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.
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.