Ronald Coase

In "The Nature of the Firm" (1937), a brief but highly influential essay, Coase attempts to explain why the economy features a number of business firms instead of consisting exclusively of a multitude of independent, self-employed people who contract with one another. Given that "production could be carried on without any organization [that is, firms] at all", Coase asks, why and under what conditions should we expect firms to emerge?

Since modern firms can only emerge when an entrepreneur of some sort begins to hire people, Coase's analysis proceeds by considering the conditions under which it makes sense for an entrepreneur to seek hired help instead of contracting out for some particular task.

The traditional economic theory of the time (in the tradition of Adam Smith) suggested that, because the market is "efficient" (that is, those who are best at providing each good or service most cheaply are already doing so), it should always be cheaper to contract out than to hire.

Coase noted, however, a number of transaction costs involved in using the market; the cost of obtaining a good or service via the market actually exceeds the price of the good. Other costs, including search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs, can all potentially add to the cost of procuring something from another party. This suggests that firms will arise which can internalise the production of goods and services required to deliver a product, thus avoiding these costs. This argument sets the stage for the later contributions by Oliver Williamson: markets and hierarchies are alternative co-ordination mechanisms for economic transactions. [23][24]

There is a natural limit to what a firm can produce internally, however. Coase notices "decreasing returns to the entrepreneur function", including increasing overhead costs and increasing propensity for an overwhelmed manager to make mistakes in resource allocation. These factors become countervailing costs to the use of the firm.

Coase argues that the size of a firm (as measured by how many contractual relations are "internal" to the firm and how many "external") is a result of finding an optimal balance between the competing tendencies of the costs outlined above. In general, making the firm larger will initially be advantageous, but the decreasing returns indicated above will eventually kick in, preventing the firm from growing indefinitely.

Other things being equal, therefore, a firm will tend to be larger:

• the lower the costs of organising and the slower these costs rise with an increase in the number of transactions organised
• the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organised
• the greater the lowering (or the smaller the rise) in the supply price of factors of production to firms of larger size

The first two costs will increase with the spatial distribution of the transactions organised and the dissimilarity of the transactions. This explains why firms tend to either be in different geographic locations or to perform different functions. Additionally, technology changes that mitigate the cost of organising transactions across space may allow firms to become larger – the advent of the telephone and of cheap air travel, for example, would be expected to increase the size of firms.

A further exploration of the dichotomy between markets and hierarchies as co-ordination mechanisms for economic transactions derived a third alternative way called Commons based peer production, in which individuals successfully collaborate on large-scale projects following a diverse cluster of motivational drives and social signals.

Coase at the University of Chicago Law School in 2003

Upon publishing his article The Federal Communications Commission in 1959, Coase received negative feedback from the faculty at the University of Chicago over his conclusions and apparent conflicts with A. C. Pigou. According to Coase, "What I said was thought to run counter to Pigou's analysis by a number of economists at the University of Chicago and was therefore, according to them, wrong. At a meeting in Chicago I was able to convince these economists that I was right and Pigou's analysis faulty." Coase had presented his paper in 1960 during a seminar in Chicago, to twenty senior economist including George Stigler and Milton Friedman. He gradually won over the usually skeptic audience, in what has later been considered a "paradigm-shifting moment" in the genesis of Chicago Law and Economics.[25] Coase would join the Chicago faculty four years later.

Published in the Journal of Law and Economics in 1960, while Coase was a member of the Economics department at the University of Virginia, "The Problem of Social Cost" provided the key insight that it is unclear where the blame for externalities lies. The example he gave was of a rancher whose cattle stray onto the cropland of his neighbour. If the rancher is made to restrict his cattle, he is harmed just as the farmer is if the cattle remain unrestrained.

Coase argued that without transaction costs the initial assignment of property rights makes no difference to whether or not the farmer and rancher can achieve the economically efficient outcome. If the cost of restraining cattle by, say, building a fence, is less than the cost of crop damage, the fence will be built. But the better option is to bargain without the fence (the fence is, so, a transaction cost) : Coase's goal was to give a rational answer to the Frost principle and this is why W. Block shouts, at last : "Coase, get your cattle out of my property" (look at Coase's face just below for an answer). The initial assignment of property rights determines who builds the fence. If the farmer is responsible for the crop damage, the farmer will pay for the fence (as long the fence costs less than the crop damage). The allocation of property rights is primarily an equity issue, with consequences for the distribution of income and wealth, rather than an efficiency issue.

With sufficient transaction costs, initial property rights matter for both equity and efficiency. From the point of view of economic efficiency, property rights should be assigned such that the owner of the rights wants to take the economically efficient action. To elaborate, if it is efficient not to restrict the cattle, the rancher should be given the rights (so that cattle can move about freely), whereas if it is efficient to restrict the cattle, the farmer should be given the rights over the movement of the cattle (so the cattle are restricted).

This seminal argument forms the basis of the famous Coase theorem as labelled by Stigler.

Coase at the University of Chicago Law School

Though trained as an economist, Coase spent much of his career working in a law school. He is a central figure in the development of the subfield of law and economics. He viewed law and economics as having two parts, the first "using the economists' approach and concepts to analyze the working of the legal system, often called the economic analysis of the law"; and the second "a study of the influence of the legal system on the working of the economic system."[26] Coase said that the second part "is the part of law and economics in which I am most interested."

In his Simons Lecture celebrating the centennial of the University of Chicago, titled "Law and Economics at Chicago", Coase noted that he only accidentally wandered into the field:

It is generally agreed that this article has had an immense influence on legal scholarship, but this was no part of my intention. For me, "The Problem of Social Cost" was an essay in economics. It was aimed at economists. What I wanted to do was to improve our analysis of the working of the economic system. Law came into article because, in a regime of positive transaction costs, the character of the law becomes one of the main factors determining the performance of the economy. If transaction costs were zero (as is assumed in standard economic theory) we can imagine people contracting around the law whenever the value of production would be increased by a change in the legal position. But in a regime of positive transaction costs, such contracting would not occur whenever transaction costs were greater than the gain that such a redistribution of rights would bring. As a consequence the rights which individuals possess will commonly be those established by the law, which in these circumstances can be said to control the economy. As I have said, in "The Problem of Social Cost" I had no intention of making a contribution to legal scholarship. I referred to legal cases because they afforded examples of real situations as against the imaginary ones normally used by economists in their analysis. It was undoubtedly an economist who invented the widget. But in "The Problem of Social Cost" I did something else. I pointed out that the judges in their opinions often seemed to show a better understanding of the economic problem than did many economists even though their views were not always expressed in a very explicit fashion. I did this not to praise the judges but to shame economists.[27]

Despite wandering accidentally into law and economics, the opportunity to edit the Journal of Law and Economics was instrumental in bringing him to the University of Chicago:

[W]hen I was approached to fill Aaron Director's place on his retirement, what I found most attractive about coming to Chicago was the opportunity it gave me of editing the Journal. Indeed, it is probable that without the Journal I would not have come to Chicago. I knew nothing of the original aim of the Journal. What I wanted to do was to encourage the type of research which I had advocated in "The Problem of Social Cost," and I used my editorship of the Journal as a means of bringing this about.[27]

Coase believed that the University of Chicago was the intellectual center of law and economics. He concluded his Simons lecture by stating:

I am very much aware that, in concentrating in this lecture on law and economics at Chicago, I have neglected other significant contributions to the subject made elsewhere such as those by Guido Calabresi at Yale, by Donald Turner at Harvard, and by others. But it can hardly be denied that in the emergence of the subject of law and economics, Chicago has played a very significant part and one of which the University can be proud.[27]

In law and economics, the Coase theorem (/ˈkoʊs/) describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are sufficiently low transaction costs, bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasean bargaining. This 'theorem' is commonly attributed to Coase.

Another important contribution of Coase is the Coase conjecture, which is an informal argument that durable goods monopolists do not have market power because they are unable to commit to not lowering their prices in future periods.

• MacKenzie, Douglas (2008). "Coase, Ronald H. (1910– )". In Hamowy, Ronald (ed.). The Encyclopedia of Libertarianism. Thousand Oaks, CA: Sage; Cato Institute. pp. 73–74. doi:10.4135/9781412965811.n48. ISBN 978-1412965804. LCCN 2008009151. OCLC 750831024.