Transaction costs: “the nature of the firm”

Travelling in the United States, Coase was stimulated by the “lack of any theory which would explain why . . . industries were organized in the way they were. My year in the United States was essentially devoted to a search for a theory of integration” (Coase, Reference Coase, Williamson and Winter1991a: p. 38). Since theory assumed that the price mechanism coordinated the economic system, Coase wondered whether markets supported transactions as efficiently as existing theories suggested. As is now well known, he gave a deceptively simple answer: there are costs to using the price mechanism, costs that under certain conditions can make it advantageous to use alternative arrangements, such as directing resources through an entrepreneur. Among the costs Coase mentioned were the costs of information, “of discovering what the relevant prices are” (Reference Coase1937:390), and the costs of “negotiating and concluding a separate contract for each exchange transaction which takes place on a market” (390–391). Coase then asked why, if firms can reduce such marketing costs, are there any market transactions at all. “Why is not all production carried on by one big firm” (394)?Footnote ² His answer was that there are costs to firms as well, and a “point must be reached where the costs of organizing an extra transaction within the firm are equal to the costs involved in carrying out the transaction in the open market or to the costs of organizing by another entrepreneur” (395).Footnote ³

The implications of Coase's concept of costs to using the market, later termed transaction costs, only began to be fully apparent in the late 1970s/1980s with the work of Oliver Williamson and Douglass North (described below), not to mention Alchian, Demsetz, and Cheung, and many others. Only in the 1980s and thereafter did what has been identified as transaction cost economics take off. One reason for this slow gestation was that Coase did not clearly define transaction costs in his 1937 paper, and remained somewhat vague in his 1960 article. Subsequently, different economists defined transaction costs differently as the cost of exchanging and enforcing property rights, obtaining information and measuring attributes, making and enforcing contracts (especially when agents are opportunistic), etc.Footnote ⁴ What all these definitions shared was that transactions were about the transfer of rights, and these transfers required costly supports. Subsequent work was spurred by Coase's intuition that transactions do not occur in a vacuum, but require mechanisms that support and coordinate exchange, such as markets or firms.

Despite this initial lack of precision, the basic inferences of Coase's early ideas in “The Nature of the Firm” had huge consequences for economics. The first consequence was to raise the profile of firms as solutions to the organization of transactions that outperformed markets under certain circumstances. Paradoxically, this was and remains a revolutionary idea for economic theories that reduce the firm to a technologically determined production function. Second, once we accept efficient alternatives to markets, we need to assess the conditions that motivate decision-makers to choose one alternative over another. “The Nature of the Firm” thus introduced the role of management as a means of coordination, and opened the ‘black box’ of the firm.

A third consequence was methodological: if there are alternative ways to organize transactions, we must compare the costs and benefits of the different arrangements in order to answer the question: which organizes transactions at the lowest possible cost? This was the meaning of the discussion of labor contracts in the “Nature of the Firm,” (although Coase mitigated that conclusion when he revisited the 1937 paper 50 years later—see Coase Reference Coase, Williamson and Winter1991b).

Fourth, in pointing out the need to assess the comparative advantages of firms and markets, Coase opened the door to what became the trademark question of Oliver Williamson: what characteristics of transactions explain the tradeoff between firms and markets? (We explore his answer below.)

Last, but not least, transaction costs provided a different explanation for growth and development, as Coase made explicit later:

These ideas were at the core of Coase's exploration of the Chinese experience (Coase and Wang, Reference Coase and Wang2012), which discussed how China grew rapidly without strong institutions by, among other things, exploiting informal institutions (such as family networks), fostering local innovations in institutions through trial and error, and sometimes using Hong Kong's stronger institutions (for example, by signing contracts through a Hong Kong intermediary). These ideas also explain why Douglass North and followers owe so much to Coase (see below).

The role of government

Coase's ideas about government ownership and regulation formed gradually. Over the course of his investigations into British utilities in the 1930s, he concluded that nationalization had not produced the promised results. His skepticism about the advantages of government intervention was greater than that of many economists, who assumed that a benign and well-informed government was the optimal solution to market failure. Coase, nevertheless, tempered his skepticism with his belief that economists could only discover the appropriate boundary line for government action based on “a detailed investigation of the actual results of handling the problem in different ways” (Coase, Reference Coase1960: p. 13). Even though he believed that regulation had produced a worse result in most circumstances, he did not assume that all regulation was necessarily bad. Instead, he argued that economists should carefully analyze the advantages and disadvantages of government regulation by patiently studying how markets, firms, and governments actually behaved (Coase, Reference Coase1960: p. 44).

Coase put this advice into practice in “The Federal Communications Commission” (Reference Coase1959). After carefully analyzing the political economy of broadcasting in the United States, he concluded that the FCC should sell the rights to use radio spectrum frequencies. He argued that the FCC's current method of allocating frequencies led to undesirable political control over freedom of the press, similar to what might arise if government decided who could publish newspapers or magazines. He further argued that if rights were well defined and transferrable, they would be traded and combined to maximize output, allowing private owners to deploy new technologies, adjust to changing markets, and take other actions to operate more efficiently. The main risk of private control over the spectrum was interference between signals transmitted on adjacent frequencies. Coase concluded that private actors with clear property rights would have every incentive to negotiate agreements or develop technologies to limit interference and maximize the value of their asset.Footnote ⁵ Such “spillovers” (what many call externalities), are byproducts of valuable activities “subject to the same cost/benefit analysis as other resources” (Hazlett et al., Reference Hazlett, Porter and Smith2011: p. S128). Coase argued that any decisions about radio spectrum allocation should compare the effects of the administrative costs associated with government allocation with the transaction costs associated with market allocation.

Coase's article provoked strong opposition, with the Commissioner asking in an FCC hearing on the article, “Are you spoofing us? Is this all a big joke” (Coase, Reference Coase1998a: 579)?Footnote ⁶ Opponents in the FCC argued that radio emission rights were impossible to define and sell, ignoring the long-standing secondary market doing just that. Opponents further argued that market allocation would neglect public interest outputs, such as educational programming and news, overlooking the possibility that these obligations could be required as part of the license. They also ignored the sizeable rents earned by those fortunate enough to get a license, rents that auctions would capture for the public. Coase's FCC paper fueled intense public debate in both academic and political circles, and generated a number of unsuccessful reform proposals (summarized in Hazlett, Reference Hazlett1998: Table 2). Coase's arguments only began to prevail with the surge of wireless telephony in the 1980s. The public interest arguments were irrelevant for wireless telephony, while the FCC lacked the capacity to allocate expeditiously thousands of cellular licenses through comparative hearings. Increasingly, the US Congress and the presidency also began to focus on the substantial foregone revenues. The promise of revenues may explain why reforms to spectrum allocation were attached to budget bills, first to assign nonbroadcast licenses through lotteries in 1981, and finally to permit competitive auctions for nonbroadcast licenses in 1993.

FCC license sales finally began in 1994, and over 30 countries have since used spectrum auctions. Hazlett et al. estimated that the US government captured almost $53 billion in FCC auctions from 1994 to 2009, and avoided welfare losses of $17 billion (2011: p. S125). Yet, as Hazlett et al. contended, these gains were not Coase's primary legacy. “What Coase fundamentally contributed was a symmetric analysis of property regime choices, explaining how the costs of the ‘price system’ were real, but that so were the costs of any alternative” (p. S156).

The problem of social cost

In the FCC paper, Coase suggested that if rights to the radio frequency spectrum were well-defined and transferable, it would not matter what the initial legal rights were, they would be traded and combined in ways that maximized the value of production. A group of economists at the University of Chicago disagreed with this passage and invited Coase to a meeting at the home of Aaron Director to discuss “his mistake.” As George Stigler (Reference Stigler1988) later described it, those present, and especially Milton Friedman, strongly objected to Coase's “heresy.” Yet by the end of the evening, Coase prevailed and was asked to write up his arguments in an article for The Journal of Law and Economics. The result, “The Problem of Social Cost,” is one of the most cited articles in social science.Footnote ⁷

Social costs, or “spillovers,” are the costs that arise when a business activity causes harm to another economic actor, such as when noise from an airport or smoke from a factory bothers its neighbors. Most economists followed Pigou (Reference Pigou1932), concluding that the firm that caused the noise or smoke should be held liable for the damage, be subject to a tax equivalent to the potential damage, and be regulated as to where it can locate. Coase, however, argued that social costs were reciprocal; the planes caused noise or the factory produced smoke, but forcing the planes or the factory to eliminate these spillovers imposed costs on them as well. As in the FCC paper, Coase focused on alternatives: for example, government regulation or lawsuits by neighbors could induce the airport to reduce the number of flights, but payments from the airport or the government could induce the irritated homeowners to soundproof their homes. All these remedies have costs, which economists should carefully evaluate. As Coase put it, economists should “compare the total product yielded by alternative social arrangements . . . the total effect of these arrangements in all spheres of life should be taken into account” (Coase, Reference Coase1960: p. 43). The goal should not be to compare a “state of laissez faire and some kind of an ideal world,” but to “start our analysis with a situation approximating that which actually exists” (Ibid). By treating the neglect of social costs as a deficiency in the system, economists of the Pigou persuasion were not paying enough attention to “other changes in the system which are inevitably associated with the corrective measure, changes which may well produce more harm than the original deficiency” (Coase, Reference Coase1960: pp. 26–27).

This argument was transformative, and “The Problem of Social Cost” did not stop there. To illustrate the costs of alternative approaches, Coase first described the problem of social harms if the cost of transacting were zero. Under such unrealistic circumstances, the airport or factory and its neighbors could negotiate a bargain to allocate rights in a way that would maximize production regardless of the legal assignment of those rights—liability would not matter. As Coase later explained it, liability does not matter with zero transaction costs because contractual arrangements will be made to modify the rights and duties of the parties so as it make it in their interest to undertake those actions which maximize the value of production (Coase, Reference Coase and Coase1990c: p. 178). It was this argument that was debated as “heresy” at the famous dinner and that Stigler (Reference Stigler1966) later labeled the Coase Theorem.

Although Coase (Reference Coase1960) called the assumption of costless market transactions “very unrealistic,” a strangely large number of economics texts and articles failed to recognize that Coase did not advocate addressing social costs by means of the Coase Theorem.Footnote ⁸ In fact, his point was the opposite: because market transactions, firm administration, and government regulation all have positive costs, we must measure and compare them. “Satisfactory views on policy can only come from a patient study of how, in practice, the market, firms, and governments handle the problem of harmful effects” (1960: p. 18). Even more importantly, because transaction costs are positive we must study the legal system and other institutions that determine transaction costs and the security of property rights. As Coase later advised: “It makes little sense for economists to discuss the process of exchange without specifying the institutional setting within which the trading takes place since this affects the incentives to produce and the costs of transacting” (Coase, Reference Coase1992: p. 718). This exceptional article, combined with “The Nature of the Firm,” laid the foundation for two new fields: law and economics and new institutional economics. “The Problem of Social Cost” had less effect on the analysis of what most economists call externalities. Although some economists today, following Coase, consider the reciprocal nature of social costs and compare the costs of alternative remedies, more view externalities as harms requiring government taxation or regulation.

Impact of Coase's ideas

Coase ideas influenced numerous economists (as well as lawyers, political scientists, and other social scholars), probably none more prominent than Oliver Williamson and Douglass North. If course, we are well aware that Coase influence went far beyond these two authors, for example, Alchian, Barzel, Cheung, and Demsetz, are just a few of his initial accomplices and followers. Here, we focus on North and Williamson because they likely had the most impact on economists.

Williamson operationalized the concept of transaction costs by using what he called “the lens of contract” to explore how managers chose between transacting in the market versus transacting within the firm in a world of incomplete contracts and opportunism.Footnote ⁹ Williamson argued that when buyers and suppliers make transaction-specific investments, for example, when a supplier builds specialized machines or acquires specialized skills that have value to only one buyer, there is room for agents to act strategically. Since it is costly and ultimately impossible for contracts to specify in detail all eventualities—not everything can be known in advance—there can be substantial surpluses (quasi-rents) subject to ex post haggling. Following Coase, Williamson also considered the cost of the alternative to extensive bargaining and costly haggling—vertical integration. Vertical integration could be costly, for example, if executives extracted rents in inefficient ways. Williamson argued that the choice between vertical integration (make) or a contract in the market (buy) would be determined by the extent to which assets were relationship-specific and contracts were difficult to write. These, in turn, would depend upon the frequency and complexity of the transactions between the buyer and seller, and the institutional framework under which the agents operated. Williamson's ideas launched a stream of empirical research to measure these determinants, which found that vertical integration was indeed affected by complexity and asset specificity.Footnote ¹⁰ Although Williamson published more theoretical than empirical research, his focus on ways to measure real world costs and understand business choices was very Coasean, and his followers have shown the empirical relevance of his theories.

Douglass North developed Coase's ideas in a macro and historical direction. To North, “the most important message [from ‘The Nature of the Firm’], one with profound implications for restructuring economic theory, is that when it is costly to transact, institutions matter.” (1990: p. 12). In a piece with (North and Wallis, Reference North and Wallis1986) measuring the size of the transaction sector in the US economy, North found that it is indeed very costly to transact: transaction costs grew to nearly half of United States GDP in 1970 (Table 3.13: p. 121).

North built on Coase's insights to address Adam Smith's basic question: why are some societies rich and some poor? North believed that the answer lay in their different institutions, which he defined as the formal and informal constraints that structure human interaction and reduce uncertainty. Institutions, together with technology, determine the cost of transaction (and transformation), and “transaction costs are the most observable dimension of the institutional framework that underlies the constraints in exchange” (North, Reference North1990: p. 68). To North, transaction costs were high because of information costs (including measurement), combined with enforcement costs (including uncertainty). Based on a Coasean analysis of actual countries and history, North concluded that these costs were higher in poorer countries because the institutions that supported exchange were weaker. North stressed the same institutions as Coase, such as contracts enforced by courts, which he saw as one of the explanations for successful European economic development (North and Thomas, Reference North and Thomas1973). North also diverged from Coase, becoming increasingly interested in norms, habits, and conventions, which he saw as the essential underpinning for written rules (see, for example, North, Reference North2005).Footnote ¹¹

Williamson's and North's work has spurred extensive empirical research. It also inspired a new generation of scholars who built on Coase's original ideas and furthered his goal of changing the nature of economics through an insider revolution. Most (although not all) of these followers have conducted research as Coase advised, emphasizing understanding over quantification and realism over abstraction.

The journal of law and economics

Coase became editor of the Journal of Law and Economics in 1964 and used his editorship as a tool to change economics. Landes, Carlton, and Easterbrook described his approach well:

Coase was an active mentor-editor who pursued articles that overturned conventional wisdom with carefully researched facts. For example, he was in the audience when Lee Benham, then an assistant professor at the University of Chicago Business School, presented a paper challenging the conventional wisdom that advertising increased costs and monopoly power, and quickly recruited the paper for the Journal. Benham (Reference Benham1972) compared the price of eyeglasses in states that permitted and prohibited advertising, and demonstrated for the first time that advertising could lower transaction costs, intensify competition, and thus reduce the market price. Similarly, when Coase became aware of contracts between beekeepers and orchard owners in Washington State, he asked Steven Cheung, then teaching at the University of Washington, to investigate. As with lighthouses, apples and bees were treated as a “classic” example of market failure: apple growers could not charge beekeepers for the food the bees got from their blossoms (Cheung, 1972: p. 12). Cheung (Reference Cheung1973) showed that contracts between beekeepers and apple growers involved fees to the beekeeper for pollination services and fees (in the form of honey) to the grower for nectar collection. Coase's contribution as editor was best summed up by Hayek (Reference Hayek1984) in a letter nominating him for the Nobel Prize:

Other activities

Coase was later active in promoting new institutional economics (NIE), which began to take shape as a movement within economics in the 1970’s, as a loosely organized network.Footnote ^15, Footnote ¹⁶ Scholars committed to studying institutions using Coasean realism felt isolated from mainstream economists and pushed for an organization to support their network. This bottom up movement formed a new group, the International Society for New Institutional Economics (ISNIE), which was launched on October 4, 1996 when Ronald Coase joined Douglass North to invite interested scholars to join.Footnote ¹⁷ Ronald Coase's willingness to be ISNIE's first President at the age of 87 was fundamental to its success, persuading others about the seriousness and importance of the new organization.

In his presidential address to ISNIE in 1999, Coase laid out his views on the tasks of the Society, views that closely parallel his own approach to research:

Despite ISNIE's success, Ronald Coase wanted more than an academic society focused on annual meetings and in February 2000 he propelled and supported the creation of the Ronald Coase Institute. The Institute's goal it to help people around the world improve their own lives by assisting outstanding young scholars to study important economic problems in their own countries. In helping to launch and sustain the Ronald Coase Institute, Coase was furthering his vision that young scholars, not yet captured by conventional wisdom, can transform the way we see problems. The Institute also reflected his view that, since we cannot know in advance which research ideas will be transformative, we should actively seek and assist scholars neglected by more risk-adverse organizations.

China

Even though Coase had never set foot in China—he was eagerly planning a trip right before his death—he was puzzled how a civilization so far ahead of Europe in the 13^th century could fall so far behind. China's extraordinary market reforms further surprised him. How had market supportive institutions, which could not have existed in Mao's era and without which a market economy cannot function, emerged and developed in only three decades? Coase studied China intensively, organized the 2008 Chicago Conference on China's Market Transformation, and co-authored a book with Ning Wang on how China became capitalist (Coase and Wang Reference Coase and Wang2012).

The book emphasized three major themes. First, “marginal revolutions,” and not the central government, played the key role in introducing the market and entrepreneurship back to China despite the weakness of formal institutions (particularly the legal system) and the lingering grip of the Communist Party. These “marginal revolutions,” such as the decollectivization of farms, were often the result of pressure from below and the push and pull of interests and governments at the local and provincial levels. Second, regional competition among provincial and local governments and businesses facilitated knowledge discovery and diffusion, allowing China to capitalize on its continental size and decentralized political structure. Third, China's lack of a free and open market for ideas clouded its future, since a healthy capitalist system depended on the continuous creation and application of knowledge.

The structure of production revisited

The second subject to preoccupy Coase in later years was the “institutional structure of production,” which he first dealt with in “The Nature of the Firm.” Coase came to believe that the economics literature had not fully addressed the firm's internal operation and external relations. Economics had barely begun to explore how the firm operated as a mini society with all its complexity and fluidity, staffed by individuals with different expertise and diverse interests and governed by a wealth of internal rules and external regulations. Also underdeveloped was the question of how firms coordinate their production through market and nonmarket mechanisms, competing and cooperating while pursuing their separate goals at almost every stage of production. To promote more research on these issues, Coase organized the 2010 Chicago Workshop on the Industrial Structure of Production (Coase and Wang, Reference Coase and Wang2011).