Jonathan B. Wight

Reading Ronald Coase – Pt. II

I'm still getting through Ronald Coase's, Essays on Economics and Economists (Chicago: University of Chicago Press, 1994).

In the first chapter, Coase sums up the major insight from his article "The Theory of the Firm" (1937), a breakthrough he had worked out five years earlier at the tender age of 21!

I found the answer by the summer of 1932. It was to realize that there were costs of using the pricing mechanism. What the prices are have to be discovered. There are negotiations to be undertaken, contracts to be drawn up, inspections to be made, arrangements to be made to settle disputes, and so on. These costs have common to be known as transaction costs. Their existence implies that methods of coordination alternative to the market, which are themselves costly and in various ways imperfect, may nonetheless be preferable to relying on the pricing mechanism, the only method of coordination normally analyzed by economists. It was the avoidance of the costs of carrying out transactions through the market that could explain the existence of the firm, in which the allocation of factors came about as a result of administrative decisions...(pps. 7-8).

The implication is that "to have an efficient economic system it is necessary not only to have markets but also areas of planning within organizations of the appropriate size." (Page 8).

If this were the only insight of Ronald Coase, he would deserve to be remembered forever in the discipline. But it is incorrect to say that he was the first to grapple with transaction costs. Transaction costs play a critical role in Adam Smith's acceptance of the invisible hand in The Wealth of Nations (for a longer analysis, see here).

When discussing the political economy of trade, Smith argues that business people lack familiarity with their overseas trading partners and may also face questionable legal systems abroad. High transaction costs thus make it riskier to take capital abroad and the home country thus unintentionally gains investment that promotes higher domestic output and employment:

Thus, upon equal or nearly equal profits, every wholesale merchant naturally prefers the home trade to the foreign trade of consumption, and the foreign trade of consumption to the carrying trade.... He can know better the character and situation of the persons whom he trusts, and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress. (WN, Glasgow Edition, p. 454)

Hence, Smith argues against imposing capital controls because they are unnecessary. But what makes this the result in this case? It is because there is more trust and better legal remedies in the home market. In short, Smith's endorsement of laissez-faire capital is contingent on the existence of lower transactions costs in the domestic market!

Social economics -- the consideration of the ways in which people interact in markets -- is essentially a story about transaction costs, even though Adam Smith would ground the social instincts in moral sentiments not calculations.