When Ronald Coase was awarded the Nobel prize for economics in 1991, many in the profession were stunned. No one could remember a single equation, an estimated parameter, a correlation coefficient--nary a Greek symbol--in any of his articles. How could this poseur--a man who had taught economics at the University of Chicago Law School--properly lay claim to that esteemed title?
It was not the first time in his life that Ronald Coase had surprised people. Born in England in 1910, Coase wore leg braces as a youngster and was placed in a school for "physical defectives." It was run by the same organization, Coase remembers, that ran the school for "mental defec-tives," and there was "some overlapping in the curriculum." Coase found himself in (literally) basket-weaving classes, and received virtually no academics until the age of 10.
Even at the London School of Economics, Coase was pretty much on his own. He took only business and accounting--no economics--until a seminar with Professor Arnold Plant in his senior year. The course--no readings--featured a robust discussion of the invisible hand. Coase, then a socialist, grasped as seminal the idea of spontaneous coordination in the marketplace, and his career as a creative and provocative economic thinker was born.
Again, in a most unusual way. He trekked to America in the early 1930s on a scholarship, and wandered about the industrial heartland researching the methods of business firms. Coase's scientific methodology? He asked businessmen why they did what they did. One key question, for instance, involved why firms chose to produce some of their own inputs (vertical integration), and why they sometimes chose to use the market (buying from independent suppliers). He was fascinated by their answers, but even more by their astute calculation: Firm managers were keenly aware of all the relevant trade-offs. In 1937, Coase published his article "The Nature of the Firm," explaining the basic economics of the business enterprise. It became one of the most influential works in the history of the dismal science, outlining the subtle logic of how firms pursue efficiency in a complicated world. The approach was vastly more sophisticated than the ones in vogue in America in the 1930s, which posited that the corporation was simply an accident waiting to self-destruct.
Again, in 1960, Coase rearranged the study of economics with his essay "The Problem of Social Cost." It analyzed what happens when economic actions affect third parties--say, for instance, when a railroad dumps pollution on a farmer's crops. Before Coase, economic analysis maintained that decentralized decision making--the market--in such cases would predictably fail to achieve an optimal solution, because self-interested actors (say, the railroad owners) would fail to take into account the harm imposed on others. That idea had widespread implications for the economy and provided intellectual justification for a wide range of government interventions.
Coase, whose 1959 article on the Federal Communications Commission had led him to realize how property rights could be used to manage the airwaves, saw something different: The problem actually lay in an improper definition of legal rights. He noted that once property was well-defined and easily tradable, the efficient solution would follow. Ironically, the optimal social outcome would obtain no matter who owned the property. For instance, even if the railroad possessed the right to pollute, the farmer could pay it not to. Indeed, the farmer (really the farmer's customers) would pay whenever the benefit from mitigating pollution exceeded the cost created by pollution. Hence, whenever someone clearly possessed the right to pollute: Voilà! Social efficiency! This became famously known as the Coase Theorem.
What was perhaps Ronald Coase's most important contribution to economic understanding, however, was not as an author. As editor of The Journal of Law and Economics from 1964 to 1982, Coase exercised a huge effect over the sort of topics that economists chose to investigate. Located at the University of Chicago Law School, the journal is written by and for economists, but economists working in areas that were recently the sole purview of lawyers and policy makers. The JLE under Coase was relentlessly relevant, dedicated to exploring the actual effects of actual policies. This paddled against the flow of virtually the entire profession, which was drifting to increasing abstraction and formalism. Due to its rigorous analytic standards, as well as to the demand for a reality check on the theories of economic scribblers, the Journal led its own paradigm shift in the social sciences. The ultimate success of this bold approach is today apparent, as its pages are cluttered with the writings of many of the Nobel laureates in economics. Just another Coasian demonstration, one might say, that the market works.
Reason: Could you state the Coase Theorem? How do you explain it to people?
Ronald Coase: It deals with questions of liability. Whether someone is liable or not liable for damages that he creates, in a regime of zero transaction costs, the result would be the same. Now, you can expand that to say that it doesn't matter who owns what; in a private enterprise system, the same results would occur.
Take the case of a newly discovered cave. I say, whether the law says it's owned by the person where the mouth of the cave is or whether it belongs to the man who discovers it or whether it belongs to the man under whose land it is, it'll be used for growing mushrooms, storing bank records, or as a gas reservoir according to which of these uses produces the most value. The law of property determines who owns something, but the market determines how it will be used. It's so obvious to me that I couldn't understand the fuss. All it says is that the people will use resources in the way that produces the most value, that's all. I still think it's an obvious point. You wouldn't think there was a need for a Coase Theorem, really.
But the people at the University of Chicago thought it was an error. Some people thought I should delete this section from my article on the FCC. The person who most desired this was Reuben Kessel, who was a very good economist, but he was supported by Aaron Director and George Stigler and others at the University of Chicago. I replied that if it was an error, it was a very interesting error and I would just as soon it stayed in. And it did stay in.
Then George Stigler invited me to do something at a workshop in Chicago and I presented something on another topic. I said I'd like to have an opportunity to discuss my error. Aaron Director arranged a meeting at his home. Director was there, Milton Friedman was there, George Stigler was there, Arnold Harberger was there, John McGee was there--all the big shots of Chicago were there, and they came to set me right. They liked me, but they thought I was wrong. I expounded my views and then they questioned me and questioned me. Milton was the person who did most of the questioning and others took part. I remember at one stage, Harberger saying, "Well, if you can't say that the marginal cost schedule changes when there's a change in liability, he can run right through." What he meant was that, if this was so, there was no way of stopping me from reaching my conclusions. And of course that was right. I said, "What is the cost schedule if a person is liable, and what is the cost schedule if he isn't liable for damage?" It's the same. The opportunity cost doesn't shift.
There were a lot of other points too, but the decisive thing was that this schedule didn't change. They thought if someone was liable it would be different than if he weren't. This meeting was very grueling for me. I don't know whether you've had a conversation with Milton Friedman, but an argument with Milton Friedman is a pretty strenuous affair. He's very good. He's very fair, but he doesn't let you slip up on anything. You're constantly being pressed. But when at the end of whatever the time was--say, an hour--I found I was still standing, I knew I'd won. Because if Milton can't knock you out in a few rounds, you're home.
Reason: The place the Coase Theorem comes into play most often is when talking about pollution. The pollution problem has been seen in a very different light because of the Coase Theorem.
Coase: It should be seen in a different light, but I don't see why you needed the Coase Theorem to do it. The pollution problem is always seen as someone who was doing something bad that has to be stopped. To me, pollution is doing something bad and good. People don't pollute because they like polluting. They do it because it's a cheaper way of producing something else. The cheaper way of producing something else is the good; the loss in value that you get from the pollution is the bad. You've got to compare the two. That's the way to look at it. It isn't the way that people today look at it. They think zero pollution is the best situation.
Reason: The basic idea behind the Coase Theorem is that the market is efficient, that consumers are going to direct the resources to where these resources yield the highest value.
Coase: Roughly speaking, when you are dealing with business firms operating in a competitive system, you can assume that they're going to act rationally. Why? Because someone in a firm who buys things at $10 and sells them for $8.00 isn't going to last very long in that firm. I think that the market imposes a great discipline, and the discipline of the market makes the assumption of rationality in that field correct.
I find that people behave in ways that destroy themselves and their families, produce a lot of hardship, and when it comes to policy do the same thing. I hold the view of Frank Knight: In certain areas rationality is enforced; in other areas it's weakly enforced. You get more irrationality within the family and in consumer behavior than you get, say, in the behavior of firms in their purchases.