Presentation Speech by Professor Lars Werin of the Royal Swedish Academy of Sciences.
Translation of the Swedish text.
Your Majesties, Your Royal Highnesses, Ladies and Gentlemen,
The economic system has an institutional structure, which we often regard as self-evident because we observe it around us every day. But it is actually peculiar and intricate. For instance, people make agreements among themselves in many different ways, ranging from simple purchases to complex contracts; what determines the pattern? Economic activity takes place within a framework of legal rules: contract law, tort law, etc; why are these laws formulated as they are? And why do we have firms at all?
These and other components of the institutional structure must certainly be essential elements in the functioning of the economic system. Nevertheless, economic theory could not answer these questions. This state of affairs annoyed a young economist who had just received his first degree in London in the 1930s. He wrote an essay with the perhaps untactically pretentious title The Nature of the Firm. He provided a strong and productive answer to the last question, why firms exist, although hardly anyone bothered to listen. He gradually added building blocks to his theoretical construction, and had eventually – in the early 1960s – set forth the principles for answering all of the questions. It was not until the 1970s and 1980s that the breakthrough for his ideas occurred. Astonishingly, basic economics had to be revised, managerial economics received a new foundation and research in economic history new impulses, a new discipline, law and economics, was established on the borderline between economics and legal science, and traditional jurisprudence itself became unsettled. It is for this achievement that the originator, Ronald Coase, is rewarded; no longer an angry young man, but still a most active researcher.
Coase pointed out that a large proportion of the total use of resources takes place within firms. Thus, it has deliberately been withheld from the price mechanism – the market system – in order to be coordinated administratively instead. A general theory has to be able to explain this phenomenon; traditional theory could not.
Someone has aptly described Coase’s problems as follows. A firm may be regarded as an island of administration in a sea of contracting, in “the sea of markets”. If we look out across the economy, we find that it is an archipelago. But why is it an archipelago ? Why is it not an open sea of simple contracts between separate individuals? And why are there so many small islands, that is, why are they islets rather than a few large continents?
Coase’s answer was that traditional theory disregarded what he called transaction costs, i.e., the time, work and other resources used in order to enter into contracts and manage firms and similar institutions. His relatively simple – but, as it turned out, highly viable – thesis was that a firm arises if the costs of achieving a certain use of resources are lower when carried out administratively as compared to purchases and sales on the market. If it did not cost anything to enter into contracts, then there would be no need for firms.
This was not only a new view of the firm; from now on a searchlight would be aimed at the abundance of variation inherent in the patterns of contracts which comprise what we usually call “markets”.
As a next step, Coase showed that whatever is bought and sold or otherwise becomes the object of a contract does not actually consist of goods and other resources, but of rights to the disposal of goods and resources. Rights such as ownership rights, usership rights, etc. are fundamental components of the economy. Of course, rights are also a basic component of the legal system.
In an influential study, Coase began with a now famous hypothetical experiment. He examined a court which has to determine whether a certain right should be awarded to one or the other of two subjects, each of whom is engaged in a particular type of activity. This, in fact, is a very common decision situation in the legal system. If no resources whatsoever would be consumed in contracting, as economists and perhaps even lawyers carelessly used to presuppose, then – according to Coase – it does not really matter how the court decides. The right will still end up with the party who can achieve the largest output. If she does not receive the right directly from the legal or judicial authority, then she will buy it from the other party, who stands to gain by selling it.
The conclusion of the experiment is that if, in reality, transaction costs were zero, then a great deal of legislation would obviously be pointless and unnecessary. Earlier, Coase had found that firms do not serve any purpose if transaction costs are zero. Supported by empirical studies, such as legal cases, he could now draw his fundamental conclusion: that not only firms and large bodies of the law, but the entire institutional structure of the economy can be explained by transaction costs. Transaction costs and a formulation in terms of rights: two relatively simple ideas – but with the power to propel all the economic sciences, and legal science as well, in new directions.
By your refusal to take anything for granted, and your skepticism toward conventional wisdom, you have succeeded in explaining the principles behind the institutional structure of the economy. You have remarkably improved our understanding of the way the economic system functions – although it took some time for the rest of us to realize it. On behalf of the Royal Swedish Academy of Sciences, I congratulate you warmly and sincerely. May I ask you to receive, from the hands of His Majesty the King, this year’s Prize in Economic Sciences in Memory of Alfred Nobel.
Watch the live stream of the announcements.