature of the Firm raised was why proprietorships exist at all. What value do the decisions of the proprietor provide that the price mechanism would be unable to?

The answer was that above a certain scale, transaction costs involved in continual negotiations would make the Market Restaurant unviable. While this restaurant would do a great job of responding to market demands, it would face significant difficulties in following any kind of strategy that shapes market demand. A restaurant aiming to provide a fine dine ambience to rich patrons would be stymied by a few waiters who insist on serving the economy segment, or a restaurant with a long term strategy of developing a clientele interested in Far Eastern cuisine could very soon find their strategy unworkable because its waiters insist on serving the cuisine that its patrons want right now.

While the Market Restaurant seems like a theoretical construct, one can find examples of the difficulties in effecting strategic transformation due to entrenched fiefdoms everywhere. It is a well known, if unfortunate fact, that parts of the Indian press and television, especially regional language media, have structures resembling the Market Restaurant. Journalists are paid only a token salary, and they are expected to make their money by selling coverage to the subjects of the news, or worse still, by blackmailing them. Imagine the resistance that an editor or proprietor of a newspaper would face if he tried to move his journalists to a fixed salary, and tried to transform his business into one of providing honest and unbiased news to readers.

While the task would be humongous, it has been done. An example of what must have been surely a complex and lengthy transformation is that of the armed forces. While in most modern democracies, the image of the armed forces is that of a disciplined force that responds without question to orders from civilian authority, this has been true only since recent times in historical terms.  Medieval armies were raised and would operate in ways that would remind us of the corrupt underbelly of the Indian media industry—they were paid a pittance in salary, if at all, and were expected to make their fortune through rapine and plunder. The British Army continued the practice of sale of military commissions right up to the 19th century. It must have been an enormously difficult to convert such armies into a professional army that was paid a fixed salary, but it would have been worth the transformation in terms of the ability to actually set and execute a strategy, rather than hope that the business interests of your soldiers lead to a beneficial end.

That brings us to the great governance challenge facing India today. The Indian government works very much like the Market Restaurant, at every level of government. In most modern democracies, the exchange between the government and the governed can be thought of as an exchange of votes for legislation and policies. Among the more corrupt democracies, laws and policies are sold for money. But in India, the exchange happens more at the retail level – the analogy would be with customers of the restaurant buying meals from the waiters directly. It is well known that many ‘lucrative’ government posts in India are bought by those appointed to the position, and the investment is recouped by the incumbents selling their services to the general public. In coalition governments, coalition partners are effectively sold ministries, popularly dubbed “ATM ministries” for their ability to spin money for them, in return for support to the ruling party.

As Professor Coase would have predicted, the system is creaking under the burden of transaction costs. It also makes the business of predicting elections a joke—most predictions assume that voting is a wholesale business where votes are exchanged for policy, while in reality, it is a retail transaction, where they are exchanged for favours in policy implementation. It makes policy advocacy complicated, because any serious policy analysis will need to understand how the implementation will be sold in the bazaar.

Most importantly, it makes change very difficult. In transforming any organisation, one runs into entrenched interests that resist change, but when you have people who have paid for a job and are recouping their investment, they will feel entitled to treat them as fiefdoms, and the resistance will be all the more fierce. Yet, this is the task that is facing any serious reformer who intends to improve India’s governance.