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.