Ronald Coase and his economics

Ronald Coase Image copyright AP

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.