The Central Role of Ronald Coase

Coase’s role in post-war institutionalism is central in the two meanings of the term; both essential to its development, and positioned between the two schools of thought identified here.

showed in the “Nature of the firm” that, in the absence of transaction costs, there is no eco­nomic basis for the existence of the firm. What [he] showed in the “Problem of social cost” was that, in the absence of transaction costs, it does not matter what the law is, since people can always negotiate without cost to acquire, subdivide, and combine rights whenever this would increase the value of production. (Coase 1988: 14)

Transaction costs are therefore the missing element of economic theory: they explain the role of the institutions of the market (to diminish them), the existence of the firm (to avoid them) and the influence of the initial distribution of legal rights on the final allo­cation of resources. Similarly, economic policy should not be an abstract exercise on a blackboard, but should consist of choosing one institutional arrangement among others, all being costly: this is the comparative institutional method.

Coase’s definition of the object of economics as explaining the economic system, rather than predicting the consequences of rational choices, links him to old institution­alist perspectives. His article on social cost (1960), expanding the role of transaction costs and the comparative institutional method (first introduced in his article on the firm in 1937), proved seminal for institutional economics and specifically for law and econom­ics. It stressed that what is exchanged on the market are property rights on goods and services, determined by the law, and that they have to be clearly defined and allocated for the exchange to take place. It underlined the reciprocity of harms (“externalities”) and the importance of the domain of torts and of common law for economics; and it put forward the idea of the economic efficiency of common law. While written in the old institutionalist style and cited as a source of modern institutionalism (Medema 1996), Coase’s article and the issues it raised were also interpreted and extended using standard neoclassical analysis, as in NIE.