Economist Ronald Coase died today. He was 102 years old. To pin his career down to two articles is to say not nearly enough, but two in particular have been hugely influential, both to the discipline and to my own thinking: “The Problem of Social Cost” and “The Nature of the Firm.”
In “The Problem of Social Cost,” Coase tackled the idea of competing resource uses and showed that when transaction costs are zero, it doesn’t matter who holds the original grant of right, the resource will end up in the hands of the user who values it mostly highly. All that will change is whether money is exchanged. To illustrate he uses an example of a cattle-raiser and a crop farmer operating adjacent to each other, so that without a fence the cattle damage the farmer’s crops, but a more intuitive (and hence more common) example is of an upstream user that pollutes the water and a downstream user that needs clean water. Typically we blame the polluter for the harm done, but as Coase notes, just as the polluter imposes costs on the downstream user, so the downstream user’s needs impose a cost on the upstream user.
The traditional approach has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm.
In the traditional resolution, the “harmer” has to pay the “victim,” but Coase shows that both are harming each other, so ideally we could sort out the problem by letting the higher value user buy out the lower value user. Of course in the real world transaction costs are never zero, so some would sniff at this fluffy theoretical idea. Such sniffing is appropriate when conflicting users are many, resulting in exceptionally high transaction costs, but when we are talking about two users, in proximity to each other, and with awareness of each other, transaction costs can be minimal (although never zero, because at a minimum completing the transaction requires some expenditure of time).
The application to environmental issues is fairly obvious, and one thing I’ve taken from this is to emphasize competing values of uses for particular resources when we consider environmental problems, and to emphasize that it’s often the case that environmentalists are either demanding something that is socially costly (would reduce the net value gained from the resource if a more valuable use is prevented) or, if the environmental benefit is really more valuable, can get that through the market. Case in point: The Nature Conservancy (just today on a field trip for my Environmental Politics class I pointed out a Nature Conservancy site that preserves a prairie wetland that drains into our major local river, whose likely alternative use is either agricultural or for a subdivision).
This article also provided one of the highlights of my graduate school career. A professor (whom I didn’t love much) was giving a talk on his planned new research program in environmental politics, and stated that he was going to base it on a Coasean analysis. He then proceeded to talk about an upstream user and a downstream user, and how the upstream user was harming the downstream user. At the end of the talk I raised my hand and pointed out that this was in contradiction to what Coase actually assumed, which produced the marvelous response of, “Hmm, I guess I should read Coase’s paper.”
“The Nature of the Firm,” considered why firms grew by internalizing operations, rather than contracting with other firms for their needs, through the market. It was written in the 1930s, when “vertical integration” (e.g., a steel-making firm owning not just its mills, but also the ore mines, and even the coal mines for the coal to power their mills) was all the rage, and theorists were trying to understand why businessmen were making that type of decision. In a nutshell, Coase argued that it was–again–about transaction costs. Firms internalized to avoid the transaction costs of contracting through the marker, but only up to the point where marginal internal management costs did not exceed the marginal costs of transacting. It’s wonderfully elegant and explanatory (although, of course, it’s undergone some refinement in details since then).
And as old as it is, I say it’s as-if not more–relevant than ever, given that so many new tech firms are forgoing the vertical integration model to a contract model. Microsoft realized early on that it didn’t need to build hardware, and you can even buy a computer from a company that does almost nothing other than organize the contracting out of the whole process–an order is submitted online, received by a contracted manufacturer who puts the parts together, it’s shipped via UPS, and the billing is done by a billing service. The most amazing part is that I’ve seen business writers asking why, wholly unaware that Coase gave them the answer 3/4 of a century ago.
I think the analysis, with proper refinements and adjustments, is relevant to all social organization, of societies, states (countries), provinces and large metropolitan areas (where it should be a complement to Tiebout sorting as an analytical model). I don’t think it’s been done much, yet. If so, it’s in the public choice lit and I should know about it, but don’t.
The value of Coase’s insights sheds light on the debate about whether the social sciences are, properly, sciences, as challenged recently in the New York Times, and discussed just yesterday at The Monkey Cage.
The NYT has a full obituary.