This is a summary of the article: 'the institutional structure of production' by Ronald Harry Coase. This short summary highlights Coase's contribution to Law and Economics and explains the concept of transaction costs which is relevant this week.
The Institutional Structure of Production - Ronald Harry Coase
Coase's contribution
The inclusion in our analysis of certain features of the economic system have
tended to be overlooked as they seemed too obvious. The concentration on the
determination of prices has led to a narrowing of focus which has had as a result
the neglect of other aspects of the economic system. The neglect of other
aspects of the system has been made easier by another feature of modern
economic theory, namely the growing abstraction of the analysis. The firm and
the market appear by name but they lack any substance. The efficiency of the
economic system depends on how organizations conduct their affairs.
Adam Smith's principal theme was that government regulation or centralized
planning were not necessary to make an economic system function in an orderly
way. The economy could be coordinated by a system of prices (the "invisible
hand"). Arnold Plant explained how a competitive economic system coordinated
by prices would lead to the production of goods and services which consumers
valued most highly. According to Plant, competition acting through the price
mechanism would do all the coordination necessary.
The view of the pricing system as a coordinating mechanism was clearly right,
but there were aspects of the argument which troubled Coase. Coase realized
that there were costs of using the pricing mechanism. 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.
Transaction costs
Transaction costs are costs other than the price. These costs are considered the
costs for doing an exchange. Transaction costs are what link the firm, the market
and the law. The existence of transaction costs leads to the existence of the firm,
and determined which goods will be produced. Those goods with lower
transaction costs will be produced. Institutional arrangements determine what is
produced, but the firm has to do with the efficiency of the economic system.
According to Stigler's theory no government intervention was needed because
there are zero transaction costs and therefore negotiation is cheap. However,
Coase pointed out that transaction costs are never zero. Moving from a regime of
zero transaction costs to one of positive transaction costs, the legal system in
this new world becomes of crucial importance.
Transaction costs are not zero. Therefore, bargaining is more expensive and the
government is needed to set the law. When there are transaction costs, which is
always the case, the legal system is crucial. When transaction costs prevent
bargaining because they are too high, the efficient allocation of resources
depends on the legal rule.
A large part of what we think of as economic activity is designed to accomplish
what high transaction costs would otherwise prevent or to reduce transaction
costs so that individuals can freely negotiate. The search for partners in
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