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Planet Money

The Nobel Laureate Who Figured Out How To Deal With Annoying People

Originally published on Tue September 10, 2013 4:22 pm

Update, Sept. 4: We added the audio for David Kestenbaum's radio obituary of Ronald Coase.

If you created the world as a simple economic thought experiment, companies wouldn't exist. Instead, everybody would work for themselves, and they'd be constantly selling their labor (or the fruits of their labor, or use of their tools, or whatever) to the highest bidder. Wages would rise and fall every day (every hour! every second!) depending on supply and demand. That's how the market works, after all.

But the real world is full of big companies that work like centrally planned economies, with powerful managers telling employees in different divisions what to do and workers earning wages that are mostly steady.

Why does this happen? As Matt Yglesias writes: "If markets are so great, what's with all the bosses and colleagues and meetings and internal office politics?"

Ronald Coase, the Nobel Prize-winning economist who died Monday at age 102, answered that question 81 years ago. The short version: The free market can be a huge hassle, and letting the market set prices for everything is not always the most efficient approach.

As Coase said in his Nobel acceptance speech:

"I found the answer by the summer of 1932. It was to realize that there were costs of using the pricing mechanism. What the prices are has to be discovered. There are negotiations to be undertaken, contracts have to be drawn up, inspections have to be made, arrangements have to be made to settle disputes, and so on. These costs have come to be known as transaction costs. Their existence implies that methods of coordination, alternative to the market, which are themselves costly and in various ways imperfect, may nonetheless be preferable to relying on the pricing mechanism, the only method of coordination normally analyzed by economists. It was avoidance of the costs of carrying out transactions through the market that could explain the existence of the firm in which the allocation of factors came about as a result of administrative decisions (and I thought it did)."

Coase wrote up his insight in a paper called The Theory of the Firm, which was published in 1937 and became one of the most cited papers in economics.

A few decades later, Coase published another incredibly influential paper, The Problem of Social Cost, which gave rise to the Coase Theorem. Josh Barro has a nice explanation:

"Coase's most famous contribution is the Coase Theorem, which holds that the problem of externalities — that is, me taking an action that imposes a cost on you — can be fixed without government action so long as property rights are clearly defined and transaction costs are low.

"My favorite example of the Coase Theorem in action relates to airline seats. A lot of people like to complain about airline passengers who recline, taking away precious knee-room. But Coase would have said there's a simple solution to this problem: pay the person in front of you not to recline. If you value your knee space more than he values the option to lean back, the seat will stay upright where it belongs. There's no need for the government, or the airline, to intervene to protect your knees."

Coase's big ideas seemed rather obvious, even to Coase himself. In his Nobel speech, he wrote that his contribution had been to point to "features of the economic system so obvious that ... they have tended to be overlooked."

He kept working throughout his life and published his final book, on the rise of China's economy, at age 101. We interviewed him about the book last year.

"China's rapid emergence as a global economic power — one of the most important developments of the past generation — took him completely by surprise.

" 'I thought it would take 100 years, if not more,' Coase said.

"It seemed striking that an economic legend could be so wrong about such an important subject. I asked Coase what he made of this.

" 'I've been wrong so often I don't find it extraordinary at all,' he said."

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Transcript

MELISSA BLOCK, HOST:

The Nobel Prize-winning economist Ronald Coase died this week at the age of 102. David Kestenbaum with our Planet Money team says Coase was a careful thinker who liked to tackle deep questions right up to the end.

DAVID KESTENBAUM, BYLINE: When Ronald Coase accepted his Nobel Prize for Economics, he said that he had known some great economists but never counted himself among them. His contribution, he said, had been to study things that were so obvious they tended to be overlooked.

MICHAEL SCHILL: Ronald was an amazing scholar.

KESTENBAUM: Michael Schill is dean of the University of Chicago Law School where Coase was a professor.

SCHILL: He didn't write tons and tons and tons of articles, the ones he wrote - and we should all be so lucky in our life to have one of them, or half of one of them.

KESTENBAUM: One of the papers that won him Nobel Prize concerned a deceptively simple question: Why do companies exist? In theory, in a free market we could all work for ourselves. We wouldn't need giant companies or companies at all. Coase's explanation was that, in essence, the free market can be a hassle. If we were all on our own, we'd waste time bargaining over everything. We'd need zillions of legal contracts between all of us.

Companies, he argued, were in essence shelters from the open markets. Sandeep Baliga, an economist at Northwestern's Kellogg School of Management, says Coase asked deep questions, and he reasoned out his answers almost as a philosopher would.

SANDEEP BALIGA: He always had cute examples about cattle grazing and things like that and no equations whatsoever in his papers. So if you compare it with contemporary economics, they're just completely different. He was anti-math.

KESTENBAUM: Coase could also be very practical. He famously argued that the government should treat the television spectrum and radio spectrum like property and auction off licenses, which eventually the government did, bringing in billions of dollars of revenue. Coase lived through some huge economic events: the Great Depression, the end of the gold standard, the growth of the global economy. And he never really stopped working. I interviewed him last year. He'd just co-authored a book.

RONALD COASE: I'm 101 at the moment. I get older by the minute.

KESTENBAUM: The book was about China, how it had gone from communism to capitalism so suddenly. That surprised him he said. It surprised everyone.

COASE: I thought it would take 100 years if not more.

KESTENBAUM: What does that teach us that we were all wrong about the speed?

COASE: I don't know. I've been wrong so often. I don't find it extraordinary at all.

KESTENBAUM: Michael Schill at the University of Chicago says that just five weeks ago, Ronald Coase told him he was planning to go to China to give some lectures. Schill says that the university was helping renew his passport when he became ill. David Kestenbaum, NPR News.

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BLOCK: You're listening to ALL THINGS CONSIDERED from NPR News. Transcript provided by NPR, Copyright NPR.