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Business News/ Opinion / Online Views/  The importance of Ronald Coase

I recall a conference several years ago which brought together social scientists from many disciplines. Over dinner, a few of us asked each other, if one had to pick only one work which not only reshaped our respective professions, but which resonated well beyond it, and, crucially, with powerful ideas that could be simply explained, what would be it?

My immediate reply was Ronald Coase’s The Firm, the Market, and the Law, a slender oeuvre which collects six or seven essays written over a long career. I would still give the same answer.

In a field in which Nobel prizes are routinely awarded to economists who have one “big idea" (if even that) and write hundreds of papers and books explicating versions of it, Coase’s Nobel, awarded solo in 1991, rests (apart from a few pieces here and there) on two classic papers: The Nature of the Firm (1937) and The Problem of Social Cost (1960). What’s more, these papers not only profoundly shaped the way that economists and other scholars think about the world, they profoundly affected the world itself.

Only Robert Mundell, among other Nobel winners, comes close to matching Coase in the twin feat of writing only a handful of papers which shook up not just the economics profession but the world outside the academy.

The Nature of the Firm asks a startling question: why do business firms exist in the first place? After all, in a well-functioning market economy, wouldn’t it be most efficient for all activities simply to take the form of a large series of well-specified contracts between individuals? A firm, by comparison, is, in effect, a form of central planning in which direction comes from the top and those below are told what to do, with differing degrees of autonomy.

Coase’s crucial insight is that, often, the most important cost of doing business is not what economists had previously focused on, the cost of inputs, transportation, and so forth, but what are called “transaction costs"—such things as the legal costs of enforcing contracts, the costs for searching out information, the costs of bargaining, and so on. When these activities are “internalized" within a firm, such costs are mitigated.

Coase further argued that there was a natural limit to the size of a firm, which would be that point at which the costs of internalizing transactions within the enterprise would just match the cost of contracting activities to outsiders. This understanding of the nature and scope of business firms remains central to economics and management studies to the present day.

The Problem of Social Cost extends the logic of transaction costs, and asks a profound question: In a hypothetical world without transactions costs, could economically inefficient outcomes arise because of the way that property rights have been assigned across individuals? The radical answer is “no".

In a frictionless world in which contracts can be costlessly struck and enforced, individuals will always find a way to work around existing property rights systems to extract all of the possible benefits from exchange and leave no unexploited gains from trade. The assignment of legal rights would, in effect, be irrelevant.

The stunning implication of this insight is that economists’ traditional explanation of market failure based on “externalities" is faulty, or at best incomplete, unless the centrality of transactions costs in leading to the inefficiency is acknowledged.

This idea—that a frictionless world will always produce economic efficiency—was seized upon by right-leaning economists, since it suggested that government intervention would be unnecessary to improve upon the market economy or might make things worse. Another Nobel economist, George Stigler, even dubbed this concept the “Coase theorem", which is how students of economics know it to this day.

Ironically, Coase’s own conclusion was that, since in the real world transactions costs are large and important, political, legal, and social institutions that structure the way individuals and businesses interact are absolutely crucial and can’t be ignored.

Legal rights, in particular, should be assigned so as to maximize economic gain, with the burden on governments to explain how laws and regulations achieve this end, rather than making the benign but erroneous assumption that government regulation would be assumed to work toward social good.

It’s no exaggeration to say that out of this second paper an entirely new field—“law and economics"—was born. Moreover, the current fashion in economics and policy analysis to focus on the role of “institutions" also follows directly from Coase’s early work.

If these two classic papers weren’t enough, in other work Coase argued, among other ideas, that electromagnetic spectrum should be treated as property and be auctioned in the market, rather than held as a government monopoly. While initially derided, this approach has had enormous impact worldwide, including in India (albeit imperfectly).

The world is poorer with the demise of Coase. But, as with all great thinkers, the power of his ideas is ageless.

Vivek Dehejia is an economics professor at Carleton University in Ottawa, Canada, and is co-author of Indianomix: Making Sense of Modern India (Random House India, 2012).

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Updated: 04 Sep 2013, 08:07 PM IST
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