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Ronald Coase

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Ronald Coase (1910-) is a British economist. He won The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel in 1991.

Coase is best known for two articles in particular: "The nature of the firm" (1937), which introduces the concept of transaction costs to explain the size of firms, and "The problem of social cost" (1960), which suggests that well defined property rights could overcome the problems of externalities. (These are dates of first publication.)

Coase's transaction costs approach is currently influential in modern organizational theory, where it was reintroduced by Oliver Williamson.

The Nature of the Firm

"The Nature of the Firm" is a brief essay in which Coase tries to explain why the economy is populated by a number of business firms, instead of consisting exclusively of a multitude of independent, self-employed people who contract with one another. Given that "production could be carried on without any organization [i.e. firms] at all", Coase asks, why and under what conditions should we expect firms to emerge?

Since modern firms can only emerge when an entrepreneur of some sort begins to hire people, Coase's analysis proceeds by considering the conditions under which it makes sense for an entrepreneur to seek hired help instead of contracting out for some particular task. The traditional economic theory of the time suggested that, because the market is "efficient" (i.e. those who are best at providing each good or service most cheaply are already doing so), it should always be cheaper to contract out than to hire. Coase noted, however, that there are a number of transaction costs to using the market; the cost of obtaining a good or service via the market is actually more the just the price of the good. Other costs, including search and information costs, bargaining costs, and policing and enforcement costs, can all potentially add to the cost of procuring something with a market. This suggests that firms will arise when they can arrange to produce what they need internally and somehow avoid these costs.

There is a natural limit to what can be produced internally, however. Coase notices a "decreasing returns to the entrepreneur function", including increasing overhead costs and increasing propensity for an overwhelmed manager to make mistakes in resource allocation. This is a counterveiling cost to the use of the firm.

Coase argues that the size of a firm (as measured by how many contractual relations are "internal" to the firm and how many "external") is a result of finding an optimal balance between the competing tendencies of the costs outlined above. In general, making the firm larger will initially be advantageous, but the decreasing returns indicated above will eventually kick in, preventing the firm from growing indefinitely.

Coase does not consider non-contractual relationships, as between friends or family members.