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Posts Tagged ‘problem of social cost

WINNER OF 1991 NOBEL PRIZE IN ECONOMICS

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Ronald Harry Coase was born in Willesden, England, on December 29, 1910 in a suburb of London. As a child, Coase had a weakness in his legs, for which he was required to wear leg-irons. Due to this problem, he attended the school for physical defects. At the age of 12, he was able to enter the Kilburn Grammar School on scholarship. At Kilburn, Coase completed the first year of his Bachelor in Commerce degree and then passed on to the University of London. Coase graduated from the London School of Economics in 1932, and earned a higher doctorate from the University of London in 1951.

During 1931–32, Coase traveled to the United States on a scholarship to study the structure of American industry. This study became the basis for Coase’s lifetime fascination with industrial organization and his later work on the nature of firms and their costs.

Ronald Coase received the Nobel Prize in 1991 for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.

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 nature and limits of firms, and “The Problem of Social Cost” (1960), which suggests that well-defined property rights could overcome the problems of externalities.

THE NATURE OF THE FIRM

The Nature of the Firm was a brief but highly influential 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. Coase asks, why and under what conditions should we expect firms to emerge knowing that productions could be carried on without any organization or firm?

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.

Coase explained that firms exist because they reduce the transaction costs that emerge during production and exchange, capturing efficiencies that individuals cannot. Firms are like centrally planned economies, he wrote, they are formed because of people’s voluntary choices. But why do people make these choices? The answer, wrote Coase, is “marketing costs.” (Economists now use the term “transaction costs.”) If markets were costless to use, firms would not exist. Because markets are costly to use, the most efficient production process often takes place in a firm.

For clearer understanding, take for example a broken car. If you are the owner of the car and decided not to bring it to a mechanic shop (which is a firm) it will take you “marketing cost” to fix it by yourself. You need to buy those parts which need to be repair, tools to be used in repairing, fare in going to hardware stores, and effort and time to do the work. That is what Coase tries to explain on why firm exists. If you bring the car directly to the repair shop it won’t take you marketing cost in doing the repairing.

THE PROBLEM OF SOCIAL COST

“The Problem of Social Cost,” Coase’s other widely cited article, was even more path breaking; indeed, it gave rise to the field called law and economics.

Published in the Journal of Law and Economics in 1960, while Coase was a member of the Economics department at the University of Virginia, “The Problem of Social Cost” provided the key insight that it is unclear where the blame for externalities lies.

I take a beach resort as an example. Assume that there is a known tourist spot beach resort which earns a lot of money in its services. Few kilometers away from the resort, there is a small island. Years later this island is dumping its waste into the beach which causes the tourists in the beach resort to have skin infections in their swimming. If that small island keeps their garbage in their place it will also cause health problems to the inhabitants of the island because their area is too small to make a place for their wastes.

Coase argued that without transaction costs it is economically irrelevant who is assigned initial property rights; the people living in the island and the owner of the resort shall work out an agreement about whether to restrict the waste disposal or not based on the economic efficiency of doing so. Since none of them on the ocean, property rights allocation will hence matter only in determining distribution. If the islanders held rights over the sea, the resort owner could pay him to restrict or limit the pollution; if the resort owner held the rights, the islanders could buy the right to pollute.

The Problem of Social Cost” provides more than merely a revolutionary rethinking of the question of externalities. It also suggests a new and interesting approach to the problem of defining property rights.

This seminal argument forms the basis of the famous Coase Theorem as labeled by George Stigler.

COASE THEOREM

In The Problem of Social Cost”, 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.” 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 describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that when trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. The Coase theorem is an important basis for most modern economic analyses of government regulation, especially in the case of externalities.

“Whether a transaction would be organized within a firm or whether it would be carried out on the market depended on a comparison of the costs of organizing such a transaction within the firm with the costs of a market transaction that would accomplish the same result. All this is very simple and obvious. But it took me a year to realize it – and many economists seem unaware of it (or its significance) to this day…As it was a new approach (I think) to this subject, I was quite pleased with myself. One thing I can say is that I made it all up myself. As I said in my Nobel Prize lecture, I was then twenty-one and the sun never ceased to shine.”
– Ronald Coase

Sources and Suggested Reading:

Autobiography of Ronald Coase, http://nobelprize.org/nobel_prizes/economics/laureates/1991/coase-autobio.html