Ronald H. Coase

Pre-reading

Ronald H. Coase (1910-2013) was a British-U.S. economist. He received his doctorate from the London School of Economics and taught principally there. He settled at the University of Chicago in 1964 and became the editor of The Journal of Law and Economics. He was a pioneer in the field of transaction cost economics, and studied the ways in which legal rules affect economic behavior. He believed economists should study real markets and not theoretical ones, and legal scholars should focus on the importance of an efficient marketplace and on negotiation rather than litigation.

Coase is often referred to as the “father” of reform in the policy for allocation of the electromagnetic spectrum, based on his article The Federal Communications Commission (1959), where he criticizes spectrum licensing, suggesting property rights as a more efficient method of allocating spectrum to users. In his The Nature of the Firm (1937), Coase introduces the concept of transaction costs to explain the nature and limits of firms. In The Problem of Social Cost (1960), he suggests that well-defined property rights could overcome the problems of externalities. He won the 1991 Nobel Memorial Prize in Economic Sciences.

Additionally, Coase’s transaction costs approach is currently influential in modern organizational economics, where it was reintroduced by Oliver E. Williamson.

The following passage is from Coase’s Nobel prize lecture (1991) The Institutional Structure of Production.

Prompts for Your Reading

1.What kind of book is The Wealth of Nations? Learn about the book and its author Adam Smith.

2.According to Adam Smith, the economy should be coordinated by the “invisible hand”, rather than the “visible hand”, for the efficiency and beneficial results. What does the two “hands” refer to respectively? In this passage, what is Coase’s view?

3.In what way do you find Coase’s argument different from orthodox economics? What are the limitations of modern economics?

4.What does the concentration on the determination of prices probably lead to?

5.Harold Demsetz says, “what this theory analyses 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.” What does “this theory” refer to? What do you think are the gains and losses of modern economics?

6.Lionel Robbins holds that what happens in between the purchase of the factors of production and the sale of the goods that are produced by these factors is largely ignored. What does it mean to the improvement of economics?

7.What is meant by “blackboard economics”?

8.How does Coase organize his argument? How are the ideas connected in this passage?

[1] During the two centuries since the publication of The Wealth of Nations1 the main activity of economists, it seems to me, has been to fill the gaps in Adam Smith2’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 centralized planning were not necessary to make an economic system function in an orderly way. The economy could be coordinated by a system of prices (the “invisible hand”) and, furthermore, with beneficial results.

[2] A major task of economists since the publication of The Wealth of Nations, as Harold Demsetz3 has explained, has been to formalize this proposition of Adam Smith. The given factors are technology and the tastes of consumers, and 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 decentralization. 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.

[3] 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 that anything outside this is considered as no part of their business. Thus, my old chief and wonderful human being, Lionel Robbins4, wrote, in An Essay on The Nature and Significance of Economic Science5, 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‘organization’ 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 organization — the relationship of prices and cost...” What this comes down to is that, in Robbins’ view, an economist does not interest himself in the internal arrangements within organizations 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 in 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’ attitude but it is undeniable that microeconomics6 is largely a study of the determination of prices and output, indeed this part of economics is often called price theory.

[4] 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. Holmstr?m7 and Tirole8, writing on The Theory of the Firm in the recently published Handbook of Industrial Organization9, conclude at the end of their article of 63 pages that “the evidence/theory ratio... is currently very low in this field.” Peltzman10 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.

[5] 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 organizations conduct their affairs, particularly, of course, the modern corporation.

[6] Even more surprising, given their 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.

Notes

1.The Wealth of Nations: The Adam Smith’s treatise was published in 1776 when the old mercantilist system was fast breaking down. Smith argued the case for laissezfaire with a minimum of government intervention, though he conceded the need for regulation to protect national security, such as fostering shipping. He did not believe that politicians had any competence in directing economic activity, nor did he like their motives.

2.Adam Smith: (1723-1790) the Scottish political economist and moral philosopher. Smith formed a bridge between the Scottish and French Enlightenments. From 1752 to 1764 he was Professor of Moral Philosophy at the University of Glasgow, during which The Theory of Moral Sentiments (1759) was published. In this book, Smith placed most trust on sympathy as the basis for cooperation, and introduced the idea of the invisible hand in a passage describing how the investment of the surplus of the rich unintentionally benefits the poor. In 1764 the offer of a post as tutor to a young aristocrat enabled Smith to resign his chair in Glasgow and travel in France, where he met the physiocrats, before returning to Scotland to work for ten years on The Wealth of Nations (1776). In this book, the repeat of invisible hand led to the concept of selfinterest, which gave sympathy a wider meaning.

3.Harold Demsetz: born in 1930, one of the pioneers of the Neo-Institutionalism, a founder of the managerial economics, and a major figure in industrial organization. He has expanded the theory of property rights now prevalent in law and economics. He was the first to propose emissions trading as a way of giving polluters an economic incentive to reduce their emissions of pollutants. The 1972 Demsetz and Armen Alchian article Production, Information Costs and Economic Organization was selected as one of the twenty most important articles published in the first century of The American Economic Review.

4.Lionel Robbins: (1898-1984) a British economist and head of the economics department at the London School of Economics. In the 1920s he attacked Alfred Marshall’s concept of the “representative firm”, arguing that the concept was no help in understanding the equilibrium of the firm or of an industry. He managed to shift Anglo-Saxon economics from its Marshallian direction.

5.An Essay on the Nature and Significance of Economic Science (1932): Robbins’s most famous book and one of the best-written prose pieces in economics. This book contains Robbins’s famous all-encompassing definition of economics: “Economics is the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses.” Robbins drew a bright line between positive and normative issues, and argued that the economist qua economist should be studying what is rather than what ought to be. He believed that economics is a system of logical deduction from first principles, and was skeptical about the feasibility and usefulness of empirical verification.

6.microeconomics: The branch of economics which deals with the economic behavior of individual consumers, firms, and industries and the distribution of total production and income among them. It considers individuals both as suppliers of land, labor, and capital and as the ultimate consumers of the final product, and it examines firms both as suppliers of products and as consumers of labor and capital. Microeconomics seeks to analyze the market or other mechanisms that establish relative prices among goods and services and allocate society’s resources among their many possible uses. The models have been imported into politics by writers in the rational choice tradition.

7.Bengt R. Holmstr?m: born in 1949, the Paul A. Samuelson Professor of Economics at M.I.T. He got his Ph.D. from the Graduate School of Business at Stanford University. Holmstr?m is particularly famous for his work on incentives under asymmetric information.

8.Jean Tirole: born in 1953, a French professor of economics. In 2014 he was awarded the Nobel Memorial Prize in Economic Sciences for his analysis of market power and the regulation of natural monopolies. He focuses on industrial organization, game theory, banking and finance, and economics and psychology.

9.Handbook of Industrial Organization: an academic handbook published by North Holland in late 1990s, serving as a source, reference, and teaching supplement for industrial organization, the broad field within microeconomics that focuses on business behavior and its implications both for market structures and processes, and for public policies towards them.

10.Peltzman: the Ralph and Dorothy Keller Distinguished Service Professor Emeritus of Economics at the Booth School of Business, University of Chicago. He serves on the editorial boards of several academic journals and on the Council of Academic Advisers of the American Enterprise Institute. His research has focused on issues related to the interface between the public sector and the private economy, including the regulation of banking, automobile safety, pharmaceutical innovation, the growth of government, the political economy of public education, and the economic analysis of voters and legislators.

Questions for Further Thinking

1.In what ways does this passage improve your understanding of the modern economic system?

2.In the history of economics, there are many schools of thoughts, as well as several revolutions of economic paradigm. How many have you heard of?

3.Like a scientist, an economist studies human behavior through scientific methods. Thomas Carlyle once said,“teach a parrot the terms ‘supply and demand’ and you’ve got an economist.” What do you think about economics as social science?

4.How important do you think rationality is to our daily behaviors? What does the hypothesis of rationality mean to the economic study?

5.In real economy, what roles do markets, governments, households and firms play respectively?

6.What are the similarities and differences among Wal-Mart, IKEA, Ford Motor and Amazon all firms?

7.The philosophy of empiricism has long been influencing economics greatly, which is then classified into positive and normative statements. What do you think of the two methodologies? And how do you handle them?

8.In what ways do organizations benefit the economy in terms of efficiency? Do you think a hierarchical structure helps to cope with the inefficiency caused by individual rationality?

9.Calvin Coolidge says, the business of America is business. What do you think of it?

After-reading Assignment

Oral Work

1.Explore the different research areas of macroeconomics and microeconomics and think how these areas are different but connected. Present your ideas to your class.

2.In an economy, millions of businesses and consumers engage in voluntary trade, intending to improve their own economic situations, and their actions are invisibly coordinated by a system of prices and markets. Please find some examples to illustrate who are/is responsible for making the decisions in a market economy? Share your findings with your group members.

3.Economists usually find that many economic policies and related process are different from what they suggest and assume in economics theories. Explore the economy in China in recent years and find a case to show how and why theory and policy are different. Present the results to your class.

4.Economists like to argue with each other. There are many marvelous clashes of ideas in the history of economics. George Bernard Shaw says, “If all economists were laid end to end, they would not reach a conclusion.”Find out how economists differ in their interpretation of the “internet plus” economy and share your findings with your classmates.

Written Work

1.Usually, economists try to learn about the characteristics, causes, and effects of observed phenomena through five steps, which are 1) initial observation, 2) theorizing, 3) identification of additional implications, 4) further observation and testing, 5) refinement of the theory. Would you follow the above method and research into some business affairs on campus? Write a business research report to record the process and results of your research.

2.Go to a market and interview some buyers and sellers, or visit some firms and get to know about their products, sales, and profitability. Write a report on this field research. In your report, state clearly how your research helps you understand certain economic principles, such as profit maximization, cost minimization and utility maximization.

3.How necessary do you think it is for a person to have some knowledge of economics in today’s society? Write an argumentative essay in support of the necessity of basic education of economics for all.

4.The 21st century model of share economy brings both challenges and opportunities to the market as well as to firms. Write an essay defining the sharing economy. You can use books in your library for your reference and you can use your own experiences as examples to illustrate this new model of economy.