No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Six: Applications in Markets 146 GREAT ECONOMISTS IN HISTORY RONALD COASE 1910-2013 Most great economists had a magnum opus : a great book that left its mark on the world. Others were prolific and wrote multiple scholarly articles which continue to shake the profession. But then there is Ronald Coase: a Nobel laureate with no fat book to read, and only a couple of journal articles worth mentioning. But what articles! The implications of his work were so profound that scholarly disdain for his unsophisticated work (lack of higher level math, which Coase calls “blackboard economics”) could not stop his recognition. Every economic textbook now teaches that markets don’t always work as smoothly as pure theory might suggest because of something called “transaction costs.” And Ronald Coase is the father of transaction costs. When Coase was just a young man, he was, as were many intellectuals of that era, infatuated with socialism, and wondered why the Soviet Union couldn’t work. Conservatives suggested that the USSR was trying to operate as one big factory, and therefore couldn’t work. But Coase wondered why it couldn’t, since big companies such as GM and Ford seemed to work out just fine. In seeking to understand why and how large companies organize, Coase solved the problem in his path-breaking “Theory of the Firm.” Firms could contract out all their functions. For example, let’s say you build a house. You could hire an individual carpenter, plumber, electrician, etc. as individual contractors. Or you could hire them all as employees. If you are only building one house, you’ll probably go with the first option; if you are in the construction industry with steady work, you may choose the latter. The deciding factor is the presence of transaction costs; if it is more efficient to hire employees to overcome repeated contract negotiations and the costs of finding individual contractors, you’ll hire full-time employees. If not, you’ll contract out each job. What Coase labeled as “marketing costs” for a firm are now recognized as pervasive costs throughout markets, and are labeled “transaction costs”—the costs to enter into a market exchange. Coase extended this with an even more influential paper, “The Problem of Social Cost,” which was written 23 years after his first major paper. In this paper, Coase showed that if transaction costs were low, the initial distribution of property rights (who owned what) would not affect the economic outcome, since gains from trade would lead to the same result. For instance, if a rancher allows his cows to trample a farmer’s crops, then it doesn’t matter who owns the property rights; if the cows are more valuable to markets than are the crops, then the cows will graze. Either through the rancher having the property right or paying the farmer to use his property right, the economically efficient result will happen either way. In a low transaction cost world, the rationale for government action on behalf of economic efficiency was crushed. For an excellent review of the implications of Coase’s work on transaction costs and the concepts of this chapter, watch this video: Photograph of Ronald Coase 1 The Coase Theorem