15 October 1991
The
Royal Swedish Academy of Sciences has decided to award the
Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in
Memory of Alfred Nobel, 1991, to
Professor Ronald Coase, University of Chicago, USA,
for his discovery and clarification of the significance of
transaction costs and property rights for the institutional
structure and functioning of the economy.
Breakthrough in Understanding the Institutional Structure of
the Economy
Until recently, basic economic analysis concentrated on studying
the functioning of the economy in the framework of an
institutional structure which was taken as given. Efforts to
explain the institutional structure were usually considered
unnecessary or futile. For instance, the existence of
organizations of the type we call firms seemed almost
self-evident. Observed variations in contract forms in the
economic sphere were also regarded as a given fact, and the laws
and rules of the legal system were perceived as an externally
imposed setting for economic activity.
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. His achievements have provided legal science,
economic history and organization theory with powerful impulses
and are therefore also highly significant in an interdisciplinary
context. Coase's contributions are the result of methodical
research work, where each segment was gradually added to the next
over a period of many years. It took a long time for his approach
to gain a foothold. When the breakthrough finally occurred during
the 1970s and 1980s, it was all the more emphatic. Today Coase's
theories are among the most dynamic forces behind research in
economic science and jurisprudence.
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.
Coase also demonstrated that the power and precision of analysis
may be enhanced if it is carried out in terms of rights to use
goods and factors of production instead of the goods and factors
themselves. These rights, which came to be called "property
rights" in economic analysis, may be comprised of full ownership,
different kinds of usership rights or specific and limited
decision and disposal rights, defined by clauses in contracts or
by internal rules in organizations. The definition of property
rights and their distribution among individuals by law, contract
clauses and other rules determine economic decisions and their
outcome. Coase showed that every given distribution of property
rights among individuals tends to be reallocated through
contracts if it is to the mutual advantage of the parties and not
prevented by transaction costs, and that institutional
arrangements other than contracts emerge if they imply lower
transaction costs. Modifications of legal rules by courts and
legislators are also encompassed by these arrangements. Property
rights thus constitute a basic component in analyses of the
institutional structure of the economy. In perhaps somewhat
pretentious terminology, Coase may be said to have identified a
new set of "elementary particles" in the economic system. Other
researchers, to some extent under the influence of Coase, have
also made pioneering contributions to the study of property
rights.
Coase's Contributions: First Stage
In his first major study entitled, The Nature of the Firm,
Coase posed two questions which had seldom been the objects of
strict economic analysis and, prior to Coase, lacked robust and
valid solutions, i.e. , why are there organizations of the
type represented by firms and why is each firm of a certain size?
A key result in traditional theory was to show the ability of the
price system (or the market mechanism) to coordinate the use of
resources. The applicability of this theory was diminished by the
fact that a large proportion of total use of resources was
deliberately withheld from the price mechanism in order to be
coordinated administratively within firms.
This is the point at which Coase introduced transaction costs and
illustrated their crucial importance. Alongside production costs,
there are costs for preparing, entering into and monitoring the
execution of all kinds of contracts, as well as costs for
implementing allocative measures within firms in a corresponding
way. If these circumstances are taken into account, it may be
concluded that a firm originates when allocative measures are
carried out at lower total production, contract and
administrative costs within the firm than by means of purchases
and sales on the market. Similarly, a firm expands to the point
where an additional allocative measure costs more internally than
it would through a contract on markets. If transaction costs were
zero, no firms would arise. All allocation would take place
through simple contracts between individuals.
An important element in the model is that there are two types of
contracts: those which stipulate the parties' total obligations
(or, the reverse, rights) and those which are deliberately made
incomplete by not specifying all obligations, but intentionally
allow a free margin for unilateral decisions by one of the
parties. Such "open" agreements may be exemplified by employment
contracts, which usually leave room for direction and giving
orders. According to Coase's theory, the firm is characterized by
the latitude for decision created by a particular cluster of such
open contracts. The firm in fact consists of this array of
contracts and is related to the rest of the world by other fully
specified contracts regarding purchases of inputs, sales of
products, and loans under prescribed terms.
Coase's formulation has proved to be exceedingly practicable and
has given rise to intensive examination of the contract relations
which characterize firms. It is now clear that every type of firm
is comprised of a distinctive contract structure and thereby a
specific distribution of rights and obligations (property
rights). Coase's work on the firm has become the basis for
rapidly expanding research on principal-agent relations. It has
also influenced vital aspects of financial economics, such as the
lively research devoted to explaining the pattern of financial
intermediaries.
Coase's Contributions: Second Stage
In retrospect,
it is easy to realize that these examinations of firms' basic
characteristics would provide a basis for more general
conclusions regarding the institutional structure of the economic
system. Coase himself laid the groundwork in a subsequent
stage.
In another major study entitled, The Problem of Social
Cost , Coase introduced the set-up in terms of rights or
property rights. He postulated that if a property right is well
defined, if it can be transferred, and if the transaction costs
in an agreement which transfers the right from one holder to
another are zero, then the use of resources does not depend on
whether the right was initially allotted to one party or the
other (except for the difference which can arise if the
distribution of wealth between the two parties is affected). If
the initial holding entailed an unfavorable total result, the
better result would be brought about spontaneously through a
voluntary contract, as it can be executed at no cost and both
parties gain from it. In other words, all legislation which deals
with granting rights to individuals would be meaningless in terms
of the use of resources; parties would "agree themselves around"
every given distribution of rights if it is to their mutual
advantage. Thus, a large amount of legislation would serve no
material purpose if transaction costs are zero. This thesis is a
direct parallel to the conclusion in The Nature of the Firm that
firms under the same conditions are superfluous. All allocations
could be effectuated through simple, uncomplicated agreements
without administrative features, i.e. , through
frictionless markets.
This led Coase to conclude that it is the fact that transaction
costs are never zero which indeed explains the institutional
structure of the economy, including variations in contract forms
and many kinds of legislation. Or, more exactly, the
institutional structure of the economy may be explained by the
relative costs of different institutional arrangements, combined
with parties' efforts to keep total costs at a minimum. Alongside
price formation, the formation of the institutional structure is
regarded as an integral step in the process of resource
distribution. Hence, economic institutions do not require a
"separate" theory. It is sufficient to render existing theory
complete and formulate it in terms of the primary components,
i.e., property rights.
These conclusions concerning the radical effects of ever
prevalent transaction costs are thus the main result of Coase's
analysis. Somewhat paradoxically, circumstances have ordained
that it is the preceding conclusion about the consequences of
overlooking transaction costs which has come to be called the
"Coase Theorem". Of course, the situation without transaction
costs is only a hypothetical norm of comparison. However, it can
facilitate the analysis of real-world conditions. It may also
inspire studies of contracting which can actually be observed, in
areas where earlier theory prematurely took it for granted that
transaction costs are so high that contracts are inconceivable.
Further examinations by Coase himself or students and others
inspired by him have shown that in some such cases, transaction
costs are not so high as to preclude a contract. Such contracts
are found to have strong peculiarities, created by the parties in
order to alleviate the drawbacks of high transaction costs. These
observations are wholly in line with Coase's main conclusion. In
cases where transaction costs absolutely prevent a contract,
there is - as inferred by the theorem - a tendency for other
institutional arrangements to arise, for example a firm or
amended legislation. The circle is closed; this is exactly the
message conveyed by The Nature of the Firm.
As regards legislation, in The Problem of Social Cost , Coase developed a hypothesis concerning the behavior of courts in rather frequent cases where two (or more) parties dispute rights and where agreements are impossible or extremely difficult because of high transaction costs. Coase found that courts probably try to distribute the rights among the parties so as to realize the solution which would have been the outcome of an agreement, if such an agreement had been possible. The underlying idea is that this is a natural and rational way for a court to reason if it is more intent on setting a precedent to generate expedient incentives for the future than solving a particular dispute. This means that common pleas courts serve as an extension of the market mechanism to areas where it cannot function due to transaction costs. This hypothesis has become immensely important because, along with the general formulation in terms of rights or property rights, it has become the impetus for developing the new discipline of "law and economics" and, in prolongation, for renewal of many aspects of legal science.