Ronald Coase (1910–2013)

I’ve asked myself who has influenced my way of economic thinking and I have always had trouble answering. But, one name that comes to mind with clarity is Coase’s. I’m sure that others will write much better tributes to Ronald Coase than this one, but I want to write a short one directed at those of you who haven’t had much of a chance to explore his writings. I hope I can persuade some of you aspiring economists, like myself, to read his work.

I don’t remember when the first time I heard of Coase was, but the first serious introduction to his work was probably in my undergrad law and economics class. One of the first things you typically learn in that class is the Coase theorem, which is that, regardless of the initial allocation of property, in the event of an externality the relevant parties will bargain — assuming no costs to bargaining (i.e. transaction costs) — until the externality is eliminated. Covering the Coase theorem took, literally, about ten minutes, plus a problem set, and then we went directly into legal rulings on property, which also stems from Coase’s work on social costs (when bargaining costs are too high for a private solution). I wouldn’t come across his work again for around another year.

Neither do I remember why I decided to read some of Coase’s major articles, namely “The Nature of the Firm” and “The Problem of Social Cost.” But, after I read one, I was driven to continue reading some of his other work in quick succession. I was hooked, and there is a distinct before and after in my thinking. There were many themes, some explicit others implicit, that really resonated with me.

Having been introduced to economics through, for the most part, the Austrian school, I gained an early appreciation of the pricing process. Coase taught me to think outside of of the pricing process box. In his 1937 article on the firm, Coase developed a theory of the firm which argued that the purpose of the firm is to organize production without having to incur the costs of using the price mechanism (see “Coase’s Firm“). These costs have since then been called “transaction costs.” The limits to the size of the firm, therefore, are determined by the relative costs of organization. This development not only inspired future research on the entrepreneur and the firm, which I’m not well equipped to discuss, but also influenced a large literature on non-market allocational processes and market institutions.

One well-known economist whose work builds on that of Coase is the late James Buchanan. In The Calculus of Consent, Buchanan and co-author Gordon Tullock discuss the problem of collective action. They argue that if private solutions to externalities are too costly, a solution can be organized through government. The relationship to transaction costs is clear, since it’s the costs of using the pricing process that determines whether a private solution is viable. Another Nobel laureate whose work is influenced by Coase’s is Oliver Williamson (see, for example, The Economic Institutions of Capitalism). Williamson’s research delves into the institutions which reduce transaction costs — such as semi-permanent contracts established between buyers and sellers who develop a relationship over time — and, similar to Buchanan, on the issue of governance. Quickly, it’s worth mentioning two other Nobel laureates, with similar research agendas, who influenced me, and who were themselves influenced by Coase: Elinor Ostrom and Douglass North.

Coase provided the foundation for the institutional analysis which enriched our understanding of the division of labor. The great benefit of reading Coase is in his method of laying the foundation. He made his insights look so simple on paper, because he was able to communicate his ideas through clear and simple prose. It would only be a slight exaggeration to claim that Coase flipped a switch in my brain. I can’t imagine that I would have gotten the same out of Buchanan or North, for example, without having read Coase first.

Another theme I picked up from Coase, this time from “The Problem of Social Cost,” is the concept of property as an emerging phenomenon — although, I’m sure this reflects certain idiosyncrasies (of mine). Remember that the Coase theorem (what some call the “naïve Coase theorem”) is that, in a world with zero transaction costs, externalities will be solved privately through side-payments. Some find the world of positive transaction costs, which is the world we live in, more interesting (and has led, as aforementioned, to a flourishing literature on market and non-market institutions). But, I find the “naïve” world informative, as well.1

Coase frames side-payments as trading of property rights. That’s, at least, what side-payments represent. The idea is that the relevant parties can bargain to reach a Pareto optimal agreement, internalizing the externality. As a result, the exact conditions of the right to property are changed — for example, a farmer may essentially give a railroad owner the right to damage the neighboring land. To me, this seems like a forward-looking theory of property rights, where the unique details of this right transform and emerge over time, based on changing external (to the property right model, at least) conditions. Such a theory of property may be useful, for instance, in analyzing the problem of intellectual property. Opponents of IP typically use a specific definition of property to show how knowledge cannot be property (in my opinion, confusing free goods for public goods), but the time-dependent conditions of property change and so a backwards-looking definition may not be properly suited for an analysis of a problem characterized by different conditions.

Some may be turned off of Coase, finding “grave collectivist deviations.” In his biography of Mises (p. 533, ftn. #10), Jörg Guido Hülsmann writes,

The postulate of a dichotomy between individualism and collectivism led Keynes to anticipate the now-famous Coasean view on the problem of optimal social organization. Thus Keynes surmised that the “ideal size for the unit of control and organization lies somewhere between the individual and the modern State.”

These types of comments, in my opinion, are misreadings of Coase’s work (see also “Misunderstanding Coase“). To be clear, there is no dichotomy between individualism and collectivism. As Oliver Williamson would later clarify, the choice of organization is one that the individual makes. This theme follows through to the work of later institutionalists and public choice theorists. The choice of organizing a constitution, for example, can be a voluntary decision made by a group of free individuals. To portray any of Coase’s work as showing “collectivist deviations” reveals, I think, an ideological blindfold, triggered either by an emphasis on non-price allocation or by later work (built on Coasean foundations) on governance.

But, the ultimate interpretation should be made by the reader. Even if you end up disagreeing with some of his ideas, reading Coase will still provide a net benefit. You will walk away a more knowledgeable person, and you will feel more knowledgeable. You will see the world under a different light. Rather than collectivist overtones, what you will get from Coase is a greater appreciation of the division of labor. It is a great introduction to alternative methods of organization and resource allocation — not a choice made by a central planner, but by each and every individual him- or herself —, from which you can dive into what Coase’s successor (i.e. North, Williamson, Olson, et cetera) have developed since then.

I don’t know if I have what it takes to be a good economist, but I do know that without Coase my chances would be smaller. Many of you are probably smarter than me, but I still think he can do the same for you.

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1. Allow me to make a quick, tangential point that addresses some of the concerns raised against Stigler’s “naïve Coase theorem.” Yes, a world with zero transaction costs is unrealistic. But, the idea is to provide a model with certain extreme conditions to illustrate an important point, which is that people can bargain with each other to internalize externalities. This point is relevant even in a world with positive transaction costs, because bargaining can still take place as long as these costs are low enough — they don’t have to be zero to make the bargaining argument empirically relevant. The objection raised against the “naïve theorem” seems similar to those raised against, broadly, “Neoclassical models,” but they miss the point behind these models, which is to emphasize a certain aspect of a phenomenon by abstracting from other details.

19 thoughts on “Ronald Coase (1910–2013)

  1. Pingback: Ronald Coase (1910-2013) – A Small Tribute | Econ Point of View

  2. daniilgorbatenko

    =Yes, a world with zero transaction costs is unrealistic. But, the idea is to provide a model with certain extreme conditions to illustrate an important point, which is that people can bargain with each other to internalize externalities. This point is relevant even in a world with positive transaction costs, because bargaining can still take place as long as these costs are low enough — they don’t have to be zero to make the bargaining argument empirically relevant.=

    The world of zero TC implies not just the absence of TC but the absence of any choices whatsoever. This is because from the praxeological standpoint there can be no costless action, including transactions. Thus, the absence of TC may mean only one thing: that transactions are actually absent. And indeed they are absent in mainstream equilibrium models. The price determination and reshuffling of goods are done by some fictitious entity like Walrasian auctioneer. But this means that there are essentially no choosing beings in this world. It’s in short another demonstration that unrealistic constructs aren’t needed for any explanation of the real world. The insight (that is actually not original to Coase btw) that property rights smooth out conflicts over resources can be gained without any references to the world of zero TC.

    Reply
      1. daniilgorbatenko

        I see 2 possible interpretations of the zero-TC construct which are actually one:

        1) Transactions involve no opportunity costs. Since transactions are actions they can’t be costless without essentially ceasing to be.

        2) Transactions don’t involve expending resources. It seems to be a different interpretation from (1) but in fact it is the same because if no resources are spent (including time) there are no opportunity costs.

        What interpretation do you have in mind?

        Reply
        1. JCatalan

          You can think of transaction costs as a subset of total costs. Every action involves some opportunity cost. A transaction costs is an added fee to an action, if it involves using the pricing process. It’s still an opportunity cost (all costs are opportunity costs), but it has a specific source. They’re costs that could conceivably not exist if markets didn’t have frictions (i.e. with the right institutions). For example, the opportunity cost of an indirect exchange under conditions of barter is different than that under conditions of a money-using economy, even if the benefits may be exactly the same.

          But, an economy without transaction costs is not the same thing as an economy without costs, at all. There are always alternative choices.

          Reply
          1. daniilgorbatenko

            =But, an economy without transaction costs is not the same thing as an economy without costs, at all.=

            It’s not an economy without costs, it’s an economy without transactions. The only way I can interpret this metaphor meaningfully is that there is some fictional entity that has access to agents’ exchange preferences and that acts on those preferences by reallocating goods among agents. The problem with such a construct is that exchanges essentially cease to be choices.

            I really can’t see any other interpretation and the vague language you use to defend the concept only strengthens me in this opinion.

          2. daniilgorbatenko

            =But, an economy without transaction costs is not the same thing as an economy without costs, at all.=

            It’s not an economy without costs, it’s an economy without transactions. The only way I can interpret this metaphor meaningfully is that there is some fictional entity that has access to agents’ exchange preferences and that acts on those preferences by reallocating goods among agents. The problem with such a construct is that exchanges essentially cease to be choices.

            I really can’t see any other interpretation and the vague language you use to defend the concept only strengthens me in this opinion.

          3. JCatalan

            No, it’s not an economy without transactions. In a world with zero transaction costs there would be more exchange through the pricing process than in a world with positive transaction costs. If you think my explanation is vague, then look for another one. I know Peter Klein edited a book on transaction costs. You might be interested in reading that.

          4. JCatalan

            No, it’s not an economy without transactions. In a world with zero transaction costs there would be more exchange through the pricing process than in a world with positive transaction costs. If you think my explanation is vague, then look for another one. I know Peter Klein edited a book on transaction costs. You might be interested in reading that.

          5. daniilgorbatenko

            I don’t think I have time for reading that book. But let’s continue with your explanation.

            =For example, the opportunity cost of an indirect exchange under conditions of barter is different than that under conditions of a money-using economy, even if the benefits may be exactly the same.=

            It’s all well and true. But what does it mean that such costs are zero? How do you imagine this to yourself? IOW from the fact that transaction costs differ in different institutional settings it doesn’t follow that they may even conceivably be zero. It’s like with length. Material objects may vary in length but there can’t be a material object with zero length.

          6. JCatalan

            Yes, in the real world transaction costs may never be zero (better said, they will probably never be zero). Nobody argued otherwise. But, using a hypothetical model where transaction costs can be zero helps us differentiate between what kind of costs we’re talking about. In every exchange there are costs and benefits, and this remains true in a world with zero transaction costs (again, nobody has ever argued otherwise). Transaction costs, then, are costs which can conceive as being added to the costs we may have to pay recompense the other party’s opportunity cost — for example, if knowledge of a particular set of choices isn’t available to us, there’s a cost to attaining this knowledge. The attainment of this knowledge, just to be clear, is necessary for the “transaction” (exchange; choice; whatever) to take place, but we can think about a world where this information is available (and we can think about a world where these type of costs vary between sets of choices) — this world may have zero or relatively lower transaction costs, but there are still clearly opportunity costs attached to the choices made.

          7. daniilgorbatenko

            Oops, there’s some glitch in the comments platform. Anyway, the comment about the logical contradiction is mine and it was supposed to be in response to this comment of yours.

          8. JCatalan

            Yes, in the real world transaction costs may never be zero (better said, they will probably never be zero). Nobody argued otherwise. But, using a hypothetical model where transaction costs can be zero helps us differentiate between what kind of costs we’re talking about. In every exchange there are costs and benefits, and this remains true in a world with zero transaction costs (again, nobody has ever argued otherwise). Transaction costs, then, are costs which can conceive as being added to the costs we may have to pay recompense the other party’s opportunity cost — for example, if knowledge of a particular set of choices isn’t available to us, there’s a cost to attaining this knowledge. The attainment of this knowledge, just to be clear, is necessary for the “transaction” (exchange; choice; whatever) to take place, but we can think about a world where this information is available (and we can think about a world where these type of costs vary between sets of choices) — this world may have zero or relatively lower transaction costs, but there are still clearly opportunity costs attached to the choices made.

          9. daniilgorbatenko

            I wasn’t talking about actual possibility, I was talking about logical possibility. If smth is logically impossible, asserting it is meaningless. In other words, there is a simple chain of reasoning.

            1) Transaction costs are costs associated with transacting.

            2) Transacting (in the broad sense, including search of information) is action.

            3) Action by definition involves cost.

            4) Zero TC means that transacting doesn’t involve costs.

            5) Ergo, transacting isn’t an action. Thus, we arrive at a contradiction.

          10. JCatalan

            Zero TC means that transacting doesn’t involve costs.

            Again, no. This is why I’m trying to illustrate the meaning of the term by thinking in terms of different sources, or sets, of costs.

            We’re just going in circles. There’s an opportunity cost to my time. We’ll just have to agree to disagree.

          11. daniilgorbatenko

            Can you then give a formal definition of transaction costs? Otherwise, I humbly suggest that we’re going in circles because you’re using a term that you think you know what it means while in fact you don’t.

          12. JCatalan

            I’m trying to find one, but Williamson borrows North’s definition, which I think will only make the discussion more confusing (North defines them as “the costs of running the economic system,” and I think that’s pretty cryptic — I think you and I will agree with each other on this one!). Coase associates transaction costs with the costs of contracting and re-contracting, but this definition may not be totally up to date. For example, Alchian thinks there are other sources of transaction costs, as well (I’ll have a post on that tomorrow, btw).

            I’ll give you my “formal definition,” which is what North, Williamson, Coase, etc., are basically getting at. Think of a “basic” (perfectly competitive) supply and demand curve; supply ≡ marginal costs schedule and demand ≡ marginal benefit schedule. These costs represent the opportunity cost of other party that you have to recompense.These costs will continue to exist in a world with zero transaction costs. Transaction costs, therefore, have a different source, which is that on top of your compensation to the other party, you may have to spend resources on information searches (to find parties to exchange with, or to find kind of compensation the other party is looking for) or you may have to spend resources on drafting a contract. These costs may make other choices more attractive, including the choice to avoid the pricing process (in this specific instance) altogether. The higher the transaction costs, the more the other party has to recompense you, which means lowering the likelihood that the other party is willing and able to transact with you. Transaction costs can make an otherwise attractive exchange unattractive.

          13. daniilgorbatenko

            =Transaction costs, therefore, have a different source, which is that on top of your compensation to the other party, you may have to spend resources on information searches (to find parties to exchange with, or to find kind of compensation the other party is looking for) or you may have to spend resources on drafting a contract.=

            Now you just need to fully trace out the logical implications of what you wrote. Imagine what would have to be the case for this source of costs to not exist at all. Essentially, goods would have to just be magically instantaneously reallocated from one party to the other. Because any action by the parties needed to effect the exchange would be the part of the source that you imagine can be eliminated without eliminating exchange as choice.

            But that returns us exactly to the fictitious Walrasian auctioneer and the absence of actual choices in the market in such a world. There can’t be a choice unless there is an action in which it is expressed. If no actions are undertaken to effect the exchange, it means there is no choice in the exchange.

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