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Firm,” published in Economica (1937). In “The Nature of the Firm,” Coase ex- plained that firms exist because they re- duce the transaction costs that emerge during production and exchange, cap- turing efficiencies that individuals cannot.

Coase was heavily influenced by Frank Knight’s monumental Risk, Uncer- tainty, and Profit and Philip Wick- steed’s The Common Sense of Political Economy. The former inspired his in- terest in institutions and the structure of productive process. The latter led him to study constrained optimization prob- lems, that is, choices that are con- strained by costs, information, market prices and uncertainty.1

In his article about the Federal Com- munications Commission, Coase showed economists the crucial importance of in- stitutional property rights and how their presence or absence influences the effi- cient allocation of scarce resources. In that paper, Coase first put forward what has come to be known as the Coase

Ronald Harry Coase was born in a London suburb in 1910. He was edu- cated at the London School of Eco- nomics from 1929 through 1932, study- ing industrial law with the intention of becoming a lawyer. But that changed after his exposure to Professor of Com- merce Arnold Plant, who came to the London School of Economics from a position in Cape Town, South Africa, in 1930. Plant’s influence put Coase firmly on the road to becoming an economist and also shaped his attitude that eco- nomic theory is fine as long as it’s grounded in reality.

During 1931 – 32, Coase traveled to the United States on a scholarship to study the structure of American indus- try. This study became the basis for Coase’s lifetime fascination with indus- trial organization and his later work on the nature of firms and their costs.

After leaving the London School of Economics, Coase held a series of teach- ing positions: at the Dundee School of Economics and Commerce (1932 – 34), the University of Liverpool (1934 – 35) and the London School of Economics (1935 – 51). Immigrating to the United States in 1951, Coase taught first at the University of Buffalo, then joined the faculty of the University of Virginia in 1959. He moved to the University of Chi- cago in 1964, remaining there until 1982. He was awarded the Nobel Memorial Prize in Economic Sciences in 1991.

Coase’s central contributions to modern economic theory are recorded in two seminal articles published in the University of Chicago’s Journal of Law and Economics —“The Federal Commu- nications Commission” (1959) and “The Problem of Social Cost” (1960)—as well as in an earlier article, “The Nature of the

FEDERAL RESERVE BANK OF DALLAS VOLUME 8, NUMBER 3

Ronald Coase The Nature of Firms and Their Costs

One of my favorite philosophers — Yogi

Berra — once said “You can observe a lot just

by watching.” Economist Ronald Coase did

just that, and it earned him a Nobel Prize.

Coase has always asked economists to be keen

observers, trying to understand why things

operate as they do, rather than pure theoreti-

cians, wondering why the world doesn’t con-

form to their theoretical models of reality. And

he led the way by observing industrial orga-

nizations and structures up close before theo-

rizing about them.

Karl Marx said philosophy had ex-

plained the world and now it was necessary to

change it. Coase’s writings imply that this ap-

proach is backwards. First observe the world,

he says, and then explain it. Having done so,

we learn that in many cases it is not necessary

to change it. Adam Smith expressed this fun-

damental insight about existing institutions

and market structures with his famous

metaphor of the invisible hand. And no econ-

omist has a better claim to having furthered

this key lesson than the one we recognize with

this edition of Economic Insights, a man whose

observations changed economics forever.

— Bob McTeer President Federal Reserve Bank of Dallas

Ronald Coase

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In the Pigouvian case, party A harms party B by engaging in trades with party C (and/or D …n). It is a clear case of black and white hats, for party B is seen as an innocent bystander who is suffer- ing a negative externality (cost) from party A’s action(s). For Coase, a tort occurs only because there are conflicts over resource use and all parties can harm each other. Thus, to stop party A from harming party B is akin to harm- ing party A. In this Coasian world, the assignment of property rights does not matter in terms of the efficient eco-

essential point. That point was system- atically reiterated in one of the most- cited economics articles ever published, “The Problem of Social Cost” (1960).

Using examples from English com- mon law, Coase methodically demon- strates that regulatory interventions can, under certain conditions, lead to less economically efficient outcomes than markets alone would create. This con- trasts with the contention A. C. Pigou first put forth in The Economics of Wel- fare (1920) — that government regula- tion enhances efficiency by correcting for claimed imperfections, which Pigou called market failures.

Coase gets his results with an as- sumption of zero transaction costs, but his analysis rests also on a particular view of torts quite different from Pigou’s.

Theorem, the idea that in the absence of transaction costs, any initial property rights arrangement leads to an eco- nomically efficient outcome.

This stance was so counterintuitive that the journal editors asked Coase to retract or modify it. Coase refused to modify the article but did agree to de- fend himself at a history-making meet- ing at journal editor Aaron Director’s home in Chicago. Also present and ready to question Coase were Rueben Kessel, Milton Friedman, Martin Bailey, Arnold Harberger, Gregg Lewis, John McGee, Lloyd Mints and George Stigler, as formidably skeptical an audience as any economic theorist has probably ever faced. At the end of that evening, not only was Coase still standing, but the participants had conceded his

Outside the firm, price movements direct production, which is co-ordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated, and in place of the complicated market structure with exchange transactions is substituted the entrepre- neur–co-ordinator, who directs production. It is clear that these are alternative methods of co-ordinat- ing production. Yet, having regard to the fact that if production is regulated by price movements, pro- duction could be carried on without any organization at all, well might we ask, Why is there any organization?…

In view of the fact that while economists treat the price mechanism as a co-ordinating instrument, they also admit the co-ordinating function of the “entrepreneur,” it is surely important to inquire why co-ordination is the work of the price mechanism in one case and of the entrepreneur in another. The purpose of this paper is to bridge what appears to be a gap in economic theory between the assump- tion (made for some purposes) that resources are allocated by means of the price mechanism and the assumption (made for other purposes) that this allocation is dependent on the entrepreneur–co-ordi- nator. We have to explain the basis on which, in practice, this choice between alternatives is effected….

The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of “organizing” production through the price mech- anism is that of discovering what the relevant prices are. The cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information. The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account. Again, in certain markets, e.g., produce exchanges, a technique is devised for minimizing these contract costs; but they are not eliminated. It is true that contracts are not eliminated when there is a firm but they are greatly reduced. A factor of production (or the owner thereof) does not have to make a series of contracts with the factors with whom he is co-operating within the firm, as would be necessary, of course, if this co-operation were a direct result of the working of the price mechanism….

We may sum up this section of the argument by saying that the operation of a market costs some- thing and by forming an organization and allowing some authority (an “entrepreneur”) to direct the resources, certain marketing costs are saved. The entrepreneur has to carry out his function at less cost, taking into account the fact that he may get factors of production at a lower price than the mar- ket transactions which he supersedes, because it is always possible to revert to the open market if he fails to do this. ■

— “The Nature of the Firm,” 388 – 92

Why Do Firms Exist?

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

(a) the less the costs of organizing and the slower these costs rise with an increase in the transac- tions organized;

(b) the less likely the entrepreneur is to make mistakes and the smal- ler the increase in mistakes with an increase in the transactions organized;

(c) the greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size.

Apart from variations in the supply price of factors of production to firms of different sizes, it would appear that the costs of organiz- ing and the losses through mistakes will increase with an increase in the spatial distrib- ution of the transactions organized, in the dis- similarity of the transactions, and in the proba- bility of changes in the relevant prices. As more transactions are organized by an entrepreneur, it would appear that the transactions would tend to be either different in kind or in different places. This furnishes an additional reason why efficiency will tend to decrease as the firm gets larger. Inventions which tend to bring factors of production nearer together, by lessening spa- tial distribution, tend to increase the size of the firm. Changes like the telephone and the tele- graph which tend to reduce the cost of orga- nizing spatially will tend to increase the size of the firm. All changes which improve manager- ial technique will tend to increase the size of the firm. ■

— “The Nature of the Firm,” 396 – 97

What Determines the Size of the Firm?

remains Clifton R. Musser Professor Emeritus at Chicago’s law school.

Coase’s study of positive transac- tion costs in economic exchange led him, and by extension the entire eco- nomics field, to a remarkable conclu- sion:

I explained in “The Problem of Social Cost” that what are traded on the mark- et are not, as is often supposed by eco- nomists, physical entities but the rights to perform certain actions, and the rights which individuals possess are established by the legal system.2

For our understanding of why firms exist, why institutions have evolved as

nomic outcome because the parties will bargain their way to the same out- come regardless of how property rights are assigned, that is, regardless of who gets to sue whom. (See the box titled “A New Approach to Understanding Social Cost.”)

Coase’s analysis of the theory and history of torts, combined with his as- sumptions about what the legal system ought to do in cases of conflict over resource use—maximize economic effi- ciency and thus societal wealth rather than punish specific conduct — created a huge boost for the then-young field we now call law and economics. It also

created a strong pro-market bias in cases where prior theorists — most notably Pigou — had crafted regulatory respon- ses to perceived examples of market failure.

After his successful presentation to Chicago’s top social theorists, Coase was offered a position at the University of Chicago, where he edited the Journal of Law and Economics from 1964 to 1982. Under his editorship, the journal became one of the economics profes- sion’s most influential forums. He was the first president of the International Society for New Institutional Econom- ics, which was founded in 1996, and he

This paper is concerned with those actions of business firms which have harmful effects on others. The standard example is that of a factory, the smoke from which has harmful effects on those occupying neighboring properties. The economic analysis of such a situation has usually proceed- ed in terms of a divergence between the private and social product of the factory, in which econ- omists have largely followed the treatment of Pigou in The Economics of Welfare. The conclusions to which this kind of analysis seems to have led most economists is that it would be desirable to make the owner of the factory liable for damage caused to those injured by the smoke; or to place a tax on the factory owner varying with the amount of smoke produced and equivalent in money terms to the damage it would cause; or, finally, to exclude the factory from residential districts (and presumably from other areas in which the emission of smoke would have harm- ful effects on others). It is my contention that the suggested courses of action are inappropriate in that they lead to results which are not necessar- ily, or even usually, desirable.

The traditional approach has tended to ob- scure 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 be to 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…(An) exam- ple is afforded by the problem of straying cattle which destroy crops on neighboring land. If it is

A New Approach to Understanding Social Costs inevitable that some cattle will stray, an increase in the supply of meat can only be obtained at the expense of a decrease in the supply of crops. The nature of the choice is clear: meat or crops. What answer should be given is, of course, not clear un- less we know the value of what is obtained as well as the value of what is sacrificed to obtain it….

The problem which we face in dealing with actions which have harmful effects is not simply one of restraining those responsible for them. What has to be decided is whether the gain from prevent- ing the harm is greater than the loss which would be suffered elsewhere as a result of stopping the action which produced the harm. In a world in which there are costs of rearranging the rights es- tablished by the legal system, the courts, in cases relating to nuisance, are, in effect, making a deci- sion on the economic problem and determining how resources are to be employed. It was argued that the courts are conscious of this and that they often make, although not always in a very explicit fashion, a comparison between what would be gained and what lost by preventing actions which have harmful effects. But the delimitation of rights is also the result of statutory enactments. Here we also find evidence of an appreciation of the recip- rocal nature of the problem. While statutory enact- ments add to the list of nuisances, action is also taken to legalize what would otherwise be nui- sances under the common law. The kind of situa- tion which economists are prone to consider as re- quiring corrective governmental action is, in fact, often the result of governmental action. Such action is not necessarily unwise. But there is a real dan- ger that extensive governmental intervention in the economic system may lead to the protection of those responsible for harmful effects being carried too

far…. It is my belief that the failure of economists

to reach correct conclusions about the treatment of harmful effects cannot be ascribed simply to a few slips in analysis. It stems from basic defects in the current approach to problems of welfare economics. What is needed is a change of approach. Analysis in terms of divergences between private and social products concen- trates attention on particular deficiencies in the system and tends to nourish the belief that any measure which will remove the deficiency is nec- essarily desirable. It diverts attention from those other changes in the system which are inevitably associated with the corrective measure, changes which may well produce more harm than the original deficiency….

It would clearly be desirable if the only actions performed were those in which what was gained was worth more than what was lost. But in choosing among social arrangements within the context of which individual decisions are made, we have to bear in mind that a change in the existing system which will lead to an improvement in some decisions may well lead to a worsening in others. Furthermore, we have to take into account the costs involved in operating the various social arrangements (whether it be the working of a market or of a governmental department) as well as the costs involved in moving to a new system. In devising and choos- ing among social arrangements we should have regard for the total effect. This, above all, is the change in approach which I am advocating. ■

— “The Problem of Social Cost,” 9 5– 96, 132 – 33, 153, 155 – 56

Coase, Ronald H. (1937), “The Nature of the

Firm,” Economica 4 (November): 386 – 405.

——— (1959), “The Federal Communications

Commission,” Journal of Law and Economics 2

(October): 1 – 40.

——— (1974), “The Economics of the First

Amendment: The Market for Goods and the

Market for Ideas,” American Economic Review

64 (May): 384 – 91.

——— (1988), “How Should Economists

Choose?” in Ideas, Their Origins, and Their

Consequences: Lectures to Commemorate the

Life and Work of G. Warren Nutter

(Washington, D.C.: American Enterprise

Institute for Public Policy Research) 57 – 79.

——— (1988), “The Problem of Social Cost,”

in The Firm, the Market, and the Law

(Chicago: University of Chicago Press), 5–156,

orig. pub. 1960.

——— (1991), “The Institutional Structure of

Production,” Nobel Prize Lecture to the

Memory of Alfred Nobel, December 9, 1991,

www.nobel.se/economics/laureates/1991/

coase-lecture.html

——— (1994), Essays on Economics and

Economists (Chicago: University of Chicago

Press).

they have and how this shapes public policy, we owe a large debt to Ronald Coase. ■

— Robert L. Formaini Thomas F. Siems Senior Economists

Notes 1 Cheung (1987). 2 Coase (1991).

Sources and Suggested Reading Cheung, Steven N. S. (1987), “Ronald Harry

Coase,” in The New Palgrave: A Dictionary of

Economics, vol. 1, ed. John Eatwell, Murray

Milgate and Peter Newman (New York: Stockton

Press), 455 – 57.

Economists, or at any rate enough of them, do not wait to discover whether a the- ory’s predictions are accurate before making up their minds. Given that this is so, what part does testing a theory’s predictions play in eco- nomics? First of all, it very often plays either no part or a very minor part….

I remarked earlier on the tendency of economists to get the result their theory tells them to expect. In a talk I gave at the University of Virginia in the early 1960s, … I said that if you torture that data enough, nature will always confess, a saying which, in a somewhat altered form, has taken its place in the statisti- cal literature. Kuhn puts the point more ele- gantly and makes the process sound more like a seduction: “nature undoubtedly responds to the theoretical predispositions with which she is approached by the measuring scientist.” ■

— “How Should Economists Choose?” 72, 74

Theories and Reality: Making the Data Talk

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What is the general view that I will be examining? It is that, in the market for goods, government regulation is desirable whereas, in the market for ideas, government regulation is undesirable and should be strictly limited. In the market for goods, the government is commonly regarded as competent to regulate and properly motivated. Consumers lack the ability to make the appropriate choices. Producers often exercise monopolistic power and, in any case, without some form of government intervention, would not act in a way which promotes the public interest. In the market for ideas, the position is very dif- ferent. The government, if it attempted to regu- late, would be inefficient and its motives would, in general, be bad, so that, even if it were suc- cessful in achieving what it wanted to accomplish, the results would be undesirable. Consumers, on the other hand, if left free, exercise a fine dis- crimination in choosing between the alternative views placed before them, while producers, whether economically powerful or weak, who are found to be so unscrupulous in their behavior in other markets, can be trusted to act in the public interest, whether they publish or work for the New York Times, the Chicago Tribune or the Columbia Broadcasting System. Politicians, whose actions sometimes pain us, are in their utterances beyond reproach. It is an odd feature of this attitude that commercial advertising, which is often merely an expression of opinion and might, therefore, be thought to be protected by the First Amendment, is considered to be part of the market for goods. The result is that government action is regarded as desirable to regulate (or even suppress) the expression of an opinion in an advertisement which, if expressed in a book or article, would be

completely beyond the reach of government reg- ulation….

My argument is that we should use the same approach for all markets when deciding on public policy. In fact, if we do this and use for the market for ideas the same approach which has commended itself to economists for the market for goods, it is apparent that the case for gov- ernment intervention in the market for ideas is much stronger than it is, in general, in the mar- ket for goods….

[C]onsider the question of consumer ig- norance which is commonly thought to be a jus- tification for government intervention. It is hard to believe that the general public is in a better posi- tion to evaluate competing views on economic and social policy than to choose between different kinds of food. Yet there is support for regulation in the one case but not in the other. Or consider the question of preventing fraud, for which govern- ment intervention is commonly advocated. It would be difficult to deny that newspaper articles and the speeches of politicians contain a large number of false and misleading statements — in- deed, sometimes they seem to consist of little else. Government action to control false and mis- leading advertising is considered highly desir- able. Yet a proposal to set up a Federal Press Commission or a Federal Political Commission modeled on the Federal Trade Commission would be dismissed out of hand. ■

— “The Economics of the First Amendment: The Market for Goods and

the Market for Ideas,” 384 – 85, 389 – 90

How Much Government Intervention is Appropriate?