Ronald Coase was one of those economists whose contributions were so significant and so longstanding that you assumed he had to be dead. But he wasn’t, until yesterday, when he died at the age of 102.
Coase’s most famous contribution is the Coase Theorem, which holds that the problem of externalities — that is, me taking an action that imposes a cost on you — can be fixed without government action so long as property rights are clearly defined and transaction costs are low.
My favourite example of the Coase Theorem in action relates to airline seats. A lot of people like to complain about airline passengers who recline, taking away precious knee-room. But Coase would have said there’s a simple solution to this problem: pay the person in front of you not to recline. If you value your knee space more than he values the option to lean back, the seat will stay upright where it belongs. There’s no need for the government, or the airline, to intervene to protect your knees.
One upshot of the Coase Theorem is that it doesn’t even matter how the property rights are initially assigned. That is, we currently have a system where you own the right to decide whether to recline your seat; but if reclining were only allowed with the permission of the passenger behind you, you could buy the right to lean back from him.
The big question with the Coase Theorem is how often it’s true that property rights are clear and transaction costs are low. When I wrote about the airline seat problem two years ago, a lot of people protested to me that costs of this transaction are actually high, because people with normal personalities hate having impromptu negotiations about the price of reclining an airline seat.
That’s all a lot of whining from people who didn’t actually value their knee room enough to pay for it. But in a broader sense, they are right: Often, externalities can’t be resolved through the market because the cost of the transactions would be too high.
Carbon pollution is a good example. Reclining my airline seat might impose an externality on one person, but carbon emissions cause climate change that impacts billions of people, who cannot practically band together and negotiate a price for the emitters to stop. Government action, such as a tax, is needed to address that externality.
The Coase Theorem came out of a 1960 paper called “The Problem of Social Cost.” His other really important paper is even older: “The Nature of the Firm,” published in 1937, when he was 26 years old. Theoretically, you don’t need firms; everyone could be an independent contractor, and you might even conceivably get better market signals that way. In that key paper, Coase tries to answer the question of when and why people form companies, and why they become large or small.
Coase argues that the purpose of the firm is to reduce transaction costs: It’s easier to put your writers on staff than to negotiate a new freelance price for each individual piece of writing. Or maybe it’s not, depending on the nature of the space you’re competing in; Coase says firm size, vertical integration and the like will be determined by the relative transaction costs that arise from integrating and not integrating.
The ideas in those two papers were the main reasons Coase won the Nobel Prize in Economics 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.”
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