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Ronald Coase:Uncommon common sense & a towering contrarian!

, October 17, 2013, 0 Comments

Ronald coase

Tribute to one of the intellectual giants of contemporary economics – Ronald Coase (aged 103), who passed away last month.

Coase himself acknowledged in a speech a few years after winning the 1991 Sveriges Riksbank (a.k.a the Nobel) prize for economics, fortuitous twists and turns at various points in his life prevented him from ending up as a basket weaver, a historian, a chemist or a lawyer.

What these vocations lost, economics gained in terms of a common sense economist whose feet stood firmly rooted on empirical terra firma and whose convictions refused to be swayed by the then prevailing dogma of abstract economic theory and obtuse assumptions.

Coase was educated in England and both, was taught and taught, at the London School of Economics, before deciding to move to America, where he spent the latter half of his life. A voracious writer and publisher all his life, Coase is known in contemporary economics for two outstanding yet remarkably “simple” (hindsight bias!) pieces of work.

His first paper titled “The Nature of the Firm” which was published in the Economica when he was just 27, attempted to answer a question which market centric economists had apparently failed to ask or answer –if the co-ordinating function of the market (through prices) is so powerful, why does the firm exist at all? Is there a reason? This led to an extremely insightful discovery – that markets are not always efficient and that there are frictions or transaction costs that prevent the pricing mechanism from providing optimal solutions. In simple terms, there are costs of searching for information, striking a deal or enforcing it in a market that make it more attractive to use internal co-ordination within a firm than using the price co-ordination function of markets.

In effect, Coase showed theoretically through argument and descriptive logic (Coase had a self-confessed aversion to mathematics) that firms are alternatives to the market and at the margin, a transaction would be struck either within the firm or on the market, depending on which one offers a less costly solution. His second remarkable piece of work titled “The Problem of Social Cost” offered a direct challenge to then accepted Pigovian thought that government regulation was necessary to counter problems of social cost e.g. pollution or nuisance causing activities.

Again using the tools of logical reasoning, he asserted that in the absence of transaction costs, private parties can often negotiate more efficiently and work out arrangements to mutual advantage what government regulation would not achieve. Since transaction costs exist in the real world, laws must take efficiency into account so that collective welfare can be maximised rather than trying to enforce a solution which is not efficient. In effect, he argued that laws and regulations are not relevant and the most efficient solution is optimal, in either case.

The latter led to much debate in academic circles with rebuttals and reinforcements flowing to and fro, eventually leading to an extra-ordinary outcome – “The Problem of Social Cost” is mentioned in Wikipedia as the most cited law review article in history as of June 2012.

In the wake of his demise, I have been following an interesting debate on the continued relevance of his ideas on the existence of firms, especially in the area of business strategy. Steve Denning argues on Forbes , that the firm exists for reasons other than transaction costs, principally on account of product or service complexity e.g. airline manufacturing or multi-disciplinary services. According to Steve, in the time since the publication of “The Nature of the Firm”, technology change has increased product complexity with the result that the market simply cannot provide the product or service being demanded and it is only through the coordinating activities of the firm that the goal can be efficiently achieved.

While this is apparently a strong argument, a counter-view is possible. Theoretically, the market can provide aircrafts i.e. individuals can assemble aircrafts by buying component parts from manufacturers. However, the complexity of the product makes this assembly process costly since a single individual may need to learn all aspects of aircraft technology in depth and will need to source all inputs for example, real estate for assembly and testing etc.

This would push up the time to assemble and therefore the sale price of the aircraft– also transaction costs for the buyer i.e. cost of contracting aircraft supply assembled and supplied on the market by a single individual would be very high due to risks associated with non-fulfilment or non-continuity / mortality of the supplier. Consequently, the firm emerges once again as the only viable option as it is able to surmount transaction cost barriers and assemble at lower price (even in the absence of vertical integration).

With vertical integration, the airline assembler may be able to bring down costs further by reducing dependency on key component manufacturers. Viewed from this perch, the Coasian view of why firms exist (transaction costs) seems quite consistent with the complexity view and is strengthened rather than defeated because of complexity considerations. Defence for Coase comes from Andrew Hill in the Financial times. Which one is more convincing – take your pick.

All said, Coase’s work has spawned off an entire industry of economists who have modified the assumptions of neo-classical microeconomic theory and attempted to apply their tool set to the real world – a world in which frictions exist and the market does not necessarily operate like a well-oiled machine. This industry now has a formal name – New Institutional Economics (NIE) and has been very active in the last 30 or so years. Proof that NIE is well on its way comes from the fact that 3 of its remarkable practitioners have been awarded the Nobel prize since Coase won it in 1991 – Douglass North, Elinor Ostrom and Oliver Williamson.

However, more work needs to be done on developing a coherent theory – a theory that seeks to explain how economic institutions affect the efficiency of markets, what is the process of institutional change and what implications does this process have for economic growth, especially in the developing world. Perhaps, that would be the best tribute to the enduring legacy of Ronald H Coase.