Ronald Coase received the Nobel Prize in 1991 “for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.” Coase is an unusual economist for the twentieth century, and a highly unusual Nobel Prize winner. First, his writings are sparse. In a sixty-year career he wrote only about a dozen significant papers—and very few insignificant ones. Second, he uses little or no mathematics, disdaining what he calls “blackboard economics.” Yet his impact on economics has been profound. That impact stems almost entirely from two of his articles, one published when he was twenty-seven and the other published twenty-three years later.
Coase conceived of the first article, “The Nature of the Firm,” while he was an undergraduate on a trip to the United States from his native Britain. At the time he was a socialist, and he dropped in on perennial Socialist Party presidential candidate Norman Thomas. He also visited Ford and General Motors and came up with a puzzle: how could economists say that Lenin was wrong in thinking that the Russian economy could be run like one big factory, when some big firms in the United States seemed to be run very well? In answering his own question, Coase came up with a fundamental insight about why firms exist. Firms are like centrally planned economies, he wrote, but unlike the latter they are formed because of people’s voluntary choices. But why do people make these choices? The answer, wrote Coase, is “marketing costs.” (Economists now use the term “transaction costs.”) If markets were costless to use, firms would not exist. Instead, people would make arm’s-length transactions. But because markets are costly to use, the most efficient production process often takes place in a firm. His explanation of why firms exist is now the accepted one and has given rise to a whole literature on the issue. Coase’s article was cited 169 times in academic journals between 1966 and 1980.
“The Problem of Social Cost,” Coase’s other widely cited article (661 citations between 1966 and 1980), was even more pathbreaking; indeed, it gave rise to the field called law and economics. Economists before Coase of virtually all political persuasions had accepted British economist Arthur Pigou’s idea that if, say, a cattle rancher’s cows destroy his neighboring farmer’s crops, the government should stop the rancher from letting his cattle roam free or should at least tax him for doing so. Otherwise, believed economists, the cattle would continue to destroy crops because the rancher would have no incentive to stop them.
But Coase challenged the accepted view. He pointed out that if the rancher had no legal liability for destroying the farmer’s crops, and if transaction costs were zero, the farmer could come to a mutually beneficial agreement with the rancher under which the farmer paid the rancher to cut back on his herd of cattle. This would happen, argued Coase, if the damage from additional cattle exceeded the rancher’s net returns on these cattle. If, for example, the rancher’s net return on a steer was two dollars, then the rancher would accept some amount over two dollars to give up the additional steer. If the steer was doing three dollars’ worth of harm to the crops, then the farmer would be willing to pay the rancher up to three dollars to get rid of the steer. A mutually beneficial bargain would be struck.
Coase considered what would happen if the courts made the rancher liable for the damage caused by his steers. Economists had thought that the number of steers raised by the rancher would be affected. But Coase showed that the only thing affected would be the wealth of the rancher and the farmer; the number of cattle and the amount of crop damage, he showed, would be the same. In the above example, the farmer would insist that the rancher pay at least three dollars for the right to have the extra steer roaming free. But because the extra steer was worth only two dollars to the rancher, he would be willing to pay only up to two dollars. Therefore, the steer would not be raised, the same outcome as when the rancher was not liable.
This insight was stunning. It meant that the case for government intervention was weaker than economists had thought. Yet Coase’s soulmates at the free-market-oriented University of Chicago wondered, according to George Stigler, “how so fine an economist could make such an obvious mistake.” So they invited Coase, who was then at the University of Virginia, to come to Chicago to discuss it. They had dinner at the home of Aaron Director, the economist who had founded the Journal of Law and Economics.
We strongly objected to this heresy. Milton Friedman did most of the talking, as usual. He also did much of the thinking, as usual. In the course of two hours of argument the vote went from twenty against and one for Coase to twenty-one for Coase. What an exhilarating event! I lamented afterward that we had not had the clairvoyance to tape it.
Stigler himself labeled Coase’s insight the Coase theorem.