In early September, the global economics profession was met with the unwelcome news that British economist Ronald Coase, father of the ‘law and economics’ school and leading figure of the ‘new institutional economics’ paradigm, passed away in his adopted home of Chicago.
Coase was born in Willesden, north west London, in 1910. After having missed an earlier opportunity to study history and Latin in secondary school, and finding mathematics not to his liking, he switched his scholastic interests to commerce.
Upon passing his intermediate examinations, Coase was enrolled at the London School of Economics to undertake a commerce degree. It was here that he became acquainted with economics, coming under the particular influence of famed British economist Arnold Plant.
Winning a travelled scholarship from the LSE, Coase visited the United States in 1931 and 1932 to observe the organisation and behaviour of different industries.
What perplexed Coase was the prevalence of firms, with their hierarchical structures and internal planning methods, and not independent contracting by individuals, within the productive structure of modern competitive economies.
Why are there islands of planning, in the form of companies, in a sea of the market economy, which is the product of human action but not design?
His classic 1937 paper ‘The Nature of the Firm’ provided an ingenious answer to this question.
Entrepreneurs establish firms, and managers operate them, in attempts to supersede the price mechanism because ‘there is a cost of using the price mechanism.’ These so called ‘transaction costs’ may include the costs of negotiating and concluding contracts, and even of discovering the relevant prices for goods and services.
The transaction cost theme not only became a mainstay of modern economic reasoning in general, but it proved a regular conceptual ally for Coase when prosecuting arguments for reform.
In a 1959 paper on the US Federal Communications Commission, Coase argued that the bureaucratic regime concerning the allocation of licenses for use of the radio frequency spectrum was both impractical in economic terms and highly inefficient in practice:
The operation of a market is not itself costless, and, if the costs of operating the market exceeded the costs of running the agency by a sufficiently large amount, we might be willing to acquiesce in the malallocation of resources resulting from the agency’s lack of knowledge, inflexibility, and exposure to political pressure. But in the United States few people think that this would be so in most industries, and there is nothing about the broadcasting industry which would lead us to believe that the allocation of frequencies constitutes an exceptional case.
Coase’s solution was that the spectrum should be treated like private property, and that licenses for radio operators to access the spectrum should be auctioned off to the highest bidders. This would remove government interference in license allocation, and allow applicants to reveal the intensity of the value they place on accessing the spectrum.
Many of Coase’s colleagues believed that his claim that, insofar as rights are properly defined, market solutions will prevail was one made in error. At an evening gathering at economist Aaron Director’s home in Chicago, which included Milton Friedman, George Stigler and Arnold Harberger, Coase was able to successfully persuade them of his view.
It was this spirited conversation which led Coase to write arguably one of the most famous papers in economics, his 1960 piece ‘The Problem of Social Cost.’
If a market transaction imposes costs on third parties not involved in it, say a manufacturing plant emits noxious gases affecting the health and amenity of the resident neighbourhood, the conventional solution had been for government to impose a tax on the party causing the harm.
Coase challenged the idea that ‘Pigouvian taxes’ would necessarily lead to more socially efficient outcomes, suggesting instead that the harmer and the harmed could negotiate an efficient outcome on damages, regardless of the initial allocation of property rights.
This bargaining solution, in a world of zero transaction costs and well defined property rights, has been elevated to the status of a ‘theorem,’ however Coase himself was at pains to indicate that positive transaction costs in the real world prohibit such bargains to resolve externalities.
But by the same token, Coase emphasised, one should be sceptical of reflexive political attitudes toward using blunt fiscal instruments to address externality problems.
Coase’s powers of observation, and his preparedness to question convention, also remain evident in his 1974 article on ‘The Lighthouse in Economics.’
The conventional view held at the time was that a lighthouse represented a classic example of a ‘public good,’ a good or service which is collective in its consumption attributes, and thus, so it is said, cannot be profitably provided by the private sector.
Examining the nineteenth century lighthouse system of his home country, Coase in fact found that ‘a lighthouse service can be provided by private enterprise. … The lighthouses were built, operated, financed and owned by private individuals, who could sell the lighthouse or dispose of it by bequest.’
This proved to a devastating finding to those economists presenting an ever expanding catalogue of outputs only to be provided by government, and led other economists to revise their notions of public goods through appraising real world historical examples.
Ronald Coase made important contributions in other fields, such as agricultural pricing, monopoly pricing and conduct and the history of economic thought, and in his final years co-wrote a book about modern Chinese economic development (reviewed by the IPA’s Alan Moran in the December 2012 issue of the IPA Review).
It should be made clear that Coase was no natural rights libertarian and no Austrian school economist.
Nonetheless, his ‘observational utilitarian’ approach led him to appreciate the profound limitations of government intervention, and the extraordinary capabilities of human beings to economically cooperate in ways conducive to productivity and wealth creation.
A self described ‘accidental economist’ who became one of the most influential economists of the twentieth century, Ronald Coase has bequeathed an intellectual legacy that will inspire new generations to appreciate the enduring marvel that is the market.