Friday, 17 December 2010

Coase's big idea

The 2009 Nobel Prize in Economics co-winner Oliver Williamson has this to say about Ronald Coase
Ronald Coase is a seminal thinker and has a timeless message. On my reading, the essence of Coase is this: 1) push the logic of zero transaction costs to the limit; 2) study the world of positive transaction costs; 3) because hypothetical forms of economic organization are operationally irrelevant, and because all feasible forms of organization are flawed, assess alternative feasible forms of organization in a comparative institutional way; 4) because the action resides in the details, study the microanalytics of contract, contracting, and organization. That is a subtle and powerful combination of ideas and turns out to be difficult to implement. Although much of it goes against the main tradition, it has nevertheless made progressive headway in relation to, and parts have been incorporated within, orthodoxy.
For me the central message of Coase resides in the second of Williamson's points: study the world of positive transaction costs. It is only when we consider positive transaction costs that we can make sense of economic organisations. The firm is a product of having to deal with positive transaction costs. In a zero transaction cost world there would be no firms. As Foss, Lando and Thomsen (2000: 632) summarise it:
"The pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist".
Coase changed the very way we see economic organisations. The theory of the firm for Ronald Coase, Oliver Williamson or Oliver Hart is a very different thing from that of Arthur Pigou, Lionel Robbins, Jacob Viner, Joan Robinson or Edward Chamberlin. The questions asked of the theory have changed from being about how the firm acts in the market, how it prices its outputs or how it combines its inputs, to questions about the firm's existence, boundaries and internal organisation. That is, there has been a movement away from the theory of the firm being seen as developing a component of price theory, namely issues to do with firm behaviour, to the theory being concerned with the firm as a subject in its own right.

This change in questions is Coase's great contribution to the theory of the firm. He changed the path analysis of the firm went down. Coase's 1937 paper "The Nature of the Firm" was, as Hal Varian puts it, a "Big Idea". In Coase's work we see most of the main issues of the modern theory of the firm being raised together for the first time. He sets out to "discover why a firm emerges at all in a specialized exchange" - a question about the existence of the firm; he also sets out to "study the forces which determine the size of the firm" - an issue to do with the boundaries of the firm; and he inquires into the reasons for "diminishing returns to management" - issues to do with the internal organisation of the firm. It was the efforts to answer these questions that initiated the charge from seeing the theory of the firm as just part of price theory to seeing it as an important topic in its own right. Coase also provides one of the main building block for answers to these issues, the "costs of using the price mechanism" or transaction costs.

The importance of Coase (1937) stems from the fact that it was the major catalyst, albeit with a long delay, for the modern theory of the firm and the theory of economic organisations more generally. Coase notes "[t]he article was not an instant success." (Coase 1988: 23). In fact it took nearly 40 years for it to become an overnight success.

Coase, who turns 100 on the 29th of December, has a new book coming out from Palgrave Macmillan and the Institute of Economic Affairs, How China Became Capitalist, early next year. It’s coauthored with Ning Wang, an assistant professor at Arizona State. Not bad for an old guy!

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