Saturday, September 7, 2013

Some Thoughts on the Legacy of Ronald Coase

Taught Us Why Firms Exist, And Much More
Earlier this week Ronald Coase passed away at 102.  Coase was the Clinton R. Musser Professor of Economics Emeritus at the University of Chicago Law School.   The University of Chicago has published an obituary here.

In 1991, Coase won the Nobel Prize in Economic Science.  The statement by the Royal Swedish Academy of Sciences that accompanied the award credited Coase with a "Breakthrough in Understanding the Institutional Structure of the Economy."   The Academy explained the "breakthrough" as follows:

"By means of a radical extension of economic micro theory, Ronald Coase succeeded in specifying principles for explaining the institutional structure of the economy, thereby also making new contributions to our understanding of the way the economy functions.  . . . .  Coase showed that traditional basic microeconomic theory was incomplete because it only included production and transport costs, whereas it neglected the costs of entering into and executing contracts and managing organizations. Such costs are commonly known as transaction costs and they account for a considerable share of the total use of resources in the economy. Thus, traditional theory had not embodied all of the restrictions which bind the allocations of economic agents. When transaction costs are taken into account, it turns out that the existence of firms, different corporate forms, variations in contract arrangements, the structure of the financial system and even fundamental features of the legal system can be given relatively simple explanations. By incorporating different types of transaction costs, Coase paved the way for a systematic analysis of institutions in the economic system and their significance." 
The core of Coase's contributions can be found in two articles:  The Problem of Social Cost, 3 J. Law and Economics 1 (1960) and The Nature of the Firm, 4 Economica (n.s.) 381 (1937).  Coase summarized and restated these contributions in his Nobel Lecture, The Institutional Structure of Production, 82 American Economic Review 713 (1992).

 In "The Nature of the Firm," Coase began by noting that a competitive, decentralized market economy "worked itself," without any central direction.  Despite this fact, much economic activity occurs within firms which, as Coase noted, involve a significant amount of planning.  For instance, owners do not make repeated daily or hourly bargains with employees about what tasks employees should perform, but instead simply direct them to perform this or that task.  Coase then posed the following question:

"Having regard to the fact that if production is regulated by price movements, production could be carried on without any organization [that is, without any firms] at all, well might we ask; Why is there any organization?"

When Coase posed this question in 1937, economists universally identified two, and only two, possible reasons for complete vertical integration in a decentralized market economy.  First, such integration could create technological efficiencies and thus reduce production costs.  The classic example of such technologically-induced integration was the combination of iron production and steel manufacture under single ownership.  See George J. Stigler, The Extent and Bases of Monopoly, 32 Amer. Econ. Rev. 1, 22 (1942) (referring to the "hot strip mill" as the "stock example" of "technological economies" that can result from vertical integration).  Such a combination, it was said, would avoid the cost of reheating iron ingot before transforming that ingot into steel.     Second, forward or backward integration could foreclose rivals from important  sources of inputs, thereby creating or fortifying the integrating party's market power.  See Stigler, Extent and Bases of Monopoly, 32 Amer. Econ. Rev. at 22. 
Coase offered a completely different explanation for vertical integration and thus the existence of firms.  According to Coase, reliance upon the decentralized market to conduct economic activity was not costless, contrary to what economists generally assumed in their static models.   See Coase, Nature of the Firm, 4 Economica at 390, n. 4 (noting that "static theory" assumes that all prices are known to everyone but that "this is clearly not true of the real world").  Instead, such reliance entailed various costs of arranging and consumating a transaction, what economists would later call "transaction costs."  See Coase, Nature of the Firm, 4 Economica at 390 ("The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.")    According to Coase, such costs included the costs of discovering the prices of various inputs as well as the cost of negotiating with the input's owner over the terms of sale, including, for instance, wages and other terms governing contracts for labor.   By integrating vertically and thus performing an additional task itself, then, a firm could avoid such transaction costs it would otherwise incur.  When it came to individual labor, for instance, vertical integration replaced numerous discrete contracts for labor services with one overall contract, the employment contract, pursuant to which an individual employee agreed to follow the directions of the owner of the firm within certain limits, in return for a fixed wage.      

As Coase noted at the time, this explanation for vertical integration had nothing to do with market power or monopoly considerations. Nor did this explanation depend upon any reduction in technological production costs.  On the contrary, Coase's explanation completely undermined the "technological" account of vertical integration.  After all, absent transaction costs, independent economic actors can, by contract, create any technological combination of labor, capital and other inputs they collectively choose, without integrating vertically.   See Oliver E. Williamson, The Economic Institutions of Capitalism, 86-90 (1985) (explaining why technological considerations cannot explain vertical integration); Victor P. Goldberg, Production Functions and Transaction Costs, 397, in Issues in Contemporary Microeconomics & Welfare (George R. Feiwel, ed. 1985)  (explaining that technical economies cannot explain firm boundaries because, absent transaction costs, such economies can “be achieved equally well [by market contracting] if the factors of production are owned by independent individuals.”).  For instance, assume that making iron and steel in close proximity reduces production costs for the reasons explained above.  If so, then parties can, by contract, agree to locate their production facilities next door to each other, even "under the same roof," without vertical integration that combines such facilities under a single owner.   Thus, there must be some other motive, aside from a desire to operate in close proximity, that induces vertical integration in this setting.  Coase found that motive in transaction costs.  It is no understatement to say, as the Economist did yesterday, that Ronald Coase "explained why firms exist."  (See also e.g. here.)

Coase's argument about the rationale for complete integration also inspired others who were seeking explanations for partial contractual integration.  During the 1960s, for instance, Robert Bork relied upon The Nature of the Firm for the proposition that  "contract integration" and "ownership integration" were economically identical phenomena, both of which could reduce the costs of relying upon atomistic markets to distribute a manufacturer's product.   See Robert H. Bork, The Rule of Reason and the Per Se Concept: Price Fixing and Market Division, 75 Yale L. J. 383 (1966).   (Even before Bork, Lester Telser had argued that minimum resale price maintenance could encourage dealers to engage in optimal promotion of a manufacturer's product, by preventing dealers from free riding on the promotional expenditures of their fellow dealers.  See Lester G. Telser, Why Do Manufacturers Want Fair Trade?, 3 J. Law & Economics 86 (1960).  Unlike Bork, however, Telser did not cite Coase.)  For instance, Bork argued that vertically-imposed exclusive territories and exclusive territories ancillary to the formation of a joint venture could encourage promotional expenditures by dealers and joint venture partners by ensuring that each party could recapture the benefits of such expenditures.  

Subsequently other scholars, including Oliver Williamson and Benjamin Klein, would also identify transaction cost rationales for partial integration.   Such work also expanded the definition of "transaction costs" that could give rise to both partial and complete integration.  While Coase had focused on the cost of discerning prices and negotiating and memorializing agreements, costs analogous to technological production costs, these other scholars called attention to the problem of opportunism by trading partners, the risk of which constituted a cost of relying upon the market to conduct economic activity.  See generally Benjamin Klein, Transaction Cost Determinants of "Unfair" Contractual Arrangements, 70 American Economic Review 356 (1980); Benjamin Klein, Robert Crawford and Armen Alchian, Vertical Integration, Appropriable Rents and the Competitive Contracting Process, 21 J. L. & Econ. 297 (1978); Oliver E. Williamson, Markets and Hierarchies (1975).   See also Bork, Price Fixing and Market Division, 75 Yale L. J. at 382  (characterizing dealer free riding as "parasitical" conduct that "victimized" fellow venturers by "appropriating" to [the free rider] the contributions of other members of the group").   
Coase's 1960 work, the Problem of Social Cost, was equally revolutionary.   Before 1960, economists often asserted that market failure in the form of externalities could co-exist with perfect competition.  In 1957, for instance, future Nobel Laureate George Stigler opined that perfect competition would result in an optimal allocation of resources, unless there were positive or negative externalities which, according to Stigler, "the competitive individual ignores." See George J. Stigler, Perfect Competition, Historically Contemplated, 65 J. Pol. Econ. 1, 16-17 (1957).  More than two decades earlier, Arthur Cecil Pigou had similarly contended that externalities could persist in a world of "simple competition."  See  A.C. Pigou, The Economics of Welfare (1932).   Moreover, economists uniformly believed that some form of government intervention was necessary to correct such externalities.   Where "negative" externalities were concerned, such intervention could include so-called "Pigouvian taxes," or traditional "command and control" regulation. Where "positive externalities" were involved, such intervention could include state ownership, subsidies, and/or altering background rules so as to better specify and protect property rights.

The Problem of Social Cost debunked this universal consensus, altering how economists and others think about externalities and market failure.  In particular, Coase demonstrated that "market failure" is not an absolute or exogenous condition but instead depends upon the presence of transaction costs.  Indeed, Coase demonstrated that, in a world with no transaction costs, private parties --- what Stigler had called "the competitive individual" --- would internalize such externalities by bargaining, thereby eliminating any market failure.  (Coase also explained how some externalities do not result in market failure, given that the value of the activity producing the externality could exceed the resulting harm.  In such cases, internalizing the cost of harm via bargaining or otherwise will not alter the activity.)   This insight gave rise to what Stigler would later call the "Coase Theorem," i.e., that "under perfect competition, private and social costs will be equal."      See  George J. Stigler, The Theory of Price 133 (4th Edition 1966).

To be sure, as Coase himself recognized, transaction costs are never completely absent in the real world.  Still, such costs are often low enough that parties can negotiate to overcome a market failure that would otherwise result from an initial allocation and definition of legal entitlements.  Business format franchising provides a classic example of such bargaining.  Instead of creating and then owning franchise outlets itself, the franchisor grants licenses to independent operators, each of whom is thus entitled to operate under the franchisor's trademark.  Franchisors could stop there, allowing each franchisee to operate however he or she pleased.  In the real world, however, granting franchisees such absolute discretion in an unfettered market would result in market failure, as each individual franchisee made product design and quality decisions that would impact other members of the franchise system.  Not surprisingly, then, franchisors often include detailed provisions in contracts granting franchisees the right to operate under the franchise trademark, provisions designed to ensure optimal franchisee investments in quality.  See Paul Rubin, The Theory of the Firm and the Structure of the Franchise Contract, 21 J. Law & Economics 223 (1978).  As Coase would later explain, the legal system can facilitate such contracting by, for instance, making it easier to form contracts that overcome market failure.  See Ronald H. Coase, The Firm, the Market and the Law, 28 in Ronald H. Coase, The Firm, The Market and the Law (1988).
Taken together, Coase's work had obvious implications for numerous fields of legal study, including "common law" subjects such as Contract, Property and Tort, as well as statutory subjects such as Corporations and Antitrust.   For instance, Coase's assertion that the business firm is a particular type of contract inspired scholars to model corporations and other firms as a "nexus of contracts," the creation and maintenance of which the State could  facilitate by promulgating enabling corporate law consisting of mainly default rules that parties to the corporate contract could alter by satisfying formal requirements, such as shareholder vote.    See Frank H. Easterbrook and Daniel Fischel, The Economic Structure of Corporate Law (1991). 
Transaction cost economics also had a profound impact on antitrust law and policy.  During the 1950s and 1960s, courts articulating antitrust doctrine became increasingly hostile to various forms of complete and partial integration.  Such hostility followed naturally from the dominant economic account of the causes and consequences of such integration.  As noted earlier, economists believed that the only benefits of vertical integration were technological in nature. These supposed benefits naturally arose "within" the firm, as part of the process of production.  Thus, when economists, or, for that matter, antitrust courts or enforcement agencies, could not identify any efficiency purposes for such integration, they naturally inferred that the conduct was an anticompetitive effort  to obtain or protect market power.  Hostility toward partial contractual integration such as minimum and maximum resale price maintenance, tying, exclusive dealing, exclusive territories and exclusive supply contracts was particularly intense.  After all, such agreements reached beyond the firm, controlling the activities of trading partners before a firm took title to inputs or after a firm relinquished title by selling a finished product.  As a result, there were simply no apparent efficiency purposes of such agreements, which reduced rivalry of one form or another and thus reduced competition without any offsetting benefits.   The result was the so-called "inhospitality tradition" of antitrust law, pursuant to which the Supreme Court condemned vertical mergers in unconcentrated markets under Section 7 of the Clayton Act as well as  various forms of partial integration as unlawful per se or nearly so under Section 1 of the Sherman Act.

However, the work of Bork, Telser, Williamson, Klein and others completely undermined the economic premises of the inhospitality tradition, by explaining how complete and partial integration were often voluntary methods of overcoming market failures and thus producing non-technological efficiencies. See Oliver E. Williamson, The Economic Institutions of Capitalism, 28 (1985) (articulating rebuttable presumption that partial and complete integration has transaction cost origins).  See also here, explaining Bork's contributions in this regard.  Thus, beginning with Continental T.V. v. GTE Sylvania, 433 U.S. 36 (1977), the Supreme Court has repudiated or narrowed  several per se rules announced during the inhospitality era.  At the same time, the antitrust enforcement agencies have reversed their previous hostility to vertical mergers, and lower courts have uniformly adopted a more friendly stance to such transactions. Society's economic welfare has increased significantly as a result, thanks in large part to Ronald Coase.  Society is richer, literally, as a result.