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Ronald Harry Coase
: Journal of Economic Issues, Jun96, Vol. 30 Issue 2, p571, 8p
Medema, Steven G.
The development of political economy may be attributed to various factors, one of which is surely the need to deal with the problem of coordination--a problem whose import grew with the transition from subsistence economy to the increasing division of labor within and across economies. While the mechanisms of coordination-in particular, markets, firms, and governments-have always occupied a place at the center of economic analysis, albeit with differential degrees of positive and normative emphasis among them at different times and by different schools, relatively little attention has been devoted to the examination of the underpinnings of these mechanisms. This has several implications. First, economic theory offers little in the way of explanation for how these mechanisms function and why they function as they do. Second, there has been, until recently, little offered by way of explanation for the observed pattern of coordination within the economic system and, in particular, why certain activities are coordinated in different ways (e.g., market versus firm, short-term versus long-term contracts, etc.). Third, and reflective of the foregoing, economic theory offers little basis for the normative analysis of and choice among alternative instruments of coordination.
For Ronald Coase, issues such as these are at the heart of economic analysis, one of the central functions of which, in his view, is to understand and to make policy recommendations regarding the appropriate institutional structure of production and exchange-the mechanisms through which production and exchange are to be coordinated. In this essay, I will attempt to outline Coase's contributions in this regard and evaluate their import for economic analysis. While Coase has by no means given us a comprehensive, well-developed theory of coordination, his insights can serve to enhance our understanding of how and why coordination matters.
Why Coordination Matters: The Costs of Coordination
Traditionally, the world of neoclassical economic analysis has been one in which markets, firms, and governments coordinate economic activities in a costless manner. Ronald Coase is perhaps best known for his analysis of the implications of life within such a world-in particular, for pointing out that, if coordination costs were zero, the mechanism employed to coordinate activities would not matter, at least from an allocative perspective. As he has repeatedly pointed out, however, the insights to be gained from contemplating such a world do not lie in the results thereby implied, but rather come from their collisions with the operation of real-world coordination processes-in particular, with the reality that coordination does matter for the pattern of resource allocation within society. And for Coase, the main reason for this (the why within the why, if you will) is that there are costs associated with the coordination processes, that these costs are inevitably present, that they differ both across coordination mechanisms and for each of these mechanism across circumstances, and that, as a result, the choice of coordination mechanism in a given situation has important implications for economic outcomes.
While Coase did not construct a general theory of coordination costs, he did provide important insights into the roles that they can play and the implications that one can draw from them. In "The Nature of the Firm" [1937], Coase set out to answer a question to which, in his view, economic analysis to that point had offered no satisfactory answer: Why do firms exist? The (mainstream) economic analysis of the day, after all, assumed that the pricing mechanism could provide all of the coordination necessary within the economic system. Yet, the firm obviously serves a coordinating purpose, performing functions that could be coordinated instead through the pricing mechanism. The answer, Coase suggested, is that there are costs associated with operating through the pricing mechanism, some of which could be reduced or eliminated by internal organization-the integrated firm relationship. This led straight-away to another question: Why then do markets exist? The answer, he suggested, could be found in the existence of costs associated with internal organization, such as bureaucracy costs, which could make coordination through the market superior to that through the firm. This, in turn, raised a third question: What determines the extent of firm versus market coordination? Coase argued that an answer to this question lay in the relative costs of these alternative modes of coordination-that the firm will organize additional transactions internally as long as the costs associated with internal organization are less than the costs of organizing the same transaction through the market. And, since the relative size of these costs differs across transactions, the extent of the firm will differ across, and even within, industries.
Consider next the existence and persistence of inefficient externalities. In "The Problem of Social Cost" [1960], Coase demonstrated that, under appropriate conditions (in essence, under the standard assumptions of neoclassical theory), including zero coordination costs, inefficient external effects would not persist; the externality problems would be resolved efficiently through bargains among affected agents, and, furthermore, the resulting allocation would be invariant across alternative legal rules of liability. The more general implication of this is that the structure of law does not affect the allocation of resources in society; transactions between agents will move resources into their highest-valued uses irrespective of the legal rules in force. Returning to the issue of externalities, Coase pointed out that, in a world in which coordination costs are zero, externality problems also could be efficiently resolved through either a single-owner firm (which would take all relevant costs into account) or the government, which could employ various "Pigouvian" remedies to internalize the external costs. However, he argued that the reality of coordination costs--costs associated with market transactions, transactions within the firm, and the bureaucratic, legislative, informational, rent-seeking, etc. processes associated with the Pigouvian remedies--and the fact that these costs differ across mechanisms imply that the final allocation of resources will be impacted by the mechanism employed to resolve externality problems.
Finally, consider the case of public goods, such as the lighthouse, which is one of the few instances in which neoclassical economic theory recognizes the issue of coordination costs. In this case, the nonrival nature of the good, combined with the high cost of exclusion, is said to generate market failure and necessitate government provision. The flaw in this analysis, as Coase [1974] has shown,[1] is not the neglect of coordination costs, but rather the assumption that these costs necessarily are sufficiently high to preclude private provision. Indeed, Great Britain once had a flourishing and profitable private lighthouse system, one that arose because the agent of the crown was not providing lighthouses in a quantity sufficient to meet the demand.
The message to be taken from this is a simple one. Alternative mechanisms of coordination entail different levels and patterns of cost, because of which the allocation of resources is impacted. Understanding the import of these costs is thus central to understanding how and why coordination matters. Furthermore, because costs matter in this way they will impact the "private" choice of mechanisms by which activities are coordinated--internal versus market organization, long-term versus short-term contract, etc.--and will presumably have some degree of import for the public policy choices among alternative coordination mechanisms. Thus, understanding and making choices among coordination mechanisms entails the recognition of their relative costs. Yet, much of economic analysis (including both neoclassical and "old" institutional) continues to proceed as if these costs do not exist or are irrelevant.
Law and the Costs of Coordination
If coordination matters in part because there are costs associated with coordination, costs that vary across coordination mechanisms and circumstances, and that influence the allocation and distribution of resources, then it remains to ascertain what are the factors that determine the magnitude and extent of these costs and, hence, their influence on economic outcomes. What Coase has particularly emphasized is the influence of the law within the coordination process. Coase's perspective here is similar to that of Commons [1924] in that both tie law to coordination through the range of actions allowed to economic agents. However, Coase does far more to relate this to the accompanying effect on costs and the implications thereof.[2]
The structure of law is a unifying element that pervades market, firm, and governmental coordination forms, for it is the law that brings about the possibility or existence of each particular form of coordination and, in part, determines the efficacy of each in a particular situation. As respects the market, Coase points out that, as lawyers have long known (and economists commonly have ignored), what are traded on the market are not physical entities, but rather "bundles of rights, rights to perform certain actions." Given this, "Trade . . . its amount and character, consequently depend on what rights and duties individuals are deemed to possess-and these are established by the legal system" [Coase 1988, 656]. Numerous examples of the dependency between market and law emerge within Coase's work, including: (1) even if coordination costs are zero, law matters by its presence or absence in that, without some initial specification of rights, transactions may be impeded; (2) the completeness with which rights are defined and enforced; (3) the extent to which rights are alienable; (4) the extent to which the law imposes costly and time-consuming procedures; (5) the manner in which law treats less-than-fully-specified contracts and the legality of various contractual forms; and (6) the determination of liability for damages in externality situations (broadly defined to range from, e.g., pollution to products liability).
All of these factors (and others as well) have important implications for the fluidity with which markets function and even whether they function or exist at all. Note, for example, that the private provision of lighthouses in Great Britain, alluded to above, did not arise out of a vacuum. Rather, the government granted to prospective lighthouse operators exclusive franchises and the power to invoke the authority of the crown in order to collect dues from all of the ships that used the lighthouse services. Thus, while the law may be structured so as to preclude the working of the "market," it may also be possible to structure it in such a way as to facilitate the "market" by reducing the associated costs of coordination.
As respects the integrated firm, its existence, its form and extent, and its distinctiveness vis-a-vis the market are at least in part a function of the law governing the employer-employee relation, which establishes an authority relationship that is absent in market transactions between legal equals. The authority relations that are present within the firm allow for the allocation of resources by administrative fiat and, in the process, may offer cost advantages over market transactions [Coarse 1937, 403-404]. That is, the organizational success of the firm is at least in part derivative of the law that allows authoritative transactions through which cost economies can be generated. A similar but stronger authoritative control (with corresponding cost implications) is evidenced in government [Coarse 1960, 17-18].
If there is a signal contribution from Coarse in this regard, it lies in his emphasis on the idea that the factors of production are not the workers, the capital, and the materials, but rather the rights over them, or, more generally, the rights to perform certain actions-an idea to which one can find parallels in Commons. The form and extent of these rights are various. They differ as between internal hierarchy and external contract, and each of these, in turn, differs according to the law underlying them: hierarchy with the form of the law governing employer-employee relations, and contracting with the structure of the law governing contracts. And as Coarse pointed out in "The Problem of Social Cost," rights over externalities are also factors of production, with the presence, absence, or extent of such rights influencing the firm's production process and its costs, and thereby market prices and quantities. Given this, "the legal system will have a profound effect on the working of the economic system and may in certain respects be said to control it" [Coarse 1992, 717-718].
We Are All Planners Now
One of the hallmarks of the "old" institutionalism is its emphasis on the need to institute governmental planning to replace the supposed chaos of the market and/or the evils of corporate planning. Indeed, some claim that one cannot be considered an institutionalist unless one is in favor of coordination by means of governmental planning [Dugger 1987; 1992]. On the opposite pole, there are many who proclaim the virtues of free and unfettered markets and the evils of government interference and planning. However, the rhetoric of both of these positions masks a fundamental misconception of the idea of planning, one that is uncovered by the foregoing discussion.
Let me put this as simply as possible: there is no a priori distinction between government planning and the market nor between government planning and corporate planning. What is governmental planning? Is it not the governmental determination of the allocation and distribution of resources in society? And are allocation and distribution not a function of rights, duties, liberties, and exposures? Wherein lies the ability of the market to function? What is it that gives rise to the corporate power that manifests itself in so-called corporate planning? The working of markets and finns, and the results derivative thereof, are bound up in and determined by law-that is, by government planning. The determination of the mechanism to be used to coordinate a given set of transactions, or the establishment of a framework within which choice among such mechanisms can proceed-e.g., of the forces that affect such choice, is nothing less than planning. As such, it is nonsensical to speak in terms of government planning versus the market or versus corporate planning. The issue thus is not government planning versus something else, but rather of this type of government planning versus that type, of government giving effect to one set of interests or another. If the litmus test of the institutionalist is a belief in governmental planning, then we are all institutionalists now.
From a policy (planning) standpoint, one of the implications of the discussion in the previous sections is that there is no single best method of coordination in all situations. Furthermore, the costs associated with each of these mechanisms means that none of them satisfy the optimality claims made for them within economic theory. This has import both for those who would use the theory of optimal market outcomes to argue against government intervention and for those who would use claims of market failure to argue for such intervention. In reality, some degree of market failure, firm failure, and government failure is always present. Furthermore, the absolute and relative degrees of such failure will vary across economic activities. The issue thus becomes one of selecting, from among these imperfect alternatives, the best mechanism for coordinating a given set of transactions [e.g., Coarse 1960, 42-43].[3]
The various facets of the coordination problem evidenced in Coarse's work serve to provide pieces of a framework for understanding how and why coordination matters. At its most basic level, the question of why is simple to answer: the allocation of resources and the distribution of income and wealth-the size of the pie, its flavor, the size of its slices and to whom they go-are all determined by the coordination mechanism chosen. Indeed, if this were not the case, there would be no debate over the relative merits of alternative mechanisms of coordination. The more difficult question is that of the why behind the why. That is, in any given situation, what are the effects of the employment of each of the alternative mechanisms of coordination, and what is it that generates these effects? Coarse's analysis, with its emphasis on coordination costs, and their relation to law, provides us with a partial and (sometimes more, sometimes less) important answer to this question.[4] Other important but partial answers, such as the technological forces harnessed by alternative coordination mechanisms, have been offered within the institutional tradition. His analysis also takes us beyond the nirvana complex reflected in the writings of those who extol the virtues of so-called market or governmental solutions to economic problems while simultaneously ignoring the costs (and the sources thereof) that attend these coordination processes, both absolutely and relative to the costs of alternative means of coordinating economic activity. However, we remain in many ways ignorant of how coordination matters, particularly in an empirical sense.
Apart from lacking a solid grip on the relationship between law and coordination costs, we seem to lack even a rudimentary understanding of how these costs work through agent actions to influence economic outcomes. For example, the rational agent model suggests that these law/cost effects will be fully and advantageously exploited, at least some evidence for which is found in the reactions to the evolution of products liability law and alterations in the relative legal positions of labor unions and employers, to note just two examples. On the other hand, the experimental literature suggests that agents exhibit some tendency to take advantage of occasions for opportunistic behavior (afforded by having certain rights) but on the whole demonstrate a rather remarkable degree of forbearance in their response to these opportunities for gain. And Robert Ellickson [1991] has recently observed that, in certain situations at least, the legal position seems to have no impact on agent behavior; rather, in spite of the changes in relative power and opportunities that attend alterations in rights, agents continued to rely on norms to set fie their disputes. It seems clear that we have a long way to go in this area.
It is fashionable within the "old" institutionalism to criticize (and ignore) Coarse's work on the grounds that it reduces everything to coordination costs and/or that it assumes the primacy of markets.[5] There is both a bit of justice and a great deal of error in these critiques,[6] but none of this negates Coarse's insights regarding the fact that coordination costs matter. One of the virtues of institutionalism is that it has long been concerned with how and why coordination matters. As such, it should not make the mistake of throwing out the (positive Coarse) baby with the (normative Coarse) bath water.
1. See also Van Zandt [1993].
2. On this point and the more general relationship between Coarse's approach and that of the "old"degrees institutionalism, see Medema [1994, 24-27; 1996].
3. An examination of the normative aspects of Coarse's analysis goes beyond the scope of this essay, See Medema [1994], Medema and Samuels [1995], and Zerbe and Meclema [1995] for discussions of this topic. It should be noted, however, that in Coase's writings the idea of "best" generally refers to that which maximizes the value of output. Yet, Coase suggests that this is the economist's perspective on the problem and that what is "best" for society will often depend on other factors as well.
4. Indeed, Coase himself acknowledges that there is more to all of this than coordination costs. See, for example, Coase [1937; 1972; 1992].
5. See, for example, Dugger [1990; 1992], Hodgson [1988], and Canterbery and Marvasri [1992]. For a more balanced discussion of the related issue of the "old" versus the "new" institutionalism, see Rutherford [1994].
6. See Mederoe [1994; 1996] for discussion.
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