Ronald Coase and his economics

Ronald Coase

Ronald Reagan once said an economist was someone who saw something working in practice, and wondered if it would work in theory.

It was meant to be a joke. But Ronald Coase, who died this week at the age of 102, did exactly that, in an academic paper he developed when he was still a student in London in the 1930s.

He looked at how business was done in the real world and came up with an economic theory to explain it. Few noticed his article on "The Nature of the Firm" when it was published in 1937. But it went on to change the way we think about business forever.

Nearly a quarter of a century later he looked at how governments dealt with problems such as pollution and came up with a new way of thinking about that as well, in a paper called "The Problem of Social Cost". It was not for nothing that he won the Nobel Prize for Economics in 1991.

Grubby details

It's a common criticism of economics - market economics, especially - that it's too unrealistic. How can we trust the conclusions of these highfalutin economic models, these critics ask, when there are so many real-life details about the world that they assume away?

Ronald Coase was not one of those critics. He understood that economists were always going to have to ignore a lot of grubby details about the world in order to say anything useful about it.

But traditional economic theories tended to ignore or assume away most of the institutions that make up real-life economies, and a lot of the costs as well. Coase decided that was assuming away too much.

In effect, those classical theories tended to assume the price of a good was all that mattered in whether it was bought and sold. There was nothing about how that market process was organised, or how much the transaction cost.

Desert island

In that first seminal paper in 1937, Coase said economists needed to take those transaction and organisational costs into account because, without them, they couldn't explain the existence of the firm.

You can just about imagine a desert island economy, where everybody makes, buys, sells and/or barters everything they need. But in real life, all those different deals and negotiations cost time and money.

It's usually going to be cheaper to combine at least some of them within a single organisation - so , instead of an endless series of negotiations over each stage in the production chain, you have employees on continuous contracts, and a manager (or managers) to help organise who does what.

Bingo. That's why we have companies. And they're all different sizes because the right size of the firm will depend on the costs and benefits of organising all that activity in-house relative to the cost and benefits of buying it in.

This might sound pretty basic. In 1937 it just sounded odd. But today that same trade-off - between the costs of different ways of doing business - is something that management theorists spend their lives thinking about. And business schools around the world make their bread and butter describing how and when companies have got the trade-off right.

Regulating pollution

Coase's other seminal paper, "The Problem of Social Cost", seemed equally strange when it was published, in 1960. But in a sense, it applied a similar approach to thinking about how governments should regulate economic activity and resolve disputes. Transaction costs matter here too, he said, sometimes more than the legal question of who owns what.

His argument was that governments should regulate things like pollution, not because it's a matter of right and wrong, but because it would be too costly for all the victims of that pollution to get together to pay the company to stop, and because the pollution affects parts of the economy where there aren't well-defined property rights.

The implication of the paper was that if it were possible for two parties in a dispute to reach a mutually amicable agreement, they should probably be left to get on with it. Governments should step in only when it's difficult to establish appropriate property rights, and/or the transaction costs involved in reaching a private deal are just too high.

To some of you that will sound like common sense. To others it will sound dangerously laissez-faire.

In fact, Coase himself was pragmatic about when and where governments should intervene in the economy - though the fact that he spent most of his career teaching in the law faculty of very free market Chicago University may tell you something.

His arguments in these papers were subtle, at times, and hard to summarise. But the basic insights are not: that transaction costs matter, and you can't understand the nature of modern economies without thinking quite hard about the rules and institutions underpinning them.

Stephanie Flanders, Economics editor Article written by Stephanie Flanders Stephanie Flanders Former economics editor

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After 11 years at the BBC, I'm leaving for a new role in the City.

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  • rate this

    Comment number 16.

    Economics in One Lesson

    The bad economist (Bernake & Krugman) sees ONLY:
    - what immediately strikes the eye
    - the direct consequences of a proposed course
    - what the effect of a given policy has been or will be on ONE particular group

    The good economist:
    - always looks beyond
    - looks also at the longer and indirect consequences
    - inquires also what the effect of the policy will be on ALL groups

  • rate this

    Comment number 15.

    If I can make the law, I would force economists and politicians to have certain minimum years of commercial experience. We listen to these economic professors never work in the real world, they bring up theory after theory and crony politicians take them to the real world economy.

    Government shouldn't be economy driver, they know monkey about GROWTH because they tax, they don't produce and earn.

  • rate this

    Comment number 14.

    The real problem is that too many economic policies are driven by political dogma and egos. Allowing poorly qualified 'Fred the Shred' to run a bank is little different from allowing poorly qualified politicians to run the economy. With similar results.

  • rate this

    Comment number 13.

    Since Smith economic theories have one thing in common: they all discount or at best grossly undervalue resources and the environment. To economists natural resources and the environment are just a part of capital to be used to maximise production. Unfortunately they take no account of the method and rate of usage and it's impact on sustainability as a result. Fatally flawed pseudo-science

  • rate this

    Comment number 12.

    This is a fascinating piece Stephanie that gives real insight into how Economists think about the world. Makes a nice change from barmy bankers bonuses and central bank guidance on how they're not going to do anything.

  • rate this

    Comment number 11.

    Ronald Coase your work "The Nature of the Firm" was seminal. It helped me to understand the concept of vertical integration and enabled me to produce a thesis entitled Vertical Integration: An Analysis of the Reasons for Its Genesis in the UK Tourism Industry in 1998 as a postgraduate student of tourism marketing at the University of Surrey. For this I say thank you. R.I.P

  • rate this

    Comment number 10.

    It's something of a pity that he did not consult on the Walkie-Scorchie project which will now probably double its £200 million price tag.

    In tribute to subtle costs and derivatives.

    Wikipedia nails Vega, rather well ~

    It really, really, is all about cash flow

    His real influence was business law

  • rate this

    Comment number 9.

    THE problem with economics is that each generation THINKS it can ignore the lessons of history.

    Not surprising it thinks this as it is bribed to do so by the sponsors of the courses whose sole objecting is to make as much money as possible out of the system by corruptly tweaking it to their advantage - that is the role of economic education.

    And that is why we had 2008 and why it can't be fixed!

  • rate this

    Comment number 8.

    He was very much in favour of, and an inspiration to, the sort of market driven, hands off government that came to the fore in the 80s.

    He also led the way towards the thinking that price can be equated with cost.

    His theories were insightful. The politics they brought into the world were, to be polite, unpleasant.

  • rate this

    Comment number 7.

    The government does provide the playing field but it has never been level and has always favoured some more than others.

  • rate this

    Comment number 6.

    3. alan

    1 SJH
    Apparently Fred the Shed ...

    Yes Alan I read tat too. I was brought up in Scotland. They were very proud of that Bank. And Fred`s punishment for allowing his combination of fiscal ignorance and psychopathic megalomania to destroy it?..a publicly funded pension of around £350,000 payable now...but of course it was going to be twice that. Unbelievable. Enough to make you Marxist.

  • rate this

    Comment number 5.

    "In fact, Coase himself was pragmatic about when and where governments should intervene in the economy"

    I would argue that the question of government intervention may itself be subject to "real" costs, i.e. the availability of real resources/skills etc in the currency of issue, and by extension, inflation.

  • rate this

    Comment number 4.

    I thought Hicks was the welfare theory man.
    His book on the trade cycle has never been surpassed IMHO.

  • rate this

    Comment number 3.

    1 SJH
    Apparently Fred the Shed spent his time fretting over minutiae such as the colour of office carpets, design of filing cabinet and getting someone to pick up a cigarette butt from the front steps of his bank but wasn't particularly interested in how much money the bank lent to whom.
    Not only did he not have a qualification in banking but he didn't have one in interior decoration.

  • rate this

    Comment number 2.

    The role of Government and public agencies is central to providing "the playing field" within with private investment decisions are made, whether it's the law of the land, national aviation policy, land-use planning policy or employment policy.
    Public monies often have to be put up front to stimulate private sector investment in key projects or else it doesn't happen.

  • rate this

    Comment number 1.

    Never heard of him. Still even a dead 102 year old economist could have done a better job than the likes of Fred the Shred.


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