"The Nature of the Firm" 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. 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.
"The Problem of Social Cost" 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. 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. 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. In 1990, Coase wrote that he feared "The Problem of Social Cost" had been widely misunderstood.
Law and economics 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." 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: 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: 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.
Coase theorem In
law and economics, the Coase theorem () 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.
Coase conjecture 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. ==Political views==