Ronald Coase died Monday in Chicago at 102.
The Nobel Laureate in Economics in 1991, his two most famous papers, The Nature of the Firm (1937) and The Problem of Social Cost (1960) began by asking such profoundly simple questions—the word “childlike” is fitting, in the kindest sense—that the insights he derived would revolutionize our understanding of why companies exist and how liability for harmful activity should be assigned.
The first simply asked why companies exist at all; why create managerial overhead if, following (if mangling) Adam Smith, individuals could be relied upon to each seize upon and contribute their most valuable productive activity to the market so that an assembly line (say) ought to be able to spontaneously self-organize? Of course, to ask the question is to answer it: The transaction costs of every worker on the assembly line having to negotiate the terms of their participation in the joint venture would be prohibitive. But nobody had asked the question before.
More generally, the answer to “why do companies exist?” is that they make economic sense when they can reduce or eliminate transaction costs by subsuming those negotiations within their own structure rather than dealing at arm’s length for every deal. And it’s not far from that 1937 insight to the understanding that corporations in the first half of the 20th Century tended to become larger and more vertically integrated, whereas since the information revolution gained traction, they’ve reversed course and begun outsourcing even the most basic of operations (payroll, for example).
As the Financial Times put it in their obit of Coase:
For example, an assembly line demanded hierarchy because the costs of bargaining between each successive stage of production would be too great. A wheel fits only on an axle for which it has been designed: command and control is superior to markets in these idiosyncratic transactions. But General Motors, for instance, might buy in its tyres because the savings from competitive tendering would be greater than the benefits of ownership. Half a century later, “make” versus “buy” decisions would be routine case studies in business schools. Coase was the first to see how this issue defined the shape of the modern corporation.
I scarcely need point out that this is the starting point of analysis for the “right-sizing” of law firms, with implications for which functions and activities should, and should not, be conducted under each firm’s roof. Yes, it immediately gets complex when you delve into it, but that’s why you’re paid to manage and lead.
His second famous paper took on another bedrock assumption, that the only way to keep people and firms from doing things that injured others (polluting is the classic example) was to impose governmental regulation. Again, he pointed out that that was not necessarily so if transaction costs were sufficiently low—so that the affected parties could negotiate directly and settle the conflict privately. The goal of assigning liability should be to minimize transaction costs, not to assign blame.
The notion that liability should be imposed on the “cheapest cost-avoider,” as the shorthand has it, was not just unheard-of but deemed implausible in the extreme.
Using the example of a polluting factory, it’s cheaper to assign primary responsibility to the factory not because it’s “at fault” but because the alternative, assigning responsibility to the downwind neighbors, would incur insuperable transactions costs as they attempted to organize into a coherent bloc to negotiate with the factory, all the while avoiding the devilish problems of free-riders, holdouts, and so on. But Coase’s fundamental insight was that no matter where liability was assigned the same ‘optimal’ level of pollution would be negotiated.
This was so counterintuitive that the famous story is told of Coase having to defend his thesis (here, from the University of Chicago Law School’s essay on Coase’s passing):
Coase described being invited to defend [a previous paper on the FCC’s allocation of broadcast spectrum asserting essentially the same thesis] at University of Chicago Professor Aaron Director’s home. He was able to persuade them to his view that as long as legal rights are properly defined, efficient solutions will prevail. He was asked to write an article for The Journal of Law and Economics, which Director had recently founded. The outcome was “The Problem of Social Cost.”
“Had it not been for the fact that these economists at the University of Chicago thought that I had made an error in my article on The Federal Communications Commission, it is probable that ‘The Problem of Social Cost’ would never have been written,” Coase said.
George Stigler, an economist at UChicago and 1982 Nobel Prize winner, later wrote about that night: “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 21 against and one for Coase to 21 for Coase.
“What an exhilarating event! I lamented afterward that we had not had the clairvoyance to tape it.”
Coase was born in the London suburb of Willesden in 1910, the son of two Post Office workers who both ended their schooling at age 12. He earned a scholarship to the London School of Economics where Sir Arnold Plant, a well-known economist at the time, introduced him to Adam Smith’s invisible hand and helped him win a scholarship to travel to the US to investigate the structure of American industry. Coase would always refer to himself as “an accidental economist,” and indeed his two famous papers are remarkably equation- and jargon-free. Richard Epstein, writing his own memorial of Coase, described their last meeting, last year:
He thought that the wave of the future involved understanding China and in starting a scholarly publication called “The Journal of Man,” which would be designed to rid economics of what he termed the sins of “blackboard economics,” which did not draw its inspiration from the behavior of real individuals in concrete contexts.
Epstein distills Coase’s value to us today:
Why was Ronald so great? The answer is not because he was smart. In fact, I suspect that by the usual measures of intelligence Ronald would not do well against the types who excel in proving mathematical theorems or solving crossword puzzles. No, Ronald was not “smart.” But he was brilliant. He could look at the most mundane facts of ordinary life and distill from them insights about how the world worked — and, indeed, had to work.
After emigrating to the US in 1951 and teaching at SUNY/Buffalo and the University of Virginia, among other places, he was appointed to the Chicago Law School faculty in 1964 and stayed there the rest of his life. His wife of more than 75 years, Marion, died last year.