The Power of Exchange: Ronald H. Coase: 1910-2013

By Lemieux, Pierre | Regulation, Winter 2013 | Go to article overview

The Power of Exchange: Ronald H. Coase: 1910-2013


Lemieux, Pierre, Regulation


The number of tributes and comments that followed Ronald Coase's death last September 2nd has been staggering. By now, everybody interested in economics must know that Coase was a British-born economist who immigrated to the United States, won the 1991 Nobel Prize in Economics, and had much influence on the discipline. His work also generated much controversy. In tribute, I offer this overview and critique of his remarkable life's work.

ECONOMISTS AND ACCOUNTANTS

To most contemporary economists, Coase's earliest work would not seem very controversial, although his ideas likely would be controversial for non-economists.

In a series of articles published in 1938, he tried to explain to accountants the notion of opportunity cost. The opportunity cost of a decision takes into account the lost benefits that would have been gained if an alternative decision had been made. For example, what is the cost to a firm of using materials it already purchased and has sitting in its stock? What was previously paid for purchasing the materials is irrelevant, since that cost is sunk (that is, in the past). The opportunity cost of using those materials in a specific job is what the firm foregoes from not using them that way or reselling them on the market, if either of those decisions would yield net receipts greater than the current course of action. The materials' storage cost also must be considered, assuming the storage space could be used profitably in other ways. If the materials could not be used profitably for anything else, their opportunity cost is zero (minus any storage cost). Similarly, Coase would write in "Business Organization and the Accountant," the cost of using a machine "is the highest receipts that could be obtained by some alternative employment of the machine."

The basic idea behind opportunity cost is that what you choose not to earn is just as much a cost as any actual payments you make--a simple but crucial economic idea. It applies to all choices: in evaluating whether to buy a car and pay cash, you must consider not only the price of the car but the interest forgone that you would earn on that cash.

Opportunity cost is important because it is what businessmen and entrepreneurs use to reach their decisions. Choosing courses of action (e.g., which goods to be produced, in what quantities, which inputs to use) with the lowest opportunity costs amounts to maximizing profits, since this notion of cost already includes what could have been earned by choosing other courses of action: "To cover costs and to maximize profits are essentially two ways of expressing the same phenomenon," Coase wrote.

Nobel economics laureate James Buchanan, in his 1969 book Cost and Choice, presents Coase as one of the main theorists in the London School of Economics tradition on cost, explaining that opportunity cost is an ex ante, forward-looking concept, as opposed to the past, incurred, sunk costs that accountants fixate on. It should be understood that opportunity costs are subjective because forgone alternatives might have non-monetary costs and because the future (when the gains from these opportunities would be realized) is fraught with uncertainty.

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WHY THE FIRM?

One of Coase's seminal articles is his 1937 "The Nature of the Firm." Why, he asked, do business firms exist? Why is not all production organized by arm's-length contractors under the coordination of the market? That is, why does a car company hire people and organize factories to assemble cars, when a single individual could subcontract all parts of the work to other individual subcontractors on the open market? If the economic system automatically "works itself," as free-market economists used to say, why does the authoritarian firm exist within the free market? The question seems an obvious one, but it had not been clearly formulated before Coase.

His answer is that "there is a cost of using the price mechanism. …

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