The Nobel series: Proponent of property rights

The Nobel Prize in Economic Sciences was awarded to Ronald Coase in 1991"for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy".

Coase attended the London School of Economics for his under-graduation in commerce, which he finished in 1932. After this, he left for the University of Chicago on a scholarship, where he had the chance to study with well-known economists like Frank Knight and Jacob Viner. He returned to take up various teaching jobs at the Universities of Dundee and Liverpool before moving to the London School of Economics where he continued till 1951. He returned to the USA and joined the University of Virginia in 1958 and later the University of Chicago in 1964. Coase continued to work on the rise of China even when he was a ripe 100-years-old.

Coase was best known for two papers: 'The Nature of the Firm' (1937) and 'The Problem of Social Cost' (1960). He was a pioneer in developing the theory of transaction costs and underlining the importance of institutions in economic development. His Coase theorem is widely accepted and has been applied to a number of public policies. He was one of the stars of the field of New Institutional Economics. We will review some of the main works of Coase in this article and see how they have been applied in public policy.

Main works

Right since the time of Adam Smith, the efficiency of the market is an established wisdom in economics. The "invisible hand" of the market is supposed to efficiently allocate resources among various economic activities. This was the received wisdom in microeconomic theory and is still followed in most of the economics textbooks globally. In such a setting, there is no place for institutions like the government, political parties, legislatures, regulatory bodies etc.; they were just assumed to be given. Coase challenged this received wisdom. Let us see how.

In the first pathbreaking paper of 1937, 'The Nature of the Firm', Coase asked a simple question: Why do firms exist? Why can't the market provide all the goods and services needed? Why can't there be a series of bilateral contracts to supply the needed goods and services between producers of such goods and services? Coase suggested that this was rather inefficient because of the transaction costs of getting into such contracts and implementing and enforcing them. These transaction costs include search costs, information costs, bargaining costs, legal costs, compliance costs and enforcement costs. Hence, a firm internalises all these costs and is able to produce goods and services more efficiently through the efforts of an entrepreneur.

The second question that Coase asked in his 1937 paper was: What should be the size of the firm? Coase suggested that there were limits to how much a firm could produce internally. There would be "decreasing returns to the entrepreneur function" when overhead costs would begin to rise. Coase argued that the size of a firm depends on the magnitude of costs 'internalised' by the firm as opposed to those 'external' to the firm. Hence, the firm will grow initially until the 'decreasing returns' kick in.

In the second landmark paper, 'The Problem of Social Cost', published in 1960 in the Journal of Law and Economics, Coase addressed the issue of externalities. Using the concept of transaction costs, which he had developed earlier, Coase stated that if such costs don't exist and bargaining is permissible, a Pareto-efficient outcome will result, irrespective of the initial allocation of property. This will become clear with the example that Coase gave: There is a rancher and a farmer living next to each other, and the rancher's sheep causes an externality when they stray on the farmer's land and eat his crop. According to Coase, if the farmer and the rancher can bargain and there are no other costs, then a Pareto-efficient solution will result, no matter what the initial allocation of property rights. To elaborate this a little, one of three things might be efficient from a social perspective: a) It might be efficient to erect a fence to keep the sheep away from the crops; b) It might be efficient to close down the farm or; c) It might be efficient to close down the ranch, if the farm is valuable enough and if the fence costs more than the value of the ranch. According to Coase, the most efficient outcome will result only through negotiation between the farmer and the rancher, notwithstanding the initial allocation of property rights between them. This result was also labelled as Coase Theorem by the famous economist, Stigler.

Coase basically challenged Pigou's treatment of externalities in his1960 paper. While Pigou basically suggested the 'polluter pays' principle, Coase proposed that the market would find an efficient solution to the problem of 'nuisance'. We know that Pigou, in 1920, had applied neoclassical economics to find a solution to the problem of externalities. We also know that in the neoclassical world, efficient allocation of resources is not possible in the presence of externalities. Pigou's suggestion was to impose a tax on the generators of negative externalities and to subsidise the generators of positive externalities in order to reach the efficient allocation of resources. Pigou, of course, did not take into account the interdependent nature of the externality, a fact that Coase clearly recognised.

Coase argued that it is necessary to define initial endowments when "an externality" exists and this could be done by assigning private property rights to one of the parties or by other ways such as introducing regulations governing pollution. Coase then demonstrated that under Pigou's own assumption of costless transactions, the establishment of private property rights is all that is needed. He argued that if transaction costs are low or zero, two parties to a dispute or a 'nuisance' would bargain with one another to produce the most efficient distribution of resources. Coase used the example of a case named Sturges v Bridgman, in which two neighbours — a noisy sweet-maker and a quiet doctor — were fighting that the other should move out, and they accordingly asked the court to intervene. According to Coase, regardless of whether the judge ruled that the sweet-maker had to stop using his machinery, or that the doctor had to put up with it, they could arrive at a mutually beneficial outcome that reaches the same productive activity. Coase's point was that since transaction costs were rarely low, many welfare-maximising solutions are ignored, and hence, the market should be allowed to find a solution, as long as the initial rights are assigned.

It is clear from the above example that the Coase theorem has to do with badly defined property rights. Where there is a conflict of property rights, the involved parties can bargain in such a way that will accurately reflect the full costs and underlying values of the property rights, resulting in the most efficient outcome. For this to happen, one needs zero transaction costs, costless bargaining, perfect information and perfectly competitive markets.

Application and public policy

Coase's work stands at the intersection of law, economics and political science; it is therefore truly interdisciplinary. At the heart of Coase's work was the issue of property rights and their specification; all other issues such as transaction costs, bargaining etc. revolved around property rights. According to the Nobel website:

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 organisations. 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 first paper on the firm led to more fundamental research on the issue of markets versus hierarchies (Oliver Williamson) and the development of organisation theory. This work led many firms to critically examine their contract relations: How many can be internalised and how many can be outsourced? It is now clear that every type of firm consists of a distinctive contract structure and thereby has a specific distribution of rights and obligations (property rights). Coase's work has also led to expanding research on principal-agent problems.

However, it was Coase's second paper that led to more impact on public policy. The Coase theorem has been widely applied in global environmental issues (climate change, world trade etc.) and the study of law and economics. In fact, Coase can be said to be the founder of this field of study. In its basic application, the Coase theorem pushes the involved parties to negotiate and come to a conclusion rather than take recourse to legislative or regulatory solutions. Recall that this conclusion is quite similar to what Coase had concluded in the first paper in the case of firms: that firms exist precisely because transaction costs of 'transacting' in the market are high.

In the second paper, Coase concluded that it is the fact that transaction costs are never zero that explains the institutional structure of the economy, including variations in contract forms and many kinds of legislations. In other words, 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.

Coase's work has been applied in a wide range of public policy areas such as jurisprudence, environmental issues, distribution of forest rights, water policy, allocation of rights and duties in cases of global public goods such as climate change and world trade etc. In fact, Coase's work is an important component of the New Institutional Economics (NIE).

Taking the example of water supply, Coase's work would tell us that a formal market would be far superior to an informal market. The formal water market would have low transaction costs of supplying water, which means low implementation, supervising and monitoring costs of supplying water ex-ante and low enforcement costs ex-post. A formal market would also have a 'formal' institutional structure, including well-drafted contracts, an independent regulator to settle disputes, market-determined water charges and organised service providers (private, municipal or public).

Another application is in the area of climate change negotiations. Coase's ideas provide a possible way to come to an agreement, which would be equitable, fair and acceptable to all members. The reason is that his works emphasise the interdependence between members and the importance of members to overcome the collective action dilemmas of climate change governance. This interdependence was, of course, ignored in the neoclassical analysis which Pigou put forth. In Coase's world, the accord will come about if the transaction costs of negotiating are low and the initial endowments are defined. Here, initial endowments could be various rights such as global regulations, transfer of technology from developed countries to developing countries, financing of various activities in the post-accord era (say, HCFC refrigeration in place of CFC refrigeration, increase in non-polluting fuels in industry etc.) and so on.

Conclusion

While there are real-world difficulties in applying the Coase Theorem, it does explain why so many inefficient outcomes to economic disputes are found in the real world. Further, the conditions of efficient markets and perfect information are needed for Coase's theorem to be applied, and we all know that these conditions are rarely met. But Coase pointed out that he was well aware of this, and his point was precisely: Since transaction costs are never zero, it is the parties who would negotiate the most efficient solution.

Be that as it may, there is no doubt that Coase's contribution was fundamental in nature and led to a paradigm shift in how we look at externalities. Coase's work also took us to interdisciplinary research in economics, law and political science. We also learnt the importance of property rights and transaction costs in public policy and economic decision-making. It is no surprise that Coase's works continue to find resonance in so many public policy areas.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal. Views expressed are personal