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Wednesday, September 4, 2013

Remembering Coase

A Note on the Passing of “The Accidental Economist”

The year 2013 has, coincidentally, been marked by the passing of several pioneers of twentieth-century economics. 

James Buchanan, founder of constitutional economics, expired in January. Armen Alchian, who examined informational problems in markets from an evolutionary perspective, died in February. Robert Fogel passed in June. David Landes died last month. Fogel and Landes each examined the evolution of institutions and economic systems in history. Each of these four men made their own unique contributions to economics or to economic history. 

But they were all part of the same intellectual movement founded by Ronald H. Coase, who died on Tuesday at age 102. 

Coase began life on December 29, 1910, in Willesden, England. Health problems in his youth caused Coase to miss preferred opportunities to study Latin or history. Coase found science unfulfilling, so he opted for the only remaining “choice”: commerce. High scholastic aptitude led Coase to the London School of Economics. Study of commerce at the LSE put Coase into contact with two eminent scholars: Sir Arnold Plant and F. A. Hayek. 

Though Coase ended up in economics by accident, he excelled. Plant introduced Coase to Adam Smith’s concept of the invisible hand of markets. Hayek familiarized Coase with the organization of industries and commerce across stages of production. Coase made a major contribution to economic science by explaining how firms fit into the market system. 


Firms and Transaction Costs

Coase argued that business managers face a choice between producing needed goods internally or buying them from other businesses. Transaction costs are the key factor. High transaction costs for a needed good make it profitable to produce it in house. Low transaction costs facilitate trades with other organizations. 

For example, Henry Ford decided to produce steel for his cars at his own foundry: the River Rouge Plant. Ford saved the bother of contracting with outside steel producers, but incurred extra administrative costs. Rational people compare the costs of different ways of organizing human activity and choose the cheapest ways. In some cases it’s cheaper for people to bargain with each other in markets. Other times it’s cheaper to administer plans for economic activity in a firm. Since people experiment to find the cheapest way of interacting, private institutions can be efficient. Coase would win the Nobel Prize for his transaction cost theory of business organization.

The main point of Coase’s analysis is simple, but the applications of his theory are varied and complex. Some economists claimed that the government must fix the prices of products from large monopolies at low levels and must provide subsidies. Coase argued that monopolies can figure out special types of pricing strategies that enable them to function with some degree of efficiency without subsidies.


The Theorem

Coase did his most famous work in the late 1950s in what is called the Coase Theorem. The general idea behind the Coase Theorem is simple: Conflicts over the use of resources disappear if transaction costs are zero and property rights are clearly defined. Coase used his theorem to analyze the early twentieth-century radio industry, specifically use of the electromagnetic spectrum. At some point the pioneers of American broadcasting ran into conflicts over who could use which frequencies. Coase found that broadcasters were managing to sort out a system of property rights in the spectrum when Secretary of Commerce Herbert Hoover created the Federal Radio Commission (now known as the FCC). According to Coase, transaction costs were low enough for a functional radio market to emerge without Hoover’s intervention. The FCC was created to fix largely nonexistent problems. 

The development of the Coase Theorem led to him to leave the University of Virginia for the University of Chicago.

Coase was agnostic on the role of government in markets. High transaction costs suggest the need to use organizations instead of markets, and this could mean public organizations, he said. In 1974 Coase published an article on lighthouses. Coase denied that lighthouses were pure public goods. Some economists have claimed that no private investor would ever build a lighthouse. Ships could take direction from light from a lighthouse, sail past, and pay nothing. Coase showed that private lighthouses could charge ships a fee as soon as they entered port.

Coase was a utilitarian rather than a libertarian. He was simply interested in finding out whether private or public institutions are more efficient. Of course, analysis of institutions by Coase-influenced economists has usually exposed the relative inferiority of the public sector. Coase himself once said that state regulations tend to work poorly. 

Coase exerted much of his influence on the economics profession by editing The Journal of Law and Economics. Coase guided the development of a school of economic thought, new institutional economics, and the development of the modern subject of law and economics. Coase is also known for the Coase Conjecture—a hypothesis on price discrimination—and for his analysis of the market for ideas. 

Ronald Coase lived a remarkable life, ending up in economics by chance but playing a crucial role in shaping the discipline’s modern form. His efforts were rewarded with the 1991 Nobel Memorial Prize in Economic Sciences. While Coase was ambivalent about laissez-faire, his influence on economic thinking weakened the case for State intervention.

  • D. W. MacKenzie is an assistant professor of economics at Dickinson College.