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Volume 8, Number 3, 2003
Federal Reserve Bank of Dallas
Ronald Coase—The Nature of Firms and
Their Costs
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| One of my
favorite philosophers—Yogi Berra—once
said “You can observe a lot just by watching.”
Economist Ronald Coase did just that, and it earned
him a Nobel Prize. Coase has always asked economists
to be keen observers, trying to understand why
things operate as they do, rather than pure theoreticians,
wondering why the world doesn’t conform
to their theoretical models of reality. And he
led the way by observing industrial organizations
and structures up close before theorizing about
them.
Karl Marx said philosophy
had explained the world and now it was necessary
to change it. Coase’s writings imply that
this approach is backwards. First observe the
world, he says, and then explain it. Having done
so, we learn that in many cases it is not necessary
to change it. Adam Smith expressed this fundamental
insight about existing institutions and market
structures with his famous metaphor of the invisible
hand. And no economist has a better claim to having
furthered this key lesson than the one we recognize
with this edition of Economic Insights,
a man whose observations changed economics forever.
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Bob McTeer
President
Federal Reserve Bank of Dallas |
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Ronald Coase—The Nature of Firms and
Their Costs
Ronald Harry Coase was born in a London
suburb in 1910. He was educated at the London School of Economics
from 1929 through 1932, studying industrial law with the intention
of becoming a lawyer. But that changed after his exposure
to Professor of Commerce Arnold Plant, who came to the London
School of Economics from a position in Cape Town, South Africa,
in 1930. Plant’s influence put Coase firmly on the road
to becoming an economist and also shaped his attitude that
economic theory is fine as long as it’s grounded in
reality.
During 1931–32, Coase traveled
to the United States on a scholarship to study the structure
of American industry. This study became the basis for Coase’s
lifetime fascination with industrial organization and his
later work on the nature of firms and their costs.
After leaving the London School of Economics,
Coase held a series of teaching positions: at the Dundee School
of Economics and Commerce (1932–34), the University
of Liverpool (1934–35) and the London School of Economics
(1935–51). Immigrating to the United States in 1951,
Coase taught first at the University of Buffalo, then joined
the faculty of the University of Virginia in 1959. He moved
to the University of Chicago in 1964, remaining there until
1982. He was awarded the Nobel Memorial Prize in Economic
Sciences in 1991.
Coase’s central contributions
to modern economic theory are recorded in two seminal articles
published in the University of Chicago’s Journal
of Law and Economics—“The Federal Communications
Commission” (1959) and “The Problem of Social
Cost” (1960)—as well as in an earlier article,
“The Nature of the Firm,” published in Economica
(1937). In “The Nature of the Firm,” Coase explained
that firms exist because they reduce the transaction costs
that emerge during production and exchange, capturing efficiencies
that individuals cannot.
Coase was heavily influenced by Frank
Knight’s monumental Risk, Uncertainty, and Profit
and Philip Wicksteed’s The Common Sense of Political
Economy. The former inspired his interest in institutions
and the structure of productive process. The latter led him
to study constrained optimization problems, that is, choices
that are constrained by costs, information, market prices
and uncertainty.[1]
In his article about the Federal Communications
Commission, Coase showed economists the crucial importance
of institutional property rights and how their presence or
absence influences the efficient allocation of scarce resources.
In that paper, Coase first put forward what has come to be
known as the Coase
Theorem, the idea that in the absence
of transaction costs, any initial property rights arrangement
leads to an economically efficient outcome.
This stance was so counterintuitive
that the journal editors asked Coase to retract or modify
it. Coase refused to modify the article but did agree to defend
himself at a history-making meeting at journal editor Aaron
Director’s home in Chicago. Also present and ready to
question Coase were Rueben Kessel, Milton Friedman, Martin
Bailey, Arnold Harberger, Gregg Lewis, John McGee, Lloyd Mints
and George Stigler, as formidably skeptical an audience as
any economic theorist has probably ever faced. At the end
of that evening, not only was Coase still standing, but the
participants had conceded his essential point. That point
was systematically reiterated in one of the mostcited economics
articles ever published, “The Problem of Social Cost”
(1960).
Using examples from English common law,
Coase methodically demonstrates that regulatory interventions
can, under certain conditions, lead to less economically efficient
outcomes than markets alone would create. This contrasts with
the contention A. C. Pigou first put forth in The Economics
of Welfare (1920)—that government regulation enhances
efficiency by correcting for claimed imperfections, which
Pigou called market failures.
Coase gets his results with an assumption
of zero transaction costs, but his analysis rests also on
a particular view of torts quite different from Pigou’s.
In the Pigouvian case, party A harms party B
by engaging in trades with party C (and/or D
…n). It is a clear case of black and white
hats, for party B is seen as an innocent bystander who is
suffering a negative externality (cost) from party A’s
action(s). For Coase, a tort occurs only because there are
conflicts over resource use and all parties can harm each
other. Thus, to stop party A from harming party B
is akin to harming party A. In this Coasian world,
the assignment of property rights does not matter in terms
of the efficient economic outcome because the parties will
bargain their way to the same outcome regardless of how property
rights are assigned, that is, regardless of who gets to sue
whom. (See the box titled “A New Approach to Understanding
Social Cost.”)
Coase’s analysis of the theory
and history of torts, combined with his assumptions about
what the legal system ought to do in cases of conflict over
resource use—maximize economic efficiency and thus societal
wealth rather than punish specific conduct—created a
huge boost for the then-young field we now call law and economics.
It also created a strong pro-market bias in cases where prior
theorists—most notably Pigou—had crafted regulatory
responses to perceived examples of market failure.
After his successful presentation to
Chicago’s top social theorists, Coase was offered a
position at the University of Chicago, where he edited the
Journal of Law and Economics from 1964 to 1982. Under
his editorship, the journal became one of the economics profession’s
most influential forums. He was the first president of the
International Society for New Institutional Economics, which
was founded in 1996, and he remains Clifton R. Musser Professor
Emeritus at Chicago’s law school.
Coase’s study of positive transaction
costs in economic exchange led him, and by extension the entire
economics field, to a remarkable conclusion:
I explained in “The Problem
of Social Cost” that what are traded on the market
are not, as is often supposed by economists, physical entities
but the rights to perform certain actions, and the rights
which individuals possess are established by the legal system.[2]
For our understanding of why firms exist,
why institutions have evolved as they have and how this shapes
public policy, we owe a large debt to Ronald Coase.
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Robert L. Formaini and Thomas
F. Siems
Senior Economists |
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| Notes
- Cheung (1987).
- Coase (1991).
Sources and Suggested Reading
Cheung, Steven N. S. (1987),
“Ronald Harry Coase,” in The New
Palgrave: A Dictionary of Economics, vol.
1, ed. John Eatwell, Murray Milgate and Peter
Newman (New York: Stockton Press), 455–57.
Coase, Ronald H. (1937),
“The Nature of the Firm,” Economica
4 (November): 386–405.
——— (1959),
“The Federal Communications Commission,”
Journal of Law and Economics 2 (October):
1–40.
——— (1974),
“The Economics of the First Amendment: The
Market for Goods and the Market for Ideas,”
American Economic Review 64 (May): 384–91.
——— (1988),
“How Should Economists Choose?” in
Ideas, Their Origins, and Their Consequences:
Lectures to Commemorate the Life and Work of G.
Warren Nutter (Washington, D.C.: American
Enterprise Institute for Public Policy Research)
57–79.
——— (1988),
“The Problem of Social Cost,” in The
Firm, the Market, and the Law (Chicago: University
of Chicago Press), 5–156, orig. pub. 1960.
——— (1991),
“The Institutional Structure of Production,”
Nobel Prize Lecture to the Memory of Alfred Nobel,
December 9, 1991, www.nobel.se/economics/laureates/1991/
coase-lecture.html
——— (1994),
Essays on Economics and Economists (Chicago:
University of Chicago Press). |
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Why Do Firms
Exist?
Outside the firm, price
movements direct production, which is co-ordinated
through a series of exchange transactions on the
market. Within a firm, these market transactions
are eliminated, and in place of the complicated
market structure with exchange transactions is
substituted the entrepreneur–co-ordinator,
who directs production. It is clear that these
are alternative methods of co-ordinating production.
Yet, having regard to the fact that if production
is regulated by price movements, production could
be carried on without any organization at all,
well might we ask, Why is there any organization?…
In view of the fact that
while economists treat the price mechanism as
a co-ordinating instrument, they also admit the
co-ordinating function of the “entrepreneur,”
it is surely important to inquire why co-ordination
is the work of the price mechanism in one case
and of the entrepreneur in another. The purpose
of this paper is to bridge what appears to be
a gap in economic theory between the assumption
(made for some purposes) that resources are allocated
by means of the price mechanism and the assumption
(made for other purposes) that this allocation
is dependent on the entrepreneur–co-ordinator.
We have to explain the basis on which, in practice,
this choice between alternatives is effected….
The main reason why it is
profitable to establish a firm would seem to be
that there is a cost of using the price mechanism.
The most obvious cost of “organizing”
production through the price mechanism is that
of discovering what the relevant prices are. The
cost may be reduced but it will not be eliminated
by the emergence of specialists who will sell
this information. The costs of negotiating and
concluding a separate contract for each exchange
transaction which takes place on a market must
also be taken into account. Again, in certain
markets, e.g., produce exchanges, a technique
is devised for minimizing these contract costs;
but they are not eliminated. It is true that contracts
are not eliminated when there is a firm but they
are greatly reduced. A factor of production (or
the owner thereof) does not have to make a series
of contracts with the factors with whom he is
co-operating within the firm, as would be necessary,
of course, if this co-operation were a direct
result of the working of the price mechanism….
We may sum up this section
of the argument by saying that the operation of
a market costs something and by forming an organization
and allowing some authority (an “entrepreneur”)
to direct the resources, certain marketing costs
are saved. The entrepreneur has to carry out his
function at less cost, taking into account the
fact that he may get factors of production at
a lower price than the market transactions which
he supersedes, because it is always possible to
revert to the open market if he fails to do this.
—“The Nature
of the Firm,” 388–92 |
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What Determines
the Size of the Firm?
Other things being equal,
therefore, a firm will tend to be larger:
(a)
the less the costs of organizing and the
slower these costs rise with an increase
in the transactions organized;
(b) the less likely
the entrepreneur is to make mistakes and
the smaller the increase in mistakes with
an increase in the transactions organized;
(c) the greater the
lowering (or the less the rise) in the supply
price of factors of production to firms
of larger size. |
Apart from variations in
the supply price of factors of production to firms
of different sizes, it would appear that the costs
of organizing and the losses through mistakes
will increase with an increase in the spatial
distribution of the transactions organized, in
the dissimilarity of the transactions, and in
the probability of changes in the relevant prices.
As more transactions are organized by an entrepreneur,
it would appear that the transactions would tend
to be either different in kind or in different
places. This furnishes an additional reason why
efficiency will tend to decrease as the firm gets
larger. Inventions which tend to bring factors
of production nearer together, by lessening spatial
distribution, tend to increase the size of the
firm. Changes like the telephone and the telegraph
which tend to reduce the cost of organizing spatially
will tend to increase the size of the firm. All
changes which improve managerial technique will
tend to increase the size of the firm.
—“The Nature
of the Firm,” 396–97 |
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A New Approach
to Understanding Social Costs
This paper is concerned
with those actions of business firms which have
harmful effects on others. The standard example
is that of a factory, the smoke from which has
harmful effects on those occupying neighboring
properties. The economic analysis of such a situation
has usually proceeded in terms of a divergence
between the private and social product of the
factory, in which economists have largely followed
the treatment of Pigou in The Economics of Welfare.
The conclusions to which this kind of analysis
seems to have led most economists is that it would
be desirable to make the owner of the factory
liable for damage caused to those injured by the
smoke; or to place a tax on the factory owner
varying with the amount of smoke produced and
equivalent in money terms to the damage it would
cause; or, finally, to exclude the factory from
residential districts (and presumably from other
areas in which the emission of smoke would have
harmful effects on others). It is my contention
that the suggested courses of action are inappropriate
in that they lead to results which are not necessarily,
or even usually, desirable.
The traditional approach
has tended to obscure the nature of the choice
that has to be made. The question is commonly
thought of as one in which A inflicts
harm on B and what has to be decided
is, How should we restrain A? But this
is wrong. We are dealing with a problem of a reciprocal
nature. To avoid the harm to B would
be to inflict harm on A. The real question
that has to be decided is, Should A be allowed
to harm B or should B be allowed
to harm A? The problem is to avoid the
more serious harm…(An) example is afforded
by the problem of straying cattle which destroy
crops on neighboring land. If it is inevitable
that some cattle will stray, an increase in the
supply of meat can only be obtained at the expense
of a decrease in the supply of crops. The nature
of the choice is clear: meat or crops. What answer
should be given is, of course, not clear unless
we know the value of what is obtained as well
as the value of what is sacrificed to obtain it….
The problem which we face
in dealing with actions which have harmful effects
is not simply one of restraining those responsible
for them. What has to be decided is whether the
gain from preventing the harm is greater than
the loss which would be suffered elsewhere as
a result of stopping the action which produced
the harm. In a world in which there are costs
of rearranging the rights established by the legal
system, the courts, in cases relating to nuisance,
are, in effect, making a decision on the economic
problem and determining how resources are to be
employed. It was argued that the courts are conscious
of this and that they often make, although not
always in a very explicit fashion, a comparison
between what would be gained and what lost by
preventing actions which have harmful effects.
But the delimitation of rights is also the result
of statutory enactments. Here we also find evidence
of an appreciation of the reciprocal nature of
the problem. While statutory enactments add to
the list of nuisances, action is also taken to
legalize what would otherwise be nuisances under
the common law. The kind of situation which economists
are prone to consider as requiring corrective
governmental action is, in fact, often the result
of governmental action. Such action is not necessarily
unwise. But there is a real danger that extensive
governmental intervention in the economic system
may lead to the protection of those responsible
for harmful effects being carried too far….
It is my belief that the
failure of economists to reach correct conclusions
about the treatment of harmful effects cannot
be ascribed simply to a few slips in analysis.
It stems from basic defects in the current approach
to problems of welfare economics. What is needed
is a change of approach. Analysis in terms of
divergences between private and social products
concentrates attention on particular deficiencies
in the system and tends to nourish the belief
that any measure which will remove the deficiency
is necessarily desirable. It diverts attention
from those other changes in the system which are
inevitably associated with the corrective measure,
changes which may well produce more harm than
the original deficiency….
It would clearly be desirable
if the only actions performed were those in which
what was gained was worth more than what was lost.
But in choosing among social arrangements within
the context of which individual decisions are
made, we have to bear in mind that a change in
the existing system which will lead to an improvement
in some decisions may well lead to a worsening
in others. Furthermore, we have to take into account
the costs involved in operating the various social
arrangements (whether it be the working of a market
or of a governmental department) as well as the
costs involved in moving to a new system. In devising
and choosing among social arrangements we should
have regard for the total effect. This, above
all, is the change in approach which I am advocating.
—“The Problem
of Social Cost,” 95–96, 132–33,
153, 155–56 |
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How Much Government
Intervention is Appropriate?
What is the general view
that I will be examining? It is that, in the market
for goods, government regulation is desirable
whereas, in the market for ideas, government regulation
is undesirable and should be strictly limited.
In the market for goods, the government is commonly
regarded as competent to regulate and properly
motivated. Consumers lack the ability to make
the appropriate choices. Producers often exercise
monopolistic power and, in any case, without some
form of government intervention, would not act
in a way which promotes the public interest. In
the market for ideas, the position is very different.
The government, if it attempted to regulate, would
be inefficient and its motives would, in general,
be bad, so that, even if it were successful in
achieving what it wanted to accomplish, the results
would be undesirable. Consumers, on the other
hand, if left free, exercise a fine discrimination
in choosing between the alternative views placed
before them, while producers, whether economically
powerful or weak, who are found to be so unscrupulous
in their behavior in other markets, can be trusted
to act in the public interest, whether they publish
or work for the New York Times, the Chicago
Tribune or the Columbia Broadcasting System.
Politicians, whose actions sometimes pain us,
are in their utterances beyond reproach. It is
an odd feature of this attitude that commercial
advertising, which is often merely an expression
of opinion and might, therefore, be thought to
be protected by the First Amendment, is considered
to be part of the market for goods. The result
is that government action is regarded as desirable
to regulate (or even suppress) the expression
of an opinion in an advertisement which, if expressed
in a book or article, would be completely beyond
the reach of government regulation….
My argument is that we should
use the same approach for all markets
when deciding on public policy. In fact, if we
do this and use for the market for ideas the same
approach which has commended itself to economists
for the market for goods, it is apparent that
the case for government intervention in the market
for ideas is much stronger than it is, in general,
in the market for goods….
[C]onsider the question
of consumer ignorance which is commonly thought
to be a justification for government intervention.
It is hard to believe that the general public
is in a better position to evaluate competing
views on economic and social policy than to choose
between different kinds of food. Yet there is
support for regulation in the one case but not
in the other. Or consider the question of preventing
fraud, for which government intervention is commonly
advocated. It would be difficult to deny that
newspaper articles and the speeches of politicians
contain a large number of false and misleading
statements—indeed, sometimes they seem to
consist of little else. Government action to control
false and misleading advertising is considered
highly desirable. Yet a proposal to set up a Federal
Press Commission or a Federal Political Commission
modeled on the Federal Trade Commission would
be dismissed out of hand.
—“The Economics
of the First Amendment: The Market for Goods and
the Market for Ideas,” 384–85, 389–90 |
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Theories and
Reality: Making the Data Talk
Economists, or at any rate
enough of them, do not wait to discover whether
a theory’s predictions are accurate before
making up their minds. Given that this is so,
what part does testing a theory’s predictions
play in economics? First of all, it very often
plays either no part or a very minor part….
I remarked earlier on the
tendency of economists to get the result their
theory tells them to expect. In a talk I gave
at the University of Virginia in the early 1960s,
… I said that if you torture that data enough,
nature will always confess, a saying which, in
a somewhat altered form, has taken its place in
the statistical literature. Kuhn puts the point
more elegantly and makes the process sound more
like a seduction: “nature undoubtedly responds
to the theoretical predispositions with which
she is approached by the measuring scientist.”
—“How Should
Economists Choose?” 72, 74 |
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| About Economic
Insights
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