Ronald H. Coase challenged conventional economic wisdom

Ronald H. Coase challenged conventional economic wisdom

Pierre Lemieux, Special to Financial Post | 13/09/03 | Last Updated:13/09/03 4:16 PM ET

obit_ronald_coase

AP Photo/Courtesy of the University of Chicago Law SchoolThis undated photo provided by the University of Chicago Law School shows professor Ronald Coase. Coase, a Nobel Prize winner and pioneer in

Coase taught us why companies make sense, and why the polluter-pay principle doesn’t

It has been said of Ronald Coase, who died on Monday aged 102, that he wrote two articles in his career, and that each of them changed economics. In truth, Coase wrote several dozen articles and a few books, but a couple of his articles especially stand out as unique contributions.

The first seminal article was “The Nature of the Firm,” published in 1937. Why, asked Coase, does the firm exist? Why is not all production organized by arms-length contractors under the coordination of the market? Why does the authoritarian firm exist within the anarchistic context of the free market? Coase’s answer was that “there is a cost of using the price mechanism.” This cost relates to what were later labelled “transaction costs” — the costs of “discovering what the relevant prices are,” and of “negotiating and concluding a separate contract for each exchange transaction.” A firm is created when these transaction costs are higher than the costs of organizing and managing the firm.Coase was a founder of the school of economic thought called “new institutional economics.” The idea, Coase explained in a 1998 article, is to bring economics closer to “what happens in the real world,” where legal, political, social, and cultural institutions influence transaction costs, production and exchange. Mainstream economic theory, he thought, had become too abstract.

The second major article of Coase was “The Problem of Social Cost,” published in 1960. This article brought the economic analysis of institutions and the concept of transaction cost to bear on the problem of externalities, that is, costs or benefits that bypass the market. It raised the question of who should pay for environmental damages. Coase demonstrated that the polluter-payer principle is defective, or at least incomplete, from the point of view of economic efficiency. In the absence of transaction costs, it doesn’t matter who pays: Polluter and polluted will reach a bargain whereby one who creates the most value will bribe the other. Whatever the original distribution of property rights, such bargains will lead to the same, efficient solution. This result came to be called “the Coase theorem.”

Ronald Coase liked to repeat that he did not like the Coase theorem because he actually wanted to focus on real-world situations where transaction costs do exist. There, he was being a bit too iconoclastic against himself, for actual transaction costs are often smaller than the cost of political and bureaucratic solutions. At any event, the Coase theorem taught economists how to approach the problem.

For these crucial insights, “for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy,” the Nobel Foundation awarded Ronald Coase the 1991 Nobel Prize in economic sciences. His research generated a whole school of thought, the economic analysis of law.

Ronald Coase was born in the U.K. and immigrated to the U.S. in 1951. He started his career as a socialist, but the study of economics persuaded him of the efficiency of free markets and capitalism. In another famous article, “The Lighthouse in Economics,” he showed that lighthouses, a standard example of “public goods” which allegedly need to be produced by the state, were in fact built and operated mainly by private entrepreneurs in England until the 19th century — albeit with the cooperation of customs agents who collected the fees in ports.

In a 1959 article, Coase suggested that frequencies on the electromagnetic spectrum should be auctioned to the highest bidders, instead of being allocated by a bureaucratic command-and-control system or through lobby-laden politics. The most important requirement of his proposal was to define private property rights on frequencies. The basic idea is the same as in the Coase theorem: Companies who can create the most value will end up purchasing the frequencies. If a specific wavelength belonging to you is more valuable to my customers than to yours, I will offer you more money than you can expect to make in profits, and you will sell. It took four decades for Coase’s revolutionary ideas to start being implemented— in a still very incomplete way.

In 2012, Ronald Coase published with Ning Wang of Arizona State University a new book, How China Became Capitalist. The book is full of original analyses on China’s extraordinary development over the past three decades —more despite government intervention than because of it. Coase and Wang quote reformer Deng Xiaoping, who was one of the main rulers of China from 1978 to 1992: “let some people get rich first.” By “some people,” he meant not only rulers. This simple recipe, like many of Coase’s ideas, seems to have eluded economists for several decades.

Ronald Coase did not address nor solve all problems in economics, but his work constantly challenged conventional wisdom. It also demonstrated in numerous ways the importance of exchange and free markets.

Pierre Lemieux is an economist and author of The Public Debt Problem: A Comprehensive Guide (Palgrave Macmillan, 2013). PL@pierrelemieux.com.

Remembering Ronald Coase

by Larry Downes  |   3:19 PM September 3, 2013

Yesterday, I texted a non-economist friend to say how sad I was to learn of the death of Ronald H. Coase, who won the Nobel Prize in Economics in 1991. She wrote back, “Was it sudden or unexpected?” Well, I answered, he was 102 years old. So no. Not unexpected.

As for sudden, it did feel so to me. I haven’t actually seen Prof. Coase since I moved from Chicago ten years ago. But I’ve just finished work on a new book with Paul Nunes on the new age of disruptive innovation (based on our March 2013 HBR article, “Big Bang Disruption“). That work brought me back, as so many things do, to Coase’s early writings — in particular his two searingly critical yet insightful essays, “The Nature of the Firm” (1937) and “The Problem of Social Cost”(1960). In these last few months, Coase, his ideas, and the very large intellectual debt I owed to them were all very much in my thoughts. So, yes, his death struck me as sudden.

“The Problem of Social Cost,” Coase once told me, was the reason he spent his career not in an economics department or a business school but at the University of Chicago School of Law. As The New York Times recounted in its obituary, during a famous dinner party Coase had to fight the entire economics department at Chicago to convince them that his novel theory on the relationship between property rights and legal rules — ever-since known as the Coase Theorem — was correct.

The group, which included Milton Friedman and George Stigler, was eventually convinced, but they didn’t invite Coase to join the department. Yet “The Problem of Social Cost” has proven to be one of the most-cited articles in the history of economics.

The earlier essay, “The Nature of the Firm,” is justly famous for its introduction to economic literature of the concept of market friction, or what Coase called “transaction costs.” Transaction costs, Coase argued, explained why some interactions were left to the market and others were internalized in increasingly large, complex enterprises.

“The Nature of the Firm” was published in 1937, when giant multinationals such as General Motors were just coming into prominence. Coase had observed first-hand the efficiencies to be gained by internalizing market transactions. Having finished his coursework at the London School of Economics but with another year of required study to go, Coase secured a traveling scholarship, which he used to come to the United States to see for himself what firms were like — what they did and didn’t do, and why.

This was perhaps his most radical contribution to modern economics. He always insisted that the more theoretical, formula-driven work that economists tended towards were of limited value. In articles, reviews, and speeches, he spent his entire career — all eighty years or so of it, up to and including one of his last publications, an essay in HBR in December 2012 — admonishing, extolling, and sometimes outright pleading with his colleagues to turn economics into a true social science, one driven by empirical research. (He gave up on traditional economics in 1996 and started his own group, the International Society for New Institutional Economics, which continues to this day.)

I had personal experience of Coase’s passion for hands-on research — the beginning of a long and always surprising relationship. In the course of an independent study during my third year of law school at Chicago, I came across an interesting experiment going on at nearby Motorola, which had built software to “engineer” complex contracts.

The system was built to help lawyers select the most useful clauses and knit them together, simplifying the often-wasteful process of negotiation between Motorola and its business partners. If clauses had already been reviewed and agreed to in previous contracts, why not start with those rather than drafting from scratch? Why not, in other words, eliminate as many of the transaction costs as possible?

I arranged a visit to meet with Motorola’s contracts team. And then I thought, why not invite Coase? He was long-since retired and had just won the Nobel Prize, but he still had an office at the law school, and still participated occasionally in activities of the school’s law and economics program. So I wrote him a note and invited him to come along. To the astonishment of some of my faculty advisors, his secretary called a few days later to say he would be pleased to join me.

I picked Prof. Coase up at his home and drove him out to Motorola headquarters in suburban Chicago, where we spent the afternoon quizzing the lawyers and the system’s developers, and where we had lunch in the company cafeteria. Coase, then a spry 80 year-old, asked the most interesting questions, and delighted our hosts with stories about the company’s early history. At the end of the day, Coase thanked me for inviting him and for serving as chauffeur, and told me to let him know when I was next going to take to the field. I was stunned from beginning to end.

I graduated law school, but after a very brief time practicing at a Silicon Valley firm I returned to consulting, which I had done for a decade before. That in turn led to my first book, Unleashing the Killer App, which took an early look at how the Internet was changing the nature of business strategy.

But the insight that grounded Killer App came to me at a conference, listening to engineers talk about how open networking standards could simplify connections between devices and users. And I thought, ah, it’s all about transaction costs. In my notes of the conference, I wrote down, simply, “Coase!”

Chapter Two of Killer App argued that Coase was the father of the new economy, where technology in the market was reducing transaction costs more quickly than technology inside firms, which couldn’t adapt as quickly. The result, I said, was that firms would get smaller, or even virtual — a simple corollary to Coase’s 1937 observation, which I called “The Law of Diminishing Firms.”

I sent Coase a draft of the chapter, and he quickly sent back a stern handwritten note to say that I had misread some things. (Coase was notorious for his plain-spoken criticisms.) We should meet for lunch soon, he said, so he could set me straight. Of course I agreed immediately, and met him, tail tucked firmly between legs, at a nearby coffee shop a few days later. As it turned out, my sins were more venal than cardinal — I had erred mostly in a few biographical facts about Coase, which were easily corrected.

The revised chapter met his approval, or in any case did not generate any further disapproval. When I invited Coase to come to the launch party for the book, well, he came, and patiently answered questions from some very surprised attendees, who didn’t expect a Nobel laureate to show up for a book party for a non-academic publication. I had long ceased being surprised by anything Coase did or did not do.

Since then, Chapter Two of every book I’ve written has been about the impact of Coasean economics on whatever I’m writing about, whether business strategy, technology deployment, or regulatory policy. But in truth, every chapter, every book, every blog post I’ve written is, in some sense, in debt to Coase. If not his insights, then certainly his work ethic.

Most of the obituaries, remembrances, and accolades he will deservedly receive in the coming weeks will focus on his groundbreaking work, his uncompromisingly critical mind, and his devotion to his field. I will read all of these. But I will be tempering these portraits of a daunting intellectual giant with fondness for the Ronald Coase I had the pleasure to know, a man who was inexplicably kind to me whenever I asked him for help.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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