Ronald Coase: What the U.S. Learned From the Nobel Laureate

The world of economics is mourning one of his greatest contributors. Ronald Harry Coase, British economist and Economics Nobel laureate in 1991, lived in the U.S. for about half of his 102 years of life and died on September 2 according to his former employer, the University of Chicago. Although the name will sound unfamiliar to most millennials, his contribution to the world is significant. You are probably familiar with his famous quote: "If you torture a data long enough, it will confess anything."

His first influential work, The Nature of the Firm, was published in 1937 and looked at how and why firms came into existence. After all, according to classical economics (from Adam Smith to Karl Marx), market efficiency implied that it would cost less for producers to contract out their production rather then hire people, i.e. buy products on the mythical market. And according to neoclassical economics, information is widely available at little or no cost.

Coase showed that both those assertions were false. In particular, subcontracting production can actually cost more that the product itself. Bargaining, information, and policing costs can also increase production costs substantially. In order to contain those transactional costs, founding a firm makes sense as those costs can be internalized and diminished as the firm grows up (the famous economies of scale). This can explain both why firms like Ford were vertically integrated at the beginning of the 20th century and why 21st century corporations are outsourcing most of their production. It also explains why a firm, even one that is very-well managed, cannot grow indefinitely because of diminishing returns.

Coase's other major contribution, The Problem of Social Cost, was published in 1960 and earned him his Nobel Prize. The award was well-deserved; he was able to show that property rights can be mutually beneficial and that they can be negotiated without direct government intervention. His classical example talked of a dispute between a cattle rancher and a farmer, whose crops are eaten by his neighbor's cow. Coase's Theorem states that if it costs less to build a fence rather than compensate the farmer, then the rancher will build a fence. Inversely, if it costs less to build a fence than compensate the rancher (his cow feeds off the crops), then the farmer will build the fence.

A real-life example of the theorem can be applied to the way New York City gets its water supply. In order to quench the thirst of its eight million residents, the Big Apple has to take its water from the Catskill Mountains, about 200 km northwest of the city. To minimize the cost of filtration and cleaning up, it pays upstream residents (mainly farmers) so they can take means not to pollute the many effluents flowing into the water supply. This way, everyone is a winner.

Finally, although Coase did not consider himself a libertarian, he was very critical of government regulation. When a regulation was enacted, he first wanted to see its effect. In the end, it almost unavoidably ended costing more because something that wasn't predicted happened.