The ninth scholar we discuss in our series, In Memoriam, is yet another Nobel laureate and yet another of my personal heroes, Ronald Coase. Coase was born in 1910 in the UK where he attended the LSE. Coase was, by his own amused admission, a lifelong economist who never studied economics. Of course, he meant that his degree was in commerce and that his economics training was largely autodidactic.
Coase initially thought he would become a lawyer or historian. Such predilections might help explain the fact that, despite a career spent in the academe, Coase was doggedly empirical and eschewed the trend in modern economics toward increasing theoretical (i.e. mathematical) sophistication in isolation from the real world and the functioning of real institutions. Coase was truly a prolific thinker and writer—he published his last book, How China Became Capitalist, in 2012 at age 101—and his contributions to the social sciences are too many to be recounted here. I will limit my remarks to the contribution by Coase that began his 80-year career as an institutional economist.
Nature of the Firm
In the 1930’s, as a student and still quite a young man, Coase began struggling with somewhat of a paradox. While many economists were arguing that markets require no top-down coordination, or, to put it another way, that markets worked most efficiently when coordinated in a decentralized fashion by countless individual decision-makers each responding to changes in relative prices of the factors of production, Coase observed that “within a firm, the description does not fit at all.” In effect, real markets operated with a high degree of conscious control over some operations and virtually no conscious control over others:
Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-coordinator, who directs production. It is clear that these are alternative means of coordinating production. Yet, having regard to the fact that if production is regulated by price movements, production could be carried on without any organization at all, well might we ask, why is there any organization? [Download "The Nature of the Firm" (1937) here]
After visiting American factories and businesses, Coase realized several things. First, “there is a cost of using the price mechanism.” These costs are largely the costs associated with finding what the relevant prices are and of organizing exchanges around the fluctuations of those prices. Second, firms form because they are seen as reducing many of these costs, especially when it comes to certain factors of production such as labor. Moreover, market actors must decide whether it is cheaper to make or buy, that is, whether to organize internally or exchange on the market for a factor of production. Thus, how production decisions are made within a market are determined by a comparison of costs which till Coase were not properly taken into account by theoretical economists. These costs, known now as transactions costs, are essential to understanding the nature and function of institutions in various aspects of social and economic life. Thanks to the insight of Coase, multiple disciplines now take account of these costs as well as what they reveal about the human propensity toward institution-building.
Hat’s off to you, Professor Coase!