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The economist, the market and the environment

My tribute to Ronald Coase, who has died aged 102,
in The Times:


It’s not often that the ideas of a 102-year-old
have as much relevance to the future as the past. But the death
this week of Ronald Coase, one of the world’s most cited
economists, comes at a time when there is lively debate about the
very issue he raised: why neither markets nor government are

Born in Willesden in 1910, Coase spent much of his career in the
US, winning the Nobel Prize for Economics in 1991. His fame rested
on two papers. The first, in 1937, explained why companies exist —
islands of central planning in a sea of market negotiation. His
answer was “transaction costs”: you could order a car from the
suppliers of its many parts, but it’s a lot simpler to get Henry
Ford to assemble it for you.

Not only do companies lower the cost of goods by co-ordinating
production, they depend on having a reputation for doing so. You
cannot know all the suppliers with whom you might deal, let alone
if they can be trusted. Firms such as Amazon spring up to save us
these transaction costs.

Companies also face transaction costs: for renting buildings,
employing accountants and managers and so on. Coase taught us that
the ideal size of a company will be set by the interplay of lower
co-ordination costs through central planning and higher transaction
costs associated with holding managers accountable.

This is a penetrating insight for markets and government. Steam
and electricity, by making production lines possible, lowered
co-ordination costs, making bigger firms viable. But bigger
companies, like bigger government bureaucracies, have higher
management costs. The difference, of course, is that profits in the
marketplace signal whether firms are too big or too small.

Coase’s second famous paper, The Problem of Social Cost,
published in 1960, was also about transaction costs. It was written
after an argumentative evening in Chicago, when he changed the
minds of 21 economists, including Milton Friedman, over whether
radio frequencies could be bought and sold rather than allocated by

Coase’s insight has a more general application to environmental
issues. In a dispute between (say) two people in Sussex, one of
whom wants to drill for oil, while the other wants a pretty view,
Coase explained that in a costless world, the winner could best be
determined by negotiation, not regulation. If A values the view
more than B values the oil, let A buy out B.

Coase recognised that such transactions were not costless, but
used his legal training to show how courts clarify rights and
thereby lower transaction costs. But he did not see markets as a
panacea. A world of zero transaction costs is as unattainable as a
true vacuum in physics. In both, however, the question is how much
difference do transaction costs (or air pressure) make in the real

Coase always focused on the institutional setting, asking how
markets compare with governmental regulations. Neither is perfect.
Government regulation, too, has transaction costs: enforcement and
monitoring, corruption, inefficiency and resistance to innovation.
Just as Coase dragged economists away from assuming perfect
competition, so he tried — and largely failed — to drag them away
from assuming perfect government with perfect knowledge.

Consider pollution by an airport, a nuisance effectively
nationalised by the State. A resident of Hounslow cannot sue
Heathrow for disturbing his sleep because the Government has
decreed that airlines may make a certain amount of noise at certain
times while using the airport. That robs the Hounslow resident of
something of value. Had he been able to negotiate with Heathrow, he
might have demanded less noise, or might have settled for even more
noise so long as he was well compensated.

But government restrictions on night flying and on building a
third runway steal something from a resident of Edinburgh, too, by
insisting he circle uncompensated over Buckinghamshire every time
he flies to Heathrow. Surely there is a possible deal here. But
transactions costs might get so complicated — one Hounslow resident
holds out for more or one Edinburgh resident refuses to pay — that
government regulation may be less trouble than a noise market.
Coase, always the pragmatist, said it depends on the

Lest you think environmental markets are scarcer than hen’s
teeth, consider that a US charity called the Nature Conservancy has
purchased fishing rights off California to reduce the impact of
trawling on marine ecosystems. A think-tank in Bozeman, Montana,
called PERC, seeks out such solutions created by what it calls
“enviropreneurs”. It has found many cases of conservation
organisations doing deals with oil drillers to the benefit of both,
or buying water rights off farmers to help fish — all without any
government regulation. Terry Anderson, president of PERC, thanks
Coase “for giving us the intellectual foundation on which free
market environmentalism is built”.

Coase constantly reminded us that economics is in the business
of explaining how people actually behave, not telling then how to

By Matt Ridley | Tagged:  rational-optimist  the-times