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Few other economists have been read and cited as often as R.H. Coase has been, even though, as he admits, "most economists have a different way of looking at economic problems and do not share my conception of the nature of our subject." Coase's particular interest has been that part of economic theory that deals with firms, industries, and markets—what is known as price theory or microeconomics. He has always urged his fellow economists to examine the foundations on which their theory exists, and this volume collects some of his classic articles probing those very foundations. "The Nature of the Firm" (1937) introduced the then-revolutionary concept of transaction costs into economic theory. "The Problem of Social Cost" (1960) further developed this concept, emphasizing the effect of the law on the working of the economic system. The remaining papers and new introductory essay clarify and extend Coarse's arguments and address his critics.
"These essays bear rereading. Coase's careful attention to actual institutions not only offers deep insight into economics but also provides the best argument for Coase's methodological position. The clarity of the exposition and the elegance of the style also make them a pleasure to read and a model worthy of emulation."—Lewis A. Kornhauser, Journal of Economic Literature
Ronald H. Coase was awarded the Nobel Prize in Economic Science in 1991.
The Firm, the Market, and the Law
I. The Aim of the Book
The core of this book consists of three papers, "The Nature of the Firm" (1937), "The Marginal Cost Controversy" (1946), and "The Problem of Social Cost" (1960). Other papers which extend, illustrate, or explain the arguments in these three papers are also included. As will become apparent, these essays all embody essentially the same point of view.
My point of view has not in general commanded assent, nor has my argument, for the most part, been understood. No doubt inadequacies in my exposition have been partly responsible for this and I am hopeful that this introductory essay, which deals with some of the main points raised by commentators and restates my argument, will help to make my position more understandable. But I do not believe that a failure of exposition is the main reason why economists have found my argument so difficult to assimilate. As the argument in these papers is, I believe, simple, so simple indeed as almost to make their propositions fall into the category of truths which can be deemed self-evident, their rejection or apparent incomprehensibility would seem to imply that most economists have a different way of looking at economic problems and do not share my conception of the nature of our subject. This I believe to be true.
At the present time the dominant view of the nature of economics is that expressed in Robbins' definition: "Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." This makes economics the science of human choice. In practice, most economists, including Robbins, restrict their work to a much narrower set of choices than this definition would suggest. Recently, however, Becker has argued that Robbins' way of looking at economics need not be so constrained and that the economic approach, as he terms it, can and should be applied more generally throughout the social sciences. That the economic approach can be applied successfully in the other social sciences is demonstrated by Becker's own work. Its very success, however, poses the question, Why have the economists' tools of trade proved to be so versatile?
My particular interest has been in that part of economic theory which deals with firms, industries, and markets, which used to be called Value and Distribution and is now usually termed price theory or micro-economics. It is an intricate structure of high intellectual quality and has produced valuable insights. Economists study how the choice of consumers, in deciding which goods and services to purchase, is determined by their incomes and the prices at which goods and services can be bought. They also study how producers decide what factors of production to use and what products and services to make and sell and in what quantities, given the prices of the factors, the demand for the final product, and the relation between output and the amounts of factors employed. The analysis is held together by the assumption that consumers maximize utility (a nonexistent entity which plays a part similar, I suspect, to that of ether in the old physics) and by the assumption that producers have as their aim to maximize profit or net income (for which there is a good deal more evidence). The decisions of consumers and producers are brought into harmony by the theory of exchange.
The elaboration of the analysis should not hide from us its essential character: it is an analysis of choice. It is this which gives the theory its versatility. Becker points out that "what most distinguishes economics as a discipline from other disciplines in the social sciences is not its subject matter but its approach." If the theories which have been developed in economics (or at any rate in micro-economics) constitute for the most part a way of analyzing the determinants of choice (and I think this is true), it is easy to see that they should be applicable to other human choices such as those that are made in law or politics. In this sense economists have no subject matter. What has been developed is an approach divorced (or which can be divorced) from subject matter. Indeed, since man is not the only animal that chooses, it is to be expected that the same approach can be applied to the rat, cat, and octopus, all of whom are no doubt engaged in maximizing their utilities in much the same way as does man. It is therefore no accident that price theory has been shown to be applicable to animal behaviour.
This preoccupation of economists with the logic of choice, while it may ultimately rejuvenate the study of law, political science, and sociology, has nonetheless had, in my view, serious adverse effects on economics itself. One result of this divorce of the theory from its subject matter has been that the entities whose decisions economists are engaged in analyzing have not been made the subject of study and in consequence lack any substance. The consumer is not a human being but a consistent set of preferences. The firm to an economist, as Slater has said, "is effectively defined as a cost curve and a demand curve, and the theory is simply the logic of optimal pricing and input combination." Exchange takes place without any specification of its institutional setting. We have consumers without humanity, firms without organization, and even exchange without markets.
The rational utility maximizer of economic theory bears no resemblance to the man on the Clapham bus or, indeed, to any man (or woman) on any bus. There is no reason to suppose that most human beings are engaged in maximizing anything unless it be unhappiness, and even this with incomplete success. Knight has expressed the thought very well: "... [the] argument of economists ... that men work and think to get themselves out of trouble is at least half an inversion of the facts. The things we work for are 'annoyers' as often as 'satisfiers,' we spend as much ingenuity in getting into trouble as in getting out, and in any case enough to keep in effectively.... A man who has nothing to worry about immediately busies himself in creating something, gets into some absorbing game, falls in love, prepares to conquer some enemy, or hunt lions or the North Pole or what not."
I believe that human preferences came to be what they are in those millions of years in which our ancestors (whether or not they can be classified as human) lived in hunting bands and were those preferences which, in such conditions, were conducive to survival. It may be, therefore, that ultimately the work of sociobiologists (and their critics) will enable us to construct a picture of human nature in such detail that we can derive the set of preferences with which economists start. And if this result is achieved, it will enable us to refine our analysis of consumer demand and of other kinds of behaviour in the economic sphere. In the meantime, however, whatever makes men choose as they do, we must be content with the knowledge that for groups of human beings, in almost all circumstances, a higher (relative) price for anything will lead to a reduction in the amount demanded. This does not only refer to a money price but to price in its widest sense. Whether men are rational or not in deciding to walk across a dangerous thoroughfare to reach a certain restaurant, we can be sure that fewer will do so the more dangerous it becomes. And we need not doubt that the availability of a less dangerous alternative, say, a pedestrian bridge, will normally reduce the number of those crossing the thoroughfare, nor that, as what is gained by crossing becomes more attractive, the number of people crossing will increase. The generalization of such knowledge constitutes price theory. It does not seem to me to require us to assume that men are rational utility maximizers. On the other hand, it does not tell us why people choose as they do. Why a man will take a risk of being killed in order to obtain a sandwich is hidden from us even though we know that, if the risk is increased sufficiently, he will forego seeking that pleasure.
None of the essays in this book deals with the character of human preferences, nor, as I have said, do I believe that economists will be able to make much headway until a great deal more work has been done by sociobiologists and other noneconomists. But the acceptance by economists of a view of human nature so lacking in content is of a piece with their treatment of institutions which are central to their work. These institutions are the firm and the market which together make up the institutional structure of the economic system. In mainstream economic theory, the firm and the market are, for the most part, assumed to exist and are not themselves the subject of investigation. One result has been that the crucial role of the law in determining the activities carried out by the firm and in the market has been largely ignored. What differentiates the essays in this book is not that they reject existing economic theory, which, as I have said, embodies the logic of choice and is of wide applicability, but that they employ this economic theory to examine the role which the firm, the market, and the law play in the working of the economic system.
II. The Firm
The firm in modern economic theory is an organization which transforms inputs into outputs. Why firms exist, what determines the number of firms, what determines what firms do (the inputs a firm buys and the output it sells) are not questions of interest to most economists. The firm in economic theory, as Hahn said recently, is a "shadowy figure." This lack of interest is quite extraordinary, given that most people in the United States, the United Kingdom, and other western countries are employed by firms, that most production takes place within firms, and that the efficiency of the whole economic system depends to a very considerable extent on what happens within these economic molecules. It was the purpose of my article on "The Nature of the Firm" to provide a rationale for the firm and to indicate what determines the range of activities it undertakes. Although the article has been much cited, it is obvious from such remarks as those of Hahn that the ideas in this article (published about fifty years ago) have not become part and parcel of the equipment of an economist. And it is easy to see why. In order to explain why firms exist and what activities they undertake, I found it necessary to introduce a concept which I termed in that article "the cost of using the price mechanism," "the cost of carrying out a transaction by means of an exchange on the open market," or simply "marketing costs." To express the same idea in my article on "The Problem of Social Cost," I used the phrase "the costs of market transactions." These have come to be known in the economic literature as "transaction costs." I have described what I had in mind in the following terms: "In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on." Dahlman crystallized the concept of transaction costs by describing them as "search and information costs, bargaining and decision costs, policing and enforcement costs." Without the concept of transaction costs, which is largely absent from current economic theory, it is my contention that it is impossible to understand the working of the economic system, to analyze many of its problems in a useful way, or to have a basis for determining policy. The existence of transaction costs will lead those who wish to trade to engage in practices which bring about a reduction of transaction costs whenever the loss suffered in other ways from the adoption of those practices is less than the transaction costs saved. The people one deals with, the type of contract entered into, the kind of product or service supplied, will all be affected. But perhaps the most important adaptation to the existence of transaction costs is the emergence of the firm. In my article on "The Nature of the Firm" I argued that, although production could be carried out in a completely decentralized way by means of contracts between individuals, the fact that it costs something to enter into these transactions means that firms will emerge to organize what would otherwise be market transactions whenever their costs were less than the costs of carrying out the transactions through the market. The limit to the size of the firm is set where its costs of organizing a transaction become equal to the cost of carrying it out through the market. This determines what the firm buys, produces, and sells. As the concept of transaction costs is not usually used by economists, it is not surprising that an approach which incorporates it will find some difficulty in getting itself accepted. We can best understand this attitude if we consider not the firm but the market.
III. The Market
Although economists claim to study the working of the market, in modern economic theory the market itself has an even more shadowy role than the firm. Alfred Marshall had a chapter "On Markets" in his Principles of Economics, but it was general in character and did not probe, perhaps because this was a topic reserved for what ultimately became Industry and Trade. In the modern textbook, the analysis deals with the determination of market prices, but discussion of the market itself has entirely disappeared. This is less strange than it seems. Markets are institutions that exist to facilitate exchange, that is, they exist in order to reduce the cost of carrying out exchange transactions. In an economic theory which assumes that transaction costs are nonexistent, markets have no function to perform, and it seems perfectly reasonable to develop the theory of exchange by an elaborate analysis of individuals exchanging nuts for apples on the edge of the forest or some similar fanciful example. This analysis certainly shows why there is a gain from trade, but it fails to deal with the factors which determine how much trade there is or what goods are traded. And when economists do speak of market structure, it has nothing to do with the market as an institution but refers to such things as the number of firms, product differentiation, and the like, the influence of the social institutions which facilitate exchange being completely ignored.
The provision of markets is an entrepreneurial activity and has a long history. In the medieval period in England, fairs and markets were organized by individuals under a franchise from the King. They not only provided the physical facilities for the fair or market but were also responsible for security (important in such unsettled times with a relatively weak government) and administered a court for settling disputes (the court of piepowder). Fairs and markets have continued to be provided in modern times, including exhibition halls and the like, and have often (again in England) been a municipal function. Of course, their relative importance has tended to diminish with the growth in the number of shops and similar facilities operated by private retailers and wholesalers. With the government providing security and with a more developed legal system, proprietors of the old markets no longer had to assume a responsibility for providing security or to undertake legal functions, although some courts of piepowder survived late into the nineteenth century.
If the traditional markets of the past have diminished in importance, new markets have emerged in recent times of comparable importance in our modern economy. I refer to commodity exchanges and stock exchanges. These are normally organized by a group of traders (the members of the exchange) which owns (or rents) the physical facility within which transactions take place. All exchanges regulate in great detail the activities of those who trade in these markets (the times at which transactions can be made, what can be traded, the responsibilities of the parties, the terms of settlement, etc.), and they all provide machinery for the settlement of disputes and impose sanctions against those who infringe the rules of the exchange. It is not without significance that these exchanges, often used by economists as examples of a perfect market and perfect competition, are markets in which transactions are highly regulated (and this quite apart from any government regulation that there may be). It suggests, I think correctly, that for anything approaching perfect competition to exist, an intricate system of rules and regulations would normally be needed. Economists observing the regulations of the exchanges often assume that they represent an attempt to exercise monopoly power and aim to restrain competition. They ignore or, at any rate, fail to emphasize an alternative explanation for these regulations: that they exist in order to reduce transaction costs and therefore to increase the volume of trade. Adam Smith said this: "The interest of the dealers ... in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the publick. To widen the market and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the publick; but to narrow the competition must always be against it ..." The eloquence and force of Adam Smith's denunciations of regulations designed to narrow the competition seem to have blinded us to the fact that dealers also have an interest in making regulations which widen the market, perhaps because this was a subject to which Adam Smith gave little attention. But there is, I believe, another reason for this neglect of the role which regulation may play in widening the market. Monopoly and impediments to trade such as tariffs are easily handled by normal price theory, whereas the absence of transaction costs in the theory makes the effect of a reduction in them difficult to incorporate in the analysis.
Excerpted from The Firm, the Market, and the Law by R. H. Coase. Copyright © 1988 The University of Chicago. Excerpted by permission of The University of Chicago Press.
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1: The Firm, the Market, and the Law
2: The Nature of the Firm
3: Industrial Organization: A Proposal for Research
4: The Marginal Cost Controversy
5: The Problem of Social Cost
6: Notes on the Problem of Social Cost
7: The Lighthouse in Economics