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The Firm, the Market, and the Law

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Ronald Coase is a Nobel Prize-winning economist, whose work is probably cited more often by lawyers than by economists. "The Firm, The Market, and the Law" is principally a collection of his seminal scholarship, although it does contain some useful new material. The opening chapter is new and shows how a consistent theory of firms and markets, as well as a unique conception of economics and economically-oriented scholarship, runs through Coase's work from the 1930s to the late 1980s (when the book was published).

Coase is best known for two seminal articles. The earlier article "The Theory of the Firm" is the seminal work on the so-called nexus of contracts theory of the firm, as well as an early source for the transaction cost branch of the New Institutional Economics. The nexus of contracts model treats the firm not as an entity, but as an aggregate of various inputs acting together to produce goods or services. Employees provide labor. Creditors provide debt capital. Shareholders initially provide equity capital and subsequently bear the risk of losses and monitor the performance of management. Management monitors the performance of employees and coordinates the activities of all the firm's inputs. The firm is simply a legal fiction representing the complex set of contractual relationships between these inputs. Besides emphasizing the importance of examining the various contracts making up the firm, however, Coase's fundamental insight was that the contractual nature of the firm does not preclude an element of command and control absent from market transactions. If a corporate employee moves from department Y to department X he does so not because of change in relative prices, but because he is ordered to do so. In other words, markets allocate resources via the price mechanism but firms allocate resources via authoritative direction. The set of contracts making up the firm consists in very large measure of implicit agreements, which by definition are both incomplete and unenforceable. Under conditions of uncertainty and complexity, the firm's many constituencies cannot execute a complete contract, so that many decisions must be left for later contractual rewrites imposed by fiat. It is precisely the unenforceability of implicit corporate contracts that makes it possible for the central decisionmaker to rewrite them more-or-less freely. The parties to the corporate contract presumably accept this consequence of relying on implicit contracts because the resulting reduction in transaction costs benefits them all.

Even better known, and even more central to transaction cost economics, however, is Coase's later article "The Problem of Social Cost," which also is reprinted in full here. In that article, Coase laid a critical foundation of modern law and economics - the so-called Coase theorem. The Coase theorem has been formulated in various ways, but one useful statement might be that: "When the parties can bargain successfully, the initial allocation of legal rights does not matter." Suppose a steam locomotive drives by a field of wheat. Sparks from the engine set crops on fire. Should the railroad company be liable? In a world of zero transaction costs, the initial assignment of rights is irrelevant. If the legal rule we choose is inefficient, the parties can bargain around it. Put another way, according to the Coase theorem, rights will be acquired by those who value them most highly, which creates an incentive to discover and implement transaction cost minimizing governance forms.

The Coase theorem has been widely criticized. The second major set of new material in this book is a chapter entitled "Notes on the Problem of Social Cost," in which Coase answers the more serious criticisms. That essay provides a useful intellectual history of the Coase theorem, as well as a trenchant defense of its main claims. One of the less-well informed criticisms of Coase is that he assumes transaction costs are zero. He does not, as this new essay makes clear. Indeed, as Coase points out, the interesting cases are those in which transactions costs are non-zero. In a world of positive transaction costs, however, the parties may not be able to bargain. This is likely to be true in our example. The railroad travels past the property of many landowners, who put their property to differing uses and put differing values on those uses. Negotiating an optimal solution will all of those owners would be, at best, time consuming and onerous. Hence, the allocation of legal rights becomes quite important.

This collection of seven of economist Ronald Coase's essays provides important understanding of the workings of market economies, the boundary between private and public, and what determines the size and structure of a firm. Coase distinguished his work from other economists by focusing on the role of transaction costs-now a common theme in discussions of the new economy. If you read only one of the chapters, it should be "The Nature of the Firm". Here Coase provides the intellectual foundations for strategic thinking about business architectures, mergers and acquisitions, outsourcing, and collaborative commerce. Some of this work was later elaborated on by Oliver Williamson (see his 1985 book, The Economic Institutions of Capitalism.) Like Joseph Schumpeter, Ronald Coase is an economist whose works from decades ago are now more relevant than ever. While Schumpeter's phrase "creative destruction" may be more memorable, in the end it is Coase's views on transaction costs and the nature of the firm that may be the more significant (and certainly more readable).

This book consists of Nobel Prize winner Ronald Coases classic articles where the 1937 _Nature of the Firm_ and The 1960 _The Problem of Social Cost_ stands out.

This is _the_ book to own on the subject as Coase takes his time to explain some of the reasons why economists in general has misunderstood his argument.

It is also well worth reading if you like Oliver Williamson's elaborations on the subject as a reading of Coases original articles reveals much of Williamsons work as just that. If you haven't read Williamson's 1985 The Economic Institutions of Capitalism book I recommend it highly _after_ you've read this.

Unlike other Nobel Prize winners, Coase's original papers, reprinted in this book, actually are the best sources to explain his own theory. Anyone seeking to understand the "Chicago School" of economics should read this book. To readers more familiar with the modern, more linear, writing style, however, Coase may appear to be a bit rambling at times.

(This review was posted earlier, but somehow my names was removed from it. Please put it back or allow this re-post of the review. Thanks!)

This book consists of Nobel Prize winner Ronald Coases classic articles where the 1937 "Nature of the Firm" and The 1960 "The Problem of Social Cost" stands out.

This is *the* book to own on the subject as Coase takes his time to explain some of the reasons why economists in general has misunderstood his argument.

It is also well worth reading if you like Oliver Williamson's elaborations on the subject as a reading of Coases original articles reveals much of Williamsons work as just that. If you haven't read Williamson's 1985 The Economic Institutions of Capitalism book I recommend it highly *after* you've read this.

The essays in this book are the foundation for New Institutional Economics. Coase arrived at a simple explanation for institutions: transaction costs. In 1937 Coase argued that organizations exist because of high transaction costs, or what he referred to as market costs. This 1937 article became chapter two. It also became the basis for the modern theory of the firm, as developed by Williamson, Demsetz, Fama, and many others.

Coasean economics is important because it pushes us to make fair and realistic comparisons between private and public institutions. In 1959 Coase published an article on the Federal Communications Commission which demonstrated that market imperfections do not automatically imply the need for government regulation. Transaction costs make markets imperfect, but government suffers from its own imperfections. In 1969 Harold Demsetz explained the Coasean approach to institutional analysis in his "Institutions and Efficiency, another Viewpoint". Coase's opponents are guilty of committing the Nirvana Fallacy. Economists used to condemn markets for failing to deliver ideal conditions. Those who compare real imperfect markets to an idealized perfect government will always "prove" the need for government regulation. In reality, the nirvana of perfect government never exists, so the need for governmental intervention is always questionable.

Unfortunately, this 1959 article did not make it into this book. Instead, Coase used his 1960 follow up paper "The Problem of Social Cost" (chapter five) to explain his ideas about law and economics. Chapter five explains "The Coase Theorem" and "The Invariance Proposition". The 1960 paper on social costs is an outgrowth of an informal debate between Coase and Milton Friedman. This is a rare instance where Friedman admitted defeat. Given Friedman's talent for debate, Coase's victory is not a small matter. Having proven his point to the satisfaction of the Chicago economics faculty, Coase was able to join this faculty and edit The Journal of Law and Economics. Not bad for an informal after-dinner debate.

The reprinting of the Problem of Social Cost is important because so many economists misconstrue the Coase Theorem. Contrary to what many believe, Coase does not assume that transaction costs are zero. The idea of zero transaction costs is just a thought experiment. Coase saw little value in thought experiments. The real message from Coase is that we should focus on real examples where transaction costs are positive and vary. Good institutions are the ones that reduce transaction costs to a minimal level. Coase explains his position further in chapter six: notes on the problem of social cost. It is also important to guard against George Stigler's misinterpretation of Coase. The idea that all institutions are imperfect does not imply that we arrive at the least imperfect institutions.

The Marginal Cost Controversy (Chapter Four) and the Lighthouse in Economics (chapter seven) are also notable. Coase demonstrated that Abba Lerner and Harold Hotelling were wrong about the need for government to subsidize firms with declining average costs. Besting Lerner and Hotelling is no small feat. In chapter seven Coase took on none other than John Stuart Mill. It turns out that lighthouses are not necessarily public goods. History and common sense show that entrepreneurs can supply lighthouses for profit.

The Firm, the Market, and the Law is brilliant, but often misunderstood. This is hard to explain because it is highly readable and thought provoking. Some of its points are simple, others are subtle, but they are all well reasoned. Most of the misunderstandings about this book seem to derive from the fact that some people judge Coasean economics based on what they have heard, rather than from reading this book. While I do not agree with everything in this book, reading it (and re-reading it) has made me a better economist. All social scientists and legal scholars could benefit from reading The Firm, the Market, and the Law, if they have not read it already.

This little book is a fantastic introduction to some of the powerful ideas introduced by Coase. Coase initiated two different ideas that today govern or inform much of the work of economists. The first was his introduction of the idea of "transaction costs", from an article suggesting an investigation into the root causes for industrial organization. The second is now known as the Coase Theorem, and stems from his insightful refutation of the Pigouvian view of social cost. There is also an article investigating the actual history of lighthouses in England, something which has usually been cited as a pure public good, and therefore requiring government provision. The history shows that most lighthouses - in some periods, all lighthouses - were privately provided. Coase's writing is lucid, his ideas profound, and his influence widespread. This collection is very important to anyone wanting to understand externalities, transaction costs, and social welfare.

Ronald Coase is a fantastic economist. He writes with great lucidity and a confidence which suggests to the reader that his arguments "fall into the category of truths which can be deemed self-evident" (page 1). Coase's principal aim in these essays is to correct what he believes to be the flaws of mainstream economic theory. In the process of doing so, he asks some remarkably novel and challenging questions, but in the end fails to pursue them consistently, arriving at conclusions which employ the same assumptions by those whom he is trying to refute.

The book consists of seven essays. Very briefly, the first essay is an introduction in which Coase describes his economic outlook while introducing the concepts contained in each of the following essays. The remaining six essays can be divided up as follows. Chapters two and three contain discussions of the firm. The second essay is the highly influential "The Nature of the Firm" essay while the third essay applies these arguments to a general research proposal on industrial organization. Chapter four and seven are essays which can be described as historical. Chapter four summarizes and contributes to the "marginal cost controversy." For those with little exposure to this issue, this essay can be passed over. Chapter seven is the famous "The Lighthouse in Economics" which challenges the public goods argument by showing that the lighthous has historically been provided by private companies. The remaining two chapters contain arguments and notes on what has come to be called "The Coase Theorem." Chapter five is the actual essay "The Problem of Social Cost" and chapter six contains a series of replies to various criticisms that have been directed at the arguments presented in "The Problem of Social Cost" essay.

Clearly, the best aricles in this book are chapters two and five, "The Nature of the Firm" and "The Problem of Social Cost". As I mentioned earlier, Coase begins his analysis by asking a very novel and challenging question: If the price system works itself, as is conventionally taught, then why do we see firms? His answer is that there are costs to conducting transactions through the market. The two examples he gives in various forms are:

1. discovering what the relevant prices are, since outside equilibrium the relevant prices are not known.

2. The costs of negotiating and concluding contracts.

To my disappointment, Coase inexplicably spends the rest of the essay extending the example of the costs of contractual arrangements. Now this is an important problem, but until the question of relevant prices is resolved, the problem of executing costly contracts seems to be almost insuperable because if we still have no way of discovering what the relevant prices are, then how can we measure the degree of costs involved in "negotiating and concluding contracts" (page 38)?

I would have liked to see Coase concentrate his remarkable intellectual abilities on the first problem; namely, that of disovering what the relevant prices are. He mentions this problem just once, and then omits it from all subsequent discussions of costs and market transactions. I cannot make sense of this.

This problem is carried into his other famous essay "The Problem of Social Cost". Now the economic analysis contained in this essay is both rigorous and logically consistent. Given certain prices, and given a world in which transaction costs are absent, it would seem superfluous to assign rights because they would simply be re-negotiated in a way which maximizes the social product. This world is a world of equilibrium, and in such a world we can presume that the relevant prices are known. What I like about this argument is that it demonstrates to the advocates of this model (equilibrium) that economists cannot simultaneously present theories of perfect competition and market failure. In a world of perfect competition, rights will be arranged in a way consistent with the maximization of the social product. It does not make any sense to speak of market failire in conditions of perfect equilibrium. We can use Coase's analysis and say to economists:

"The nature of the choice is clear: [perfect competition] or [market failure]. What answer should be given is, of course, not clear unless we know the value of what is obtained as well as teh value of what is sacrificed to obtain it" (page 96).

But when Coase does admit the existence of transaction costs into the analysis, he falls into the same error of assuming that the relevant prices are still known in such a world. He writes:

"In earlier sections, when dealing with the problem of the rearrangement of legal rights through the market, I argued that such a rearrangement would be made through the market whenever this would lead to an increase in the value of production. But this assumed costless market transactions. Once the costs of carrying out market transactions are taken into account, it is clear that such a rearrangement of rights will only be undertaken when the increase in the value of production consequent upon the rearrangement is greater than the costs which would be involved in bringing it about" (page 115).

This argument, while laudable in its emphasis on transaction costs, still begs the question. We first must know what the relevant prices are before we can compare the relative advantages of alternative sets of rights. I think Coase's argument would be strengthened considerably once these considerations are brought into clearer light. To my knowledge, this observation has yet to be made. Before we can speak of transaction "costs", it behooves us to know, as Coase recognized, what the relevant prices are. We could not speak of cost without first solving this very important problem.

Coase is an excellent read not only for the economist and the student of law, but for anyone interested in the functioning of society. It is also fun to read, since Coase's language is highly original, provocative and precise. Plus you have a whole bunch of original stories to explain real world phenomena to your students or your kids, especially the difficulty to arrive at a consensus when there is a real conflict of interests. My favorite is: The lighthouse in economics.

Two of the essays in this short book -- "The Nature of the Firm" and "The Problem of Social Cost" -- are classic pieces of economic analysis. Together they practically created the field of law and economics. Unfortunately, the central ideas (for which Coase won the Nobel prize) have been so thoroughly integrated into economics curricula that they no longer seem fresh or novel; in fact, they are now almost humdrum economic "common sense."

That's a tribute to Coase and his impact on economic thinking, but it does make it hard for the reader to get excited about this book. Nevertheless, Coase's writing still has great value as a model of clear exposition, and it reminds us that simple, non-mathematical thought experiments can profoundly shape our view of economics. Any well-stocked economics library must include "The Firm, the Market, and the Law." Highly recommended.