Wednesday, September 18, 2013

Ronald Coase 1910 - 2013

Ronald Coase, the 1991 Nobel Memorial Laureate in Economics, passed away on 2 September at the age of 102.  He was working to the end, having recently published a co-authored book on China. A good one.

I have loved Coase's work ever since I first came across it. He won his Nobel Memorial for essentially two articles. One he wrote as an undergraduate in his 20s, the 1937 article The Nature of the Firm (pdf).  The other was published in 1960, The Problem of Social Cost (pdf), the most cited law article. Both pieces, plus his somewhat notorious The Lighthouse in Economics (pdf) and some other key articles and essays, were published in 1988 in his The Firm, the Market and the Lawavailable on Amazon in Kindle edition for $US15.12.

Buy or do?
Coase is best known for a concept he did not name--transaction costs--and a theorem he did not formulate--the Coase Theorem. The concept of transaction costs first appears in a 1931 article by economist John R. Commons. Coase, however, elaborated the concept and applied to a very practical problem--why do firms exist? Why is not the price mechanism always used? Why does everyone not operate as sole traders trading their services in the market place?

As he sets out in his Nobel Memorial Prize lecture, having completed the course requirements for his degree in Commerce from the LSE in two years, but graduation requiring three years attendance, he spent the third year traveling the US studying vertical and horizontal integration of firms. Thomas Hazlett describes nicely what young Coase did in the introduction to a 1997 interview with Coase:
Coase's scientific methodology? He asked businessmen why they did what they did. One key question, for instance, involved why firms chose to produce some of their own inputs (vertical integration), and why they sometimes chose to use the market (buying from independent suppliers). He was fascinated by their answers, but even more by their astute calculation: Firm managers were keenly aware of all the relevant trade-offs.
Coase identified the costs of transacting as the key variable determining the answer and therefore the existence, and boundaries, of firms. Firms existed because it was cheaper to do some things within a firm than in a market place; that there were costs to using the price mechanism. One of those insights which is blindingly obvious once someone has pointed it out.

Ronald Coase
In doing so, he explicitly disagreed with economist Frank Knight's analysis that risk led to non-market transactions, establishing an on-going pattern where risk and transaction costs are the key factors used by economists to discuss institutional arrangements. For example, Deidre McCloskey and Stefano Fenoaltea's debate over the structure of medieval manors turns very much on the relative importance of transaction costs and risks. Similarly, a paper on (pdf) taxation policy in the Ottoman Empire looks at the balance of risk and transaction costs according to what level taxes were levied at. If risks were more constraining, it made sense to tax at a more territorially encompassing level, so risks could be pooled. If transaction costs were more constraining, it made sense to tax at a more local level, so local knowledge could be used.

Economist Yoram Barzel has offered an analysis of the boundary of the firm which puts risk back at the centre, the boundary being set by the range of transactions guaranteed by the equity capital. Though transaction costs are hardly irrelevant in that decision. Especially as risks can be transferred--to other transactions, to other agents, across time--while risks and transaction costs overlap.

Coase's insight also make it easier to see how the IT revolution and the Internet has affected both the structure of firms and the variety of commercial and other arrangements.

While Coase's insight on the boundary of the firm may be obvious in retrospect, the insight remained remarkably fallow in economics for decades. As Coase himself noted in his Nobel Memorial lecture, the concept needed to be "operationalised", quoting 2009 Nobel Memorial Laureate Oliver Williamson. As was done by such scholars as Williamson himself, Steven Cheung and Harold Demsetz. But informing and inspiring the work of other scholars is what makes great insights intellectually productive.

Social costs going both ways
If the idea at the heart of The Nature of the Firm seems obvious in retrospect, there is nothing obvious in the massively counter-intuitive idea at the heart of Coase's other seminal piece, The Problem of Social Cost, which is that, in a world with costless bargaining, it may make no difference to the net social outcome whether a producer has liability for the damage they cause or not. If they have liability, they can pay others for the damage caused to them. If they have no liability, they can be paid by others not to do the damage. Either way, the same level of production will be agreed to. As Coase himself put it in that 1997 interview:
The law of property determines who owns something, but the market determines how it will be used.
The operative term is in a world of costless bargaining. Coase's intent was to draw attention to the role and importance of law in a world of positive transaction costs and to the reciprocal nature of the problem of damage (i.e. both the doing and the not doing cause costs to someone). But it is much easier to model a world with zero transaction costs. Economists became entranced by the world of what 1982 Nobel Memorial Laureate George Stigler termed the Coase Theorem--that, in a world of zero transaction costs, private and social costs were the same. It was a world without externalities (a term Coase did not approve of) because they could all be bargained away.

This fascination with an unreal zero transaction costs world of tractable models frustrated Coase. As he wrote in Notes on the Problem of Social Costs:
The world of zero transaction costs has often been described as a Coasian world. Nothing could be further from the truth (p.174).
But this unreal world was great for mathematical models. As Coase wrote at the end of Notes on the Problem of Social Costs:
In my youth it was said that what was too silly to be said may be sung. In modern economics it may be put into mathematics (p.185).
It was not that Coase was against the use of mathematics in economics. Far from it. He just wanted the maths to have a strong connection to the world we actually live in.

Which is a world where price mechanisms are not always used because it is a world of positive transaction costs. Hence not only firms but also laws and institutions. Coase's insights became central to analysis of firms, to law--the entire field of law and economics flows from his insights--and economic history. The last is most obvious in the work of 1993 Nobel Memorial Laureate Douglass North with his analysis of institutions as ways of dealing (indeed minimising) transaction costs but it also lurks underneath 1993 Nobel Memorial Laureate Robert Fogel's work on the efficiency of slavery. Anyone who reads a significant amount of economic history becomes very aware of how basic transaction costs are to making sense of history because they are so important to making sense of law, rules and institutions. No wonder economic historians find Coase's insights so useful.

(As an aside, the committee which picks Nobel Memorial Laureates does seem to like folk who extend the ambit of economics, the most imperial of the social sciences.)

Institutions can be analysed longitudinally (across time) but also laterally (across space). Coase's insights are a fundamental building block of 2009 Nobel Memorial Laureate Elinor Ostrom's work on common property and the evolution of rules to manage them.

Coase himself pointed out that what became known as transaction costs had already been basic in economic analysis of the origins of money--particularly in the famous coincidence of wants problem. Search costs are a basic transaction cost and a reason to have money. More recent work on "money is memory" (pdf) and money as a response to limited enforcement is yet another form of transaction cost analysis.

Coase was very aware of the difference in how lawyers and how economists think while linking between the two mindsets. As he notes in The Problem of Social Cost, lawyers are concerned first with establishing who has the legal right to do what, and then working through the consequences. Economists look to what bargains can be made.

Coase pointed out that exchange was not merely about physical items, but about bundles of rights to bundles of attributes. Harold Demsetz's famous beaver trade analysis (pdf) of the origins of property rights based on the cost and benefits of internalising externalities is very much based in such Coasian perspectives.

Coase's insights made it easier to see that any exchange is first and foremost an exchange of ownership. Mere physical possession can be resolved in any particular instance by force; who is functionally stronger and sufficiently motivated? It is accepted rights to which create enduring bargains.

Spreading influence
It is an instructive exercise to go through the list of Nobel Memorial Laureates and see for how many of them their seminal work was based--explicitly or implicitly--on the insights of Ronald Coase. Insights conveyed clearly and lucidly without any more mathematics than simple algebra and arithmetic.  Indeed, his two seminal articles should be read by anyone interested in social analysis.

Ronald Coase was not, however, a public intellectual in the way of KeynesHayekFriedman or Krugman. Though his work was instrumental in developing the key arguments for privatisation: indeed, the Problem of Social Cost was written as a result of a previous article on privatising the radio spectrum being challenged by Milton Friedman and other University of Chicago economists in a memorable night of argument.

Coase drew attention to the necessity of laws, rules and institutions, but also wanted economists to be a bit more sceptical about government intervention than they had been--as he pointed out governments are not immune to transaction costs. One of the reasons he disliked the concept of externalities (apart from obscuring the reciprocal nature of the issue of effects) is because he thought it encouraged intellectually lazy presumptions about government intervention. Particularly when economists did not stop to enquire how much of current private actions rested on government protections and exemptions.

Or whether other possibilities had arisen. Coase's The Lighthouse in Economics points out that the historical record regarding lighthouses does not conform to "no private provision of lighthouses is feasible" presumption of prominent economists. Elinor Ostrom's investigation of the wide range of possibilities between private ownership and government control in governing of common property is very much in the same spirit--yes, but what do people actually do, and why? There is a Coase Institute which seems to be motivated by the spirit of its namesake.

Coase may not have been a public intellectual in the way of more famous economists, but that apparently did not stop him attracting the ire of would-be policers of academic opinion. Both he and 1986 Nobel Memorial Laureate James Buchanan were apparently encouraged to leave (via) the University of Virginia because they were regarded as too "right wing". Coase refers to the hostile sentiment in the aforementioned 1997 interview:
They thought the work we were doing was disreputable. They thought of us as right-wing extremists. My wife was at a cocktail party and heard me described as someone to the right of the John Birch Society. There was a great antagonism in the '50s and '60s to anyone who saw any advantage in a market system or in a nonregulated or relatively economically free system.
A particularly silly view of Coase, as British pragmatism seems to be the best description of his views: but insisting on evidence-based policy can get in the way of all sorts of glib presumptions. As Dr Barry Marshal, the 2005 Nobel Laureate in Medicine, was also encouraged to leave said university, the University of Virginia may have an inglorious record in the number of Nobel Laureates discouraged from working there. (Though comfortable conformity is, I suppose, a branding.)

The economic blogosphere has some fine posts on Coase, with more good things in comment sections. Scott Sumner has a nice short post, Lynne Kiesling has a post with lots of links. Peter Boettke has an nice discussion of Coase's contributions.

Coase himself said of his work that:
I’ve never done anything that wasn’t obvious, and I didn’t know why other people didn’t do it. I’ve never thought the things I did were so extraordinary.
But is not pointing out the obvious-in-retrospect a mark of truly great intellectual contributions? To me, Coase is the most important economist of the C20th as his insights so expanded the ability of economics to usefully analyse social phenomena. If you think that claim of importance is too big a claim, I refer you back to the list of Nobel Memorial Prizes in Economics and how many of them had their seminal work based, at least in part, on Ronald Coase's insights.

Which he originally came to by asking folk about how they reached particular decisions. Businessfolk often seem to be the only living group academics feel entitled to analyse without ever seriously (or even not seriously) talking to any about what they do and why or ever using any work or evidence from someone who had. Here's a challenging thought: without Coase's work, how many economists would be in that situation?

[Cross-posted at Skepticlawyer.]

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