Ronald Coase received the Nobel Prize in 1991 for “his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.” His impact on social science has been profound. That impact stems almost entirely from just two of his articles, one published when he was 27 and the other published many years later.

Coase conceived the first article The Nature of the Firm while he was an undergraduate on a trip to the United States from his native Britain. At the time he was a socialist, and he dropped in on perennial Socialist Party presidential candidate Norman Thomas. He also visited Ford and General Motors and came up with a puzzle: how could economists say that Lenin was wrong in thinking that the Russian economy could be run like one big factory, when some big firms in the United States seemed to be run very well?

In answering his own question, Coase came up with a fundamental insight about why firms exist. Firms are like centrally planned economies, he wrote, but unlike the latter they are formed because of people’s voluntary choices. But why do people make these choices? The answer, wrote Coase, is “transaction costs.” If markets were costless to use, firms would not exist. Instead, people would make arm’s-length transactions. But because markets are costly to use, the most efficient production process often takes place in a firm. His explanation of why firms exist is now the accepted one and has given rise to a whole literature on the issue. 

The Problem of Social Cost, Coase’s other widely cited article, was even more pathbreaking; indeed, it gave rise to the field called law and economics. Economists before Coase of virtually all political persuasions had accepted the Pigouvian idea that if, say, a cattle rancher’s cows destroy his neighboring farmer’s crops, the government should stop the rancher from letting his cattle roam free or should at least tax him for doing so. Otherwise, believed economists, the cattle would continue to destroy crops because the rancher would have no incentive to stop them.

But Coase challenged the accepted view. He pointed out that if the rancher had no legal liability for destroying the farmer’s crops, and if transaction costs were zero, the farmer could come to a mutually beneficial agreement with the rancher under which the farmer paid the rancher to cut back on his herd of cattle. This would happen, argued Coase, if the damage from additional cattle exceeded the rancher’s net returns on these cattle. If, for example, the rancher’s net return on a steer was two dollars, then the rancher would accept some amount over two dollars to give up the additional steer. If the steer was doing three dollars’ worth of harm to the crops, then the farmer would be willing to pay the rancher up to three dollars to get rid of the steer. A mutually beneficial bargain would be struck.

Coase considered what would happen if the courts made the rancher liable for the damage caused by his steers. Economists had thought that the number of steers raised by the rancher would be affected. But Coase showed that the only thing affected would be the wealth of the rancher and the farmer; the number of cattle and the amount of crop damage, he showed, would be the same. In the above example, the farmer would insist that the rancher pay at least three dollars for the right to have the extra steer roaming free. But because the extra steer was worth only two dollars to the rancher, he would be willing to pay only up to two dollars. Therefore, the steer would not be raised, the same outcome as when the rancher was not liable.

This insight was stunning. It meant that the case for government intervention was weaker than economists had thought.

(Of course, because transaction costs are never zero and sometimes are very high, some courts are still needed to adjudicate between farmers and ranchers. Moreover, strategic behavior by the parties involved can prevent them from reaching the agreement, even if the gains from agreeing outweigh the transactions costs. Later economists such as Demsetz and Grief explored these circumstances surrounding the formation of property rights.)

Coase also upset the cart in the realm of “public goods”. Economists often presented lighthouses as an example of a public good that only government can provide. They chose this example not based on any information they have about lighthouses, but rather on their a priori view that lighthouses could not be privately owned and operated at a profit. Coase showed, with a detailed look at history, that lighthouses in 19th century Britain were privately provided and that ships were charged for their use when they came into port.

~ Excerpt from ‘Ronald Coase’ in The Concise Encyclopedia of Economics.