His ideas show us how markets really work.
The year 2025 marks two significant milestones in the history of economic thought: the 115th anniversary of the birth of Ronald Coase, one of the most brilliant economists of the 20th century, and the 65th anniversary of the publication of one of his most influential articles, “The Problem of Social Cost” (1960).
The great economic historian Robert Higgs once claimed that two of the most important papers an economist could read were Hayek’s “The Use of Knowledge in Society” (1945) and Ronald Coase’s “The Problem of Social Cost.” Although the ideas of Hayek and Coase were influential in the 20th century, it is difficult to claim that their lessons have been fully absorbed by contemporary economists.
Ronald Coase published relatively little, but his contributions were so important that he received the Nobel Prize in Economics in 1991. As economist Carlos Rodriguez Braun would say, his “rate of return per page was spectacular.” If Hayek helps us understand the importance of prices and competition, Coase delves into how transaction costs shape markets and the institutions in which they operate. In a world where government intervention is called for to solve any negative externality, Coase showed us that market solutions can be superior and that government proposals are not without problems.
The Nature of the Firm and Transaction Costs
Born in London in 1910, Coase worked his way up from a lower-middle-class background, first through grammar school and then studying at the London School of Economics, where he would go on to earn a PhD. Moving to the US in the 1950s, he would spend the latter part of his career at the University of Chicago.
In his early twenties, Coase worked on one of his most influential papers: “The Nature of the Firm” (1937). In this, he put forward a simple idea with profound implications: market exchange can be costly.
In 1931, during a seminar at the London School of Economics, economist Arnold Plant introduced Coase to the idea of how the price system provides the necessary coordination to produce goods and services in the market. Plant, a staunch advocate of free markets, opposed the various industrial planning schemes that were popular in his time. According to Plant, the price system alone would be sufficient to coordinate all productive factors within an industry.
However, as Coase pointed out, this approach overlooked “a factor of production, management, whose function was to coordinate.” Where does this productive factor come from? More importantly, where does management’s role in coordination end, and where does the price system take over in allocating resources?
Take, for instance, the production of a car. Why is there vertical integration in its manufacturing, where the car is assembled in a factory by a group of individuals coordinated through directives issued by a hierarchy of managers? Why doesn’t the car’s production take place within a more decentralized market?
In other words, why do firms exist?
Answering these questions was crucial because socialists believed that the economy could function as one large factory. (Some socialists still believe this; see this article in Jacobin—and see here for a response.)
In his Nobel Prize lecture, Coase explained it this way:
Lenin had said that the economic system in Russia would be run as one big factory. However, many economists in the West maintained that this was an impossibility. And yet there were factories in the West and some of them were extremely large. How did one reconcile the views expressed by economists on the role of the pricing system and the impossibility of successful central economic planning with the existence of management and of these apparently planned societies, firms, operating within our own economy?
Coase’s solution marked his entire career. Coase concluded that firms exist, in part, because using the price system to coordinate productive factors involves transaction costs. The price system does not operate in a frictionless vacuum: prices must be discovered, and this entails costs of negotiation, defining terms, and enforcing agreements. Firms, as intermediaries, save these costs by directly coordinating the factors of production.
Lenin was wrong: a planned economy like a large factory would be dysfunctional. An economy should allow the most efficient organizations to emerge to reduce transaction costs and respond to market demands through the price system.
Furthermore, Coase explained why firms do not grow indefinitely: the size of a firm is limited by the increasing costs of organizing activities internally. As a company grows, it may be more efficient to outsource, contracting external services rather than integrating them. This principle also applies to bureaucratic entities: their efficiency deteriorates as they grow and face greater complexity.
Economics Away from the Blackboard
Ronald Coase believed that economists focused too much on abstract theories instead of observing how people actually behaved. As Coase wryly put it: “If economists wished to study the horse, they wouldn’t go and look at horses. They’d sit in their studies and say to themselves, ‘What would I do if I were a horse?’”
In his view, observed behavior revealed the realities of the economy. This pragmatic approach led him to challenge conventional ideas, including those of Arthur Cecil Pigou, a prominent economist in the neoclassical tradition.
Introductory economics textbooks often use externalities as classic examples of market failure. A negative externality occurs when a transaction between two parties imposes a cost on a third party, while a positive externality arises when it generates a benefit for others.
Pigou argued that markets fail when private costs and benefits diverge from social costs and benefits, and that the government should intervene to address these failures through corrective taxes or subsidies. Following Pigou’s work, modern economists refer to taxes designed to address negative externalities as “Pigouvian taxes” and to subsidies aimed at correcting positive externalities as “Pigouvian subsidies.”
Economists had broadly accepted this framework, yet in “The Problem of Social Cost,” Coase argued that externalities are not market failures, but conflicts over the use of scarce resources that are difficult to resolve because of transaction costs. In a world without these costs, it was obvious to Coase that externalities would disappear because the parties could negotiate directly. In the real world, however, the government often makes problems worse: a tax that protects B harms A and does not guarantee optimal resource use. The Pigouvian treatment might push the economy to a worse equilibrium.
The Market as a Process of Discovery
In How China Became Capitalist (2012), co-written with Ning Wang, Coase described resource allocation in a market economy as a process of discovery, Hayekian style:
Resource allocation in a market economy is a Hayekian process of discovery. There is no magic way to place all economic resources where they can be most profitably employed; the efficient utilization of resources is not a given in any economy. Entrepreneurs have no choice but to resort to trial and error to figure out where to put their resources; in their constant search for higher profits, they unintentionally move resources to where they generate the highest returns.
For Coase, as for Hayek, economic competition is a dynamic process. Entrepreneurs allocate resources to the most valuable uses through trial and error, guided by profit and loss signals.
The Importance of Coase in Contemporary Economics
Coase’s impact transcends the theoretical. His work inspired economists to seek market solutions and to question excessive regulation. In an interview with Thomas W. Hazlett for Reason in 1997, he stated:
I can’t remember one [regulation] that’s good. Regulation of transport, regulation of agriculture—agriculture is a, zoning is z. You know, you go from a to z, they are all bad.
In “The Market for Goods and the Market for Ideas” (1974), Coase questioned why we did not extend the freedom we seek in the expression of ideas to the freedom to exchange goods and services. And in his 1975 essay “Economists and Public Policy,” which appears in the Essays on Economics and Economists compilation, Coase applauds economists who succeed in stopping or delaying harmful government regulations or interventions:
An economist who, by his efforts, is able to postpone by a week a government program which wastes $100 million a year (what I would consider a modest success) has, by his action, earned his salary for the whole of his life.
Ronald Coase is an economist whose work is worth exploring. He warns us about the problems of interfering with the price system, highlights the virtues of market solutions, and underscores the difficulties of addressing externalities through more government.
