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 Article written by Stephanie Flanders Stephanie Flanders Former economics editor

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  • rate this
    +2

    Comment number 36.

    35.qwerty "Economics as an academic discipline should not be discounted because it has failed to solve all economic problems"

    Two problems with what you wrote.

    1. 'solve all' should read 'solve any'.

    2. You concentrate on solving problems when the main problem is the 'creation' of problems by academic economics.

    The subject CAUSES economic problems more than it cures them!

    So it should CEASE!

  • rate this
    -1

    Comment number 35.

    "useless at creating predictions that can be tested "

    Not really, many can be tested empirically using regression analysis. Economics as an academic discipline should not be discounted because it has failed to solve all economic problems, any more than medicine should be because a cure for cancer still eludes us.

  • rate this
    0

    Comment number 34.

    23.L_o_m

    The problem with economics is that its theories are completely useless at creating predictions that can be tested - so it is completely unscientific. This is also partly true of real scientific study, but sciences generally advance over time - unlike economics which seems to thrive only when it ignores facts and economic history.

    The back ends of a male cattle produce more sense!

  • rate this
    +1

    Comment number 33.

    31.ToryBoy

    YES!

    More importantly to wholesale sackingsof the duffers who they miscalculated too! (sorry Stephanie - but you could at least dig out your dad's comic song scores and start a new career that was actually of benefit to us all - hippos in the mud and gas-men calling etc..)

    Till we expunge the nonsense from economics and de-witchcraft it we will not recover properly.

  • rate this
    +1

    Comment number 32.

    31

    There is always a case to be found for wholesale sackings of the overpaid and useless. The trouble is that because they have nothing else to do but protect their own backsides the job never actually gets done. So they usually call themselves the state.

    Whenever people talk about The Firm I think Ronnie & Reggie. They were a bit like the state as well: violent and acquisitive.

  • rate this
    0

    Comment number 31.

    No9 John from Hendon,
    Economic departments at universities have been dominated during the last thirty years by ideological nutcases adhering to the nonsense advanced by Hayek/ Friedman et al.
    In view of the outcome of their stupidity - the worst economic/ financial crisis in the history of capitalism, do you think there is a case for wholescale sackings?

  • rate this
    +1

    Comment number 30.

    Joe Post 15. Coase did get out in the real world. It was his experience and observations in the real world in the US in the 1930's that formed the foundations of The Nature of the Firm.
    Post 17 you might want to read The Telegraph obituary to see how different a person Coates was from Friedman.
    http://www.telegraph.co.uk/news/obituaries/culture-obituaries/10284602/Professor-Ronald-Coase.html

  • rate this
    +1

    Comment number 29.

    28keith_d
    Surely this is obvious. If one buys or sells something on Ebay you factor in the Ebay fee.
    If you buy a house for over £250k you factor in tax.
    If you decide to buy something in a shop you factor in the cost of getting there and, if necessary, parking.
    Am I missing something?
    Alan

  • rate this
    +1

    Comment number 28.

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

    Quite the opposite, he showed that price was a combination of underlying cost plus transaction costs, and this let to economic entities which effectively arbitraged transaction costs.

  • rate this
    +1

    Comment number 27.

    Not bad for a lad from Willesden. Well done Ronald.

  • rate this
    +1

    Comment number 26.

    Well, that's a bit different, Steffie. Thanks.

    On that second paper, the thought occurs: did Coase ever doing any work on Governments causing pollution or other social costs?

  • rate this
    0

    Comment number 25.

    So accountants are just limited economists, and we are run by accountants.

    It would be better to be run by economists, but only just.

    Best would be to be run by humans - no chance!

  • rate this
    +2

    Comment number 24.

    Economics gets stick for not having solved all the economic problems of our time, but it took 1,800 years from Archimedes to Newton, and 250 more from Newton to Einstein and still physics is not "solved".

    All praise to the likes of Coase for helping Economics on its way, but we must be pateient as there is much still to learn and it will take time with mistakes along the way.

  • rate this
    +2

    Comment number 23.

    18.John_from_Hendon



    No it doesn't - if by "academic economics" you mean (which you do not state) those academic economists that our Governments actually listen to then yes, you would be right.

    But put Neo-Lib economics to one side and you'll find many academics are spot on in their work - but our Governments don't like what they have to say a sit doesn't fit their pre existing agenda

  • rate this
    +1

    Comment number 22.

    If you want a perfect example of how transaction and organisational costs affect a market the UK house market must be it. There are the obvious transaction costs, like Stamp Duty, that cause discontinuities in market prices. Then there are the organisational costs, like planning laws, that artificially restrict supply. Add uncertainty in pensions and no CGT on gains and you get a dangerous result.

  • rate this
    -1

    Comment number 21.

    I liked the ssort programs Ms Flanders did on Hayek and Keynes
    Again what I find in this article is someone who is saying
    no or minimal govt intervention.
    With virtually every market and system being manipulated at present perhaps their caution should be listened to.
    18 JfH
    I think a nearer analogy is early medicine, Keynes as a surgeon and Hayek watching natural reaction to virus.

  • rate this
    0

    Comment number 20.

    A truly great economist. Wouldn't have been employed by a UK university though: not enough publications for the REF.

  • rate this
    +1

    Comment number 19.

    Think it be more topical to have an article on what happens when the economic equilibrium is destroyed, by huge imbalances of power and quantity of money.

  • rate this
    +1

    Comment number 18.

    It all goes to prove that there is little more to academic economics than there is to witchcraft. Both the witch and the economists would see a cow getting sick and ascribe it to a curse and both would then claim to have cured the curse when the cow - in the natural course of things - got better.

    Politicians (and bankers) listen to witches and economists in equal measure! Idiots led by fools!

  • rate this
    +1

    Comment number 17.

    And which modern era economist most deviates from the universal truth of human beings making illogical decisions...???

    Yup, Milton Friedman, the doyen of "Neo-Liberal" or "Chicago School" (call it what you will, just don't claim it works when it palpably doesn't, as witnessed by the now 5 year world wide recession....) economics....

 

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