- Shopping Bag ( 0 items )
In fifteen essays, Coase evaluates the contributions of a number of outstanding figures, including...
In fifteen essays, Coase evaluates the contributions of a number of outstanding figures, including Adam Smith, Alfred Marshall, Arnold Plant, Duncan Black, and George Stigler, as well as economists at the London School of Economics in the 1930s.
Ronald H. Coase was awarded the Nobel Prize in Economic Science in 1991.
The Institutional Structure of Production
In my long life I have known some great economists but I have never counted myself among their number nor walked in their company. I have made no innovations in high theory. My contribution to economics has been to urge the inclusion in our analysis of features of the economic system so obvious that, like the postman in G. K. Chesterton's Father Brown tale, "The Invisible Man," they have tended to be overlooked. Nonetheless, once included in the analysis, they will, I believe, bring about a complete change in the structure of economic theory, at least in what is called price theory or microeconomics. What I have done is to show the importance for the working of the economic system of what may be termed the institutional structure of production. In this lecture I shall explain why, in my view, these features of the economic system were ignored and why their recognition will lead to a change in the way we analyse the working of the economic system and in the way we think about economic policy, changes which are already beginning to occur. I will also speak about the empirical work that needs to be done if this transformation in our approach is to increase our understanding.
In speaking about this transformation, I do not wish to suggest that it is the result of my work alone. Oliver Williamson, Harold Demsetz, Steven Cheung, among others, have made outstanding contributions to the subject, and without their work and that of many others, I doubt whether the significance of my writings would have been recognised. While it has been a great advantage of the creation of the Prize in Economic Sciences in Memory of Alfred Nobel that, by drawing attention to the significance of particular fields of economics, it encourages further research in them, the highlighting of the work of a few scholars, or, in my case, one scholar, tends to obscure the importance of the contributions of other able scholars whose researches have been crucial to the development of the field.
I will be speaking of that part of economics which has come to be called industrial organisation but, to understand its present state, it is necessary to say something about the development of economics in general. During the two centuries since the publication of the Wealth of Nations, the main activity of economists, it seems to me, has been to fill the gaps in Adam Smith's system, to correct his errors and to make his analysis vastly more exact. A principal theme of the Wealth of Nations was that government regulation or centralised planning were not necessary to make an economic system function in an orderly way. The economy could be co-ordinated by a system of prices (the "invisible hand") and, furthermore, with beneficial results. A major task of economists since the publication of the Wealth of Nations, as Harold Demsetz has explained, has been to formalise this proposition of Adam Smith. The given factors are technology and the tastes of consumers. Individuals, who follow their own interest, are governed in their choices by a system of prices.
Economists have uncovered the conditions necessary if Adam Smith's results are to be achieved and where, in the real world, such conditions do not appear to be found, they have proposed changes which are designed to bring them about. It is what one finds in the textbooks. Harold Demsetz has said rightly that what this theory analyses is a system of extreme decentralisation. It has been a great intellectual achievement and it throws light on many aspects of the economic system. But it has not been by any means all gain. The concentration on the determination of prices has led to a narrowing of focus which has had as a result the neglect of other aspects of the economic system. Sometimes, indeed, it seems as though economists conceive of their subject as being concerned only with the pricing system and anything outside this is considered as no part of their business. Thus, my old chief and a wonderful human being, Lionel Robbins, wrote in The Nature and Significance of Economic Science, about the "glaring deficiencies" of the old treatment of the theory of production with its discussion of peasant proprietorships and industrial forms: "It suggests that from the point of view of the economist 'organisation' is a matter of internal industrial (or agricultural) arrangement—if not internal to the firm, at any rate internal to 'the' industry. At the same time it tends to leave out completely the governing factor of all productive organisation—the relationship of prices and cost."
What this comes down to is that, in Robbins's view, an economist does not interest himself in the internal arrangements within organisations but only in what happens on the market, the purchase of factors of production and the sale of the goods that these factors produce. What happens between the purchase of the factors of production and the sale of the goods that are produced by these factors is largely ignored. I do not know how far economists today share Robbins's attitude but it is undeniable that microeconomics is largely a study of the determination of prices and output, indeed this part of economics is often called price theory.
This neglect of other aspects of the system has been made easier by another feature of modern economic theory—the growing abstraction of the analysis, which does not seem to call for a detailed knowledge of the actual economic system or, at any rate, has managed to proceed without it. Bengt Holmstrom and Jean Tirole, writing on "The Theory of the Firm" in the recently published Handbook of Industrial Organization, conclude at the end of their 63-page article that "the evidence/theory ratio ... is currently very low in this field." Sam Peltzman has written a scathing review of the Handbook in which he points out how much of the discussion in it is theory without any empirical basis.
What is studied is a system which lives in the minds of economists but not on earth. I have called the result "blackboard economics." The firm and the market appear by name but they lack any substance. The firm in mainstream economic theory has often been described as a "black box." And so it is. This is very extraordinary given that most resources in a modern economic system are employed within firms, with how these resources are used dependent on administrative decisions and not directly on the operation of a market. Consequently the efficiency of the economic system depends to a very considerable extent on how these organisations conduct their affairs, particularly, of course, the modern corporation. Even more surprising, given economists' interest in the pricing system, is the neglect of the market or more specifically the institutional arrangements which govern the process of exchange. As these institutional arrangements determine to a large extent what is produced, what we have is a very incomplete theory.
All this is beginning to change and in this process I am glad to have played my part. The value of including such institutional factors in the corpus of mainstream economics is made clear by recent events in Eastern Europe. These ex-communist countries are advised to move to a market economy, and their leaders wish to do so, but without the appropriate institutions no market economy of any significance is possible. If we knew more about our own economy, we would be in a better position to advise them.
What I endeavored to do in the two articles cited by the Royal Swedish Academy of Sciences was to attempt to fill these gaps or more exactly to indicate the direction in which we should move if they are ultimately to be filled. Let me start with "The Nature of the Firm" (1937). I went as a student to the London School of Economics in 1929 to study for a bachelor of commerce degree, specialising in the Industry group, supposedly designed for people who wished to become works managers, a choice of occupation for which I was singularly ill-suited. However, in 1931, I had a great stroke of luck. Arnold Plant was appointed professor of commerce in 1930. He was a wonderful teacher. I began to attend his seminar in 1931, some five months before I took the final examinations. It was a revelation. He quoted Sir Arthur Salter: "The normal economic system works itself." And he explained how a competitive economic system co-ordinated by prices would lead to the production of goods and services which consumers valued most highly. Before being exposed to Plant's teaching, my notions on how the economy worked were extremely woolly. After Plant's seminar I had a coherent view of the economic system. He introduced me to Adam Smith's "invisible hand."
As I had taken the first year of University work while still at high school, I managed to complete the requirements for a degree in two years. However, university regulations required three years of residence before a degree could be granted. I had therefore a year to spare. I then had another stroke of luck. I was awarded a Cassel Travelling Scholarship by the University of London. I decided to spend the year in the United States, this being treated as a year's residence at the London School of Economics, the regulations being somewhat loosely interpreted.
I decided to study vertical and lateral integration of industry in the United States. Plant had described in his lectures the different ways in which various industries were organised but we seemed to lack any theory which would explain these differences. I set out to find it. There was also another puzzle which, in my mind, needed to be solved and which seemed to be related to my main project. The view of the pricing system as a co-ordinating mechanism was clearly right but there were aspects of the argument which troubled me. Plant was opposed to all schemes, then very fashionable during the Great Depression, for the coordination of industrial production by some form of planning. Competition, according to Plant, acting through a system of prices, would do all the coordination necessary. And yet we had a factor of production, management, whose function was to co-ordinate. Why was it needed if the pricing system provided all the co-ordination necessary?
The same problem presented itself to me at that time in another guise. The Russian Revolution had taken place only fourteen years earlier. We knew then very little about how planning would actually be carried out in a communist system. Lenin had said that the economic system in Russia would be run as one big factory. However, many economists in the West maintained that this was an impossibility. And yet there were factories in the West and some of them were extremely large. How could the views expressed by economists on the role of the pricing system and the impossibility of successful central economic planning be reconciled with the existence of management and of these apparently planned societies, that is, firms, operating within our own economy?
I found the answer by the summer of 1932. It was to realise 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 come 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 co-ordination normally analysed 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 (and I thought it did explain it).
In "The Nature of the Firm" I argued that in a competitive system there would be an optimum of planning since a firm, that little planned society, could only continue to exist if it performed its co-ordination function at a lower cost than would be incurred if co-ordination were achieved by means of market transactions and also at a lower cost than this same function could be performed by another firm. To have an efficient economic system it is necessary not only to have markets but also areas of planning within organisations of the appropriate size. What this mix should be we find as a result of competition. This is what I said in my article of 1937. However, as we know from a letter I wrote in 1932, which has been preserved, all the essentials of this argument had been presented in a lecture I gave in Dundee at the beginning of October 1932. I was then twenty-one years of age and the sun never ceased to shine. I could never have imagined that these ideas would some sixty years later become a major justification for the award of a Nobel prize. And it is a strange experience to be praised in my eighties for work I did in my twenties.
There is no doubt that the recognition by economists of the importance of the role of the firm in the functioning of the economy will prompt them to investigate its activities more closely. The work of Oliver Williamson and others has led to a greater understanding of the factors which govern what a firm does and how it does it. And we can also hope to learn much more in future from the studies of the activities of firms which have recently been initiated by the Center for Economic Studies of the Bureau of the Census of the United States. But it would be wrong to think that the most significant consequence for economics of the publication of "The Nature of the Firm" has been to direct attention to the importance of the firm in our modern economy, a result which, in my view, would have come about in any case. What I think will be considered in future to have been the important contribution of this article is the explicit introduction of transaction costs into economic analysis.
I argued in "The Nature of the Firm" that the existence of transaction costs leads to the emergence of the firm. But the effects are pervasive in the economy. Businessmen in deciding on their ways of doing business and on what to produce have to take into account transaction costs. If the costs of making an exchange are greater than the gains which that exchange would bring, that exchange would not take place and the greater production that would flow from specialisation would not be realised. In this way transaction costs affect not only contractual arrangements but also what goods and services are produced. Not to include transaction costs in the theory leaves many aspects of the working of the economic system unexplained, including the emergence of the firm, but much else besides. In fact, a large part of what we think of as economic activity is designed to accomplish what high transaction costs would otherwise prevent or to reduce transaction costs so that individuals can negotiate freely and we can take advantage of that diffused knowledge of which Friedrich Hayek has told us.
I know of only one part of economics in which transaction costs have been used to explain a major feature of the economic system, and that relates to the evolution and use of money. Adam Smith pointed out the hindrances to commerce that would arise in an economic system in which there was a division of labour but in which all exchange had to take the form of barter. No one would be able to buy anything unless he possessed something that the producer wanted. This difficulty, Smith explained, could be overcome by the use of money. Thus, a person wishing to buy something in a barter system has to find someone who has this product for sale but who also wants some of the goods possessed by the potential buyer. Similarly, a person wishing to sell something has to find someone who both wants what he has to offer and also possesses something that the potential seller wants. Exchange in a barter system requires what W. Stanley Jevons called "this double coincidence."
Clearly the search for partners in exchange with suitable qualifications is likely to be very costly and will prevent many potentially beneficial exchanges from taking place. The benefit brought about by the use of money consists of a reduction in transaction costs. The use of money also reduces transaction costs by facilitating the drawing up of contracts as well as by reducing the quantity of goods that need to be held for purposes of exchange. However, the nature of the benefits secured by the use of money seems to have faded into the background so far as economists are concerned and it does not seem to have been noticed that there are other features of the economic system which exist because of the need to mitigate transaction costs.
Excerpted from Essays on Economics and Economists by R. H. Coase. Copyright © 1994 The University of Chicago. Excerpted by permission of The University of Chicago Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.