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.
