September 23, 2013

Coase: the passing of a legend in law and economics

Posted on September 23, 2013 by Rodney Brown

The legal profession lost a giant earlier this month when Ronald H. Coase passed away Sept. 2nd. You may know Coase as the economist who framed the Coase Theorem and won the 1991 Nobel Prize in Economic Science. But you may not know that Coase spent his career at a law school, not in an economics department. Or that several of his key economic insights have as much relevance for the law as they do for economics.

Coase wrote his first influential paper, The Nature of the Firm, in 1937. In it, he announced the concept of transaction costs, the notion that people must incur costs simply to participate in supposedly free market. After he recognized that it takes time and resources for someone to gather information to make a deal in the marketplace, and even more to bargain for the deal and to police and enforce it, Coase hit on the then-radical idea that people will organize themselves into firms or corporations only if it will reduce their individual transaction costs. The firm, in other words, exists because it incurs lower transaction costs to handle certain kinds of dealings.  This explains why companies grow into large, complicated behemoths, and also why they outsource functions when the external market begins to do the same job with lower transaction costs.

Transaction costs are important for all lawyers to consider, but Coase’s next big work is particularly significant to environmental lawyers. His 1960 The Problem of Social Costsintroduced the idea that relatively free markets could allocate resources more efficiently than any regulatory system. Even more boldly, Coase showed that, if you assume no transaction costs, a free market reaches the most efficient result no matter how society’s property rights may be distributed initially. A polluter given the complete right to do so will pollute only as much as is socially useful, because otherwise his neighbors will pool their money to buy him out.

Interestingly, Coase never liked his idea as applied to the real world. He knew that assuming no transaction costs was big and unrealistic. In real life, there are transaction costs everywhere, as his 1960 paper noted:

This would seem particularly likely when, as is normally the case with the smoke nuisance, a large number of people are involved and in which therefore the costs of handling the problem through the market or the firm may be high.

When there are transaction costs, the market will not find the most efficient result, and it will end up imposing externalities on others. Coase felt that government regulation or taxation would often be needed to fix this problem. 

So in the end, Coase was an empiricist: look carefully at each situation and decide based on the facts, not ideology, whether market forces or government action will work better. We should all raise a toast in his memory.

NB: To see more of Coase’s delightful way of thinking about the world, read this 1997 interview of him at The Ronald Coase Institute’s website.

Tags: Coasetransaction costseconomicsgovernment regulationfree markets

Governmental Policy | Regulation

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