"This paper is concerned with those actions of business firms which have harmful effects on others," was a fairly modest way for Coase to begin his 1960 paper that permanently changed the way economists dealt with the topic of negative externalities. Coase's target is Arthur Cecil Pigou, the early 20th-century economist who founded the field of welfare economics and invented the concept of externalities, and whose name has become synonymous with the idea of taxing activities that have social costs not reflected in their prices. For example, one might place a Pigovian tax on gasoline so that the price consumers pay reflects the social cost of using it in terms of pollution, congestion and so forth.
Coase argues that this may not be the best way of handling social costs. "The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A?" he explains. "But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm."
Coase uses the case of Sturges v Bridgman as an example. In that case, a doctor moved next door to a confectioner, whose candy production process was extremely loud, which limited the doctor's ability to practice. In a straight Pigovian analysis, the confectioner is imposing a social cost on the doctor, and a tax or other fee should be placed on the use of the confectioner's tools so as to take that cost into account. But as Coase notes, this analysis begs the question in the doctor's favor. While the confectioner's activities are a nuisance to the doctor, to block them would be a nuisance to the confectioner. The issue isn't how to deal with the social costs the confectioner imposes, but how to weigh the two men's competing claims.
Coase theorizes that, in an ideal world with no transaction costs, the two could reach a bargain pleasing to both parties without going to court at all. "The doctor would have been willing to waive his right and allow the machinery to continue in operation if the confectioner would have paid him a sum of money which was greater than the loss of income which he would suffer from having to move to a more costly or less convenient location or from having to curtail his activities at this location or, as was suggested as a possibility, from having to build a separate wall which would deaden the noise and vibration," Coase explains. "The confectioner would have been willing to do this if the amount he would have to pay the doctor was less than the fall in income he would suffer if he had to change his mode of operation at this location, abandon his operation or move his confectionery business to some other location. The solution of the problem depends essentially on whether the continued use of the machinery adds more to the confectioner's income than it subtracts from the doctor's."
Of course, in the real world it takes time and energy to work out deals like that. For that reason, Coase argues that it is the job of the courts to come to decisions that implement the efficient outcome that would have resulted if such a cost-less negotiation had in fact taken place. Achieving this, in practice, requires that property rights be clearly allocated by the government from the get-go. Coase doesn't provide a way to deal with externalities without involving the government, but he does provide a way to deal with them without resorting to taxes of the kind that Pigovians often embrace.
Written in 1937, when Coase was only 26, this paper tackles the question of why people choose to organize themselves in business firms rather than each contracting out for themselves. In some cases, of course, the latter model predominates. In journalism, for example, there are both firms like The Washington Post, which primarily use writing produced in-house, and ones like the New York Review of Books that rely heavily on freelancers contracting for themselves. But most people in the U.S. currently work as part of a firm rather than as freelancers. This means that there is a big section of the economy — that is, transactions happening within firms — that is not governed by market forces. "Outside the firm, price movements direct production, which is co-ordinated through a series of exchange transactions on the market," Coase writes. "Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator, who directs production."
Coase's main explanation for how this came to be is the existence of "transaction costs." There are various costs to participating in the open market that are eliminated when one operates as part of a firm. "The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism," Coase explains. "The most obvious cost of 'organizing' production through the price mechanism is that of discovering what the relevant prices are." If, instead of just working for a salary, I instead sold each of my posts to the Post, we would have to determine how much each one is worth, and barter until we both agreed upon a set price. That's a substantial cost that's eliminated by working through a firm setting.
Coase's paper was only the beginning of a large literature on theories of the firm, one to which recent Nobel laureate Oliver Williamson, for example, has been a major contributor. But the idea of "transaction costs" has been hugely influential both in that subfield and throughout economics, and got its start in "The Nature of the Firm."
In 1927, Congress passed the Radio Act, which authorized the Federal Radio Commission to provide broadcast licenses to radio stations if "public interest, necessity or convenience would be served" by doing so. That included setting the wavelength that the station was to be broadcasting on. Licenses could not be sold or transferred between stations without the Commission's approval. While that authority was later transferred to the Federal Communications Commission, the same general approach was in effect when this paper was published in 1959.
In it, Coase can barely contain his contempt for this state of affairs. "The situation in the American broadcasting industry is not essentially different in character from that which would be found if a commission appointed by the federal government had the task of selecting those who were to be allowed to publish newspapers and periodicals in each city, town, and village of the United States," he writes.
The rationales for the regulatory regime offered by policymakers and judges -- such as Supreme Court justice Felix Frankfurter, in a case interpreting the Radio Act -- made no sense. "The Supreme Court appears to have assumed that it was impossible to use the pricing mechanism when dealing with a resource which was in limited supply. This is not true," Coase writes. "Despite all the efforts of art dealers, the number of Rembrandts existing at a given time is limited; yet such paintings are commonly disposed of by auction."
And the market alternatives — that is, auctioning off or otherwise selling various radio frequencies in the open market — was totally unfathomable to those in the broadcast industry. Coase cites a congressional hearing in which Frank Stanton, the president of CBS, is presented by a congressman with the possibility of auctioning off broadcast spectrum rather than giving it to whoever the FCC deems deserving:
"This 'novel theory' (novel with Adam Smith) is, of course, that the allocation of resources should be determined by the forces of the market rather than as a result of government decisions," Coase writes.
The trouble with monopoly, from a consumer's point of view, is that it can drive up prices. In a perfectly competitive market, the need to win over other firms' customers keeps the price of goods at the cost of producing an additional unit of them (or the "marginal cost"). But when there's only one firm, that competitive pressure doesn't exist and the monopoly firm is free to raise prices and reap profits.
Or at least that's how it usually works. Coase, in this 1972 paper, showed that there are some cases, involving durable goods, in which monopolies can be forced to sell at marginal cost, an argument that has become known as the "Coase Conjecture." Here's how it works. First, the monopolist sells as much as it can at the "monopoly price" — or the price at which it maximizes profit. This price is higher than it would be if the market were competitive, so there are still some customers who would pay more than marginal cost for the product who haven't bought it yet. To grab those customers and squeeze out a little more profit, the monopolist reduces the price and sells more units to them.
But here's the thing — the earlier customers know that the company is going to cut the price later on. So they hold off on buying until they can get the later price. The company is forced to lower the price from the get-go. Essentially, it's competing against future iterations of itself, which, as in more traditional competitive markets, has the effect of bringing prices down to marginal cost.
This can't happen in markets for nondurable goods like, say, fresh produce. I can't exactly hold out a month for a price reduction on avocados that are already on sale; by then, they'll be rotten. But for durable goods, it's totally possible. UCLA's Matthew Kahn has noted that this seems to be happening with iPhones. Once Apple sells all the iPhones it can at the current price, it'll release a new and improved version for about the same price — a move that is equivalent to a price reduction — to sell to people who wouldn't pay for the old one. But because Apple fans know that this is going to happen, they might hold off for the newer, better one, which puts downward price pressure on the current model.
For many years, when economists needed to name an example of a "public good" — that is, a good that is non-rivalrous (that is, one person's use of it doesn't reduce any other person's ability to use it) and non-excludable (that is, it's impossible to block anyone from using it) — their go-to was lighthouses. After all, a boat that uses a lighthouse to guide its way isn't preventing any other boats from doing the same, and there's no way to prevent boats from using a lighthouse once it's in operation. That led some to suggest that lighthouses, like many public goods, cannot be profitable for private firms to provide, as boats that haven't paid for them can simply free-ride on the contributions of others. The lighthouse, thus, "is often used as an example of something which has to be provided by government rather than by private enterprise," Coase wrote in this 1974 paper.
Here's the problem: Private enterprise, traditionally, has provided lighthouses. As Coase showed, for many years the British lighthouse system was operated mainly through the private sector, which worked largely because use of lighthouses was excludable — one could require that anyone using ports pay a fee to maintain them, making them a "club good" rather than a public good. "Shipowners and shippers could petition the Crown to allow a private individual to construct a lighthouse and to levy a (specified) toll on ships benefitting from it," Coase explains. "The lighthouses were built, operated, financed and owned by private individuals, who could sell the lighthouse or dispose of it by bequest. The role of the government was limited to the establishment and enforcement of property rights in the lighthouse. The charges were collected at the ports by agents for the lighthouses. The problem of enforcement was no different for them than for other suppliers of goods and services to the shipowner."
Coase's point isn't that this system worked better than ones in which lighthouses are publicly owned, or, as was later the case in Britain, run by a private foundation for public benefit. His point is merely that economists should use better examples. "This paper is not intended to settle the question of how lighthouse service ought to be organized and financed. This must await more detailed studies," Coase concludes. "In the meantime, economists wishing to point to a service which is best provided by the government should use an example which has a more solid backing."