YALE LAW SCHOOL

John M. Olin Center for Studies in Law, Economics, and Public Policy
Research Paper No. 510

Ronald Coase, Firms and Markets

by

George L. Priest
Yale Law School
 Ronald Coase, Firms and Markets

by
George L. Priest
Edward J. Phelps Professor of Law and Economics
Yale Law School

Draft: September 11, 2014

Abstract:
This paper will attempt to explain how Coase, from his earliest important paper, The
Nature of the Firm, transformed his interest from firm organization, determined by transaction
costs, to the influence of firm choices and individual choicescollectively, the marketon the
allocation of resources, including on the efforts of governmental organizations to allocate
resources. Over time, less interested in firm organization, Coase directed his work to showing
how the market would invariably dominate the government with respect to the allocation of
resources, limited by transaction costs. The paper will attempt to show, however, in contrast to
widespread views, that there is little link between Coases focus on transaction costs in The
Nature of the Firm and his subsequent attention to those costs in The Problem of Social Cost.
The paper will include anecdotal support: I was a student of Mr. Coase for many years.

Electronic copy available at: http://ssrn.com/abstract=2497676

 Ronald Coase, Firms and Markets

George L. Priest

I. The Puzzle of Coase

Ronald Coase was celebrated by the Nobel Prize Committee and other commentators, in

particular for his study of what have become known as transaction costs1the costs of using

market transactionsto the understanding of industrial organization and of the allocation of

resources in society. According to the Committee,2 the focus on the importance of transaction

costs links Coases earliest important paper, The Nature of the Firm,3 published in 1937 when

Coase was just 27 years old, to his subsequent and most famous work, The Problem of Social

Cost,4 published in 1960 which remains, 54 years later, the most frequently cited article in both

the economics literature and, separately, the legal literature.

But though Coase, in both articles, emphasized the importance of the costs of market

transactions, there is, in my view, a great disjuncture between the articles. This essay will

attempt to explain why the link between them as emphasized by the Nobel Prize Committee and

Edward J. Phelps Professor of Law and Economics, Yale Law School. I am grateful for comments on an earlier
draft to Henry Mohrman, Ning Wang and participants at a Mont Pelerin Society conference in Hong Kong, at which
the paper was first presented.
1
Coase himself did not originate the term.
2
"The Prize in Economics 1991 - Press Release". Nobelprize.org. Nobel Media AB 2014. Web. 3 Sep 2014.
<http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1991/press.html>; The Prize in Economics
1991 Presentation Speech. Nobelprize.org. Nobel Media AB 2014. Web 3 Sep 2014.
<http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1991/presentation-speech.html>.
3
Ronald H. Coase, The Nature of the Firm, 4 Economica n.s. (November 1937). This essay, The Problem of
Social Cost and The Marginal Cost Controversy (all discussed here) were reprinted in R.H. Coase, The Firm, The
Market and The Law (1988). This book is the most convenient access to this portion of the Coase corpus; all textual
citations are to it.
4
Coase, The Problem of Social Cost, 3 J. Law & Econ. 1 (1960).

Electronic copy available at: http://ssrn.com/abstract=2497676

by many other commentators is facile and mistakes the fundamental conceptual difference

between Coases analyses in the two articles.

The Nature of the Firm, Coases first article, discusses how the costs of market

transactions explain why there are firms and speculates about the nature of firm organization. To

my knowledge, Coase did not elaborate or even return to this issue in his subsequent work.

Coases more famous article, The Problem of Social Cost, quite differently, presumes that

there are profit-maximizing firms making allocation decisions in the market, though his

illustrations do not distinguish the firm as a market decision maker from an individualin his

first article, the counterpart to the firm. In The Problem of Social Cost the formation of a

firmthe subject of his first articleis irrelevant to allocation decisions.

Instead, Coases point in The Problem of Social Cost is to emphasize the primacy

indeed the dominanceof market decisions versus governmental decisions concerning the

allocation of resources. As I shall explain, the central theme of The Problem of Social Cost is

the radical view that governmental actions cannot importantly effect the allocation of resources

in the society. As long as the market is allowed to operate, the market, and the market alone,

will determine that allocation to the greater benefit of the society, limited only by the magnitude

of transaction costs.

As a consequence, though linked very loosely by reference to the significance of

transaction costs, The Problem of Social Cost is an exposure and devaluation of the relevance

of government decisionmaking, far different from the theme of The Theory of the Firm.

This essay will attempt preliminarily to explain how Coase made this transition and the

significance of Coases work for the understanding of the role of markets versus governments.

Electronic copy available at: http://ssrn.com/abstract=2497676

 II. Transaction Costs in The Nature of the Firm

As mentioned, The Nature of the Firm was published in 1937. Coases subject, highly

original and revealing of Coases interest in and willingness to address fundamental questions at

an early age, was why are firms organized and how does firm behavior relate to other market

behavior? Coase asks the important question that, since individual transactions in the market

serve to allocate resources through their responses to price signals, why do firms exist that

substitute administrative control for those market transactions? Why is there integration in a

firm at all, rather than complete reliance on market transactions through the price system?

Coases answer is that the existence of firms must demonstrate that there are costs of

entering into market transactions, costs that can be reduced by administrative allocative decisions

within firms. Coase gives an example of these cost savings (this is a paraphrase): in the market,

a worker moves from job X to job Y as a result of being drawn by a price differential as between

X and Y. In contrast, in a firm, a worker moves from Division X to Division Y, not as a result of

a price differential as between X and Y, but because he is ordered to do so.5

In this example, the workers manager supersedes the price mechanism by making an

allocative decision, presumably (implied by Coase) authorized to do so because of the price

savings of an administrative decision over the costs of using relative market pricing to influence

the decision of the worker to move from X to Y.

Besides this basic pointof undoubted significance in itselfCoase does not address in

detail how the manager of the firm makes decisions of this nature. Coase describes the

managerial duties within a firm as those of an entrepreneur, but does not discuss whether this

5
Coase at 35.

entrepreneur is the Chairman of the Board of Directors, the CEO, the COO, or a floor boss or,

to extrapolate, each of them with respect to different allocative decisions. According to the logic

of the article, which ever person is in the best position to make respective allocative decisions

will be empowered to make them, a matter, though, that Coase does not discuss.

Coase defines that the principal function of the entrepreneurat whatever level as

described; presumably any levelis to discover what relative prices would be and possesses a

comparative advantage (these are my terms) because he or she can do so at a lower cost than can

individuals in the market. Thus the entrepreneur knows or believes that that value of the

worker at Y is greater than its value at X, and reallocates the workers contribution appropriately.

Coase provides no analysis as to how this is done; the relatively cheaper cost of administrative

control is presumed from the existence of the firm.

Coase does not emphasize the point but his argument is really about information. In

Coases example about the operation of the firm, the managerentrepreneurhas sufficient

information about relative prices and the relative productivity of inputs to production to

outweigh the costs of using prices through a market process to determine allocation.

This point is related to other analyses of the importance of information to explaining the

function of the market, in particular the analyses of the Austrian school, led by Hayek and von

Mises. Coase, at his writing of The Nature of the Firm, was not an Austrian. In the paper

(again, published when he was 27), in the manner of an excellent student, he thoroughly

discusses the literature relevant to the issue, ranging broadly from discussions of the nature of

economic science to the economic assumptions underlying the understanding of the market

citing Joan Robinson, Kaldor, Keynes, Lionel Robbins, Robertson, Plant (Coases mentor whom

he criticizes), Knight, his later colleague at Chicago (whom he criticizes severely), discussing

Marshall (whom he criticizes as failing to pay adequate attention to the subject), Dobb, Durbin,

Shove, Usher, Batt, E.A.G. Robinson, Jones, Macgregor, J.B. Clark. Coase does not rely on the

Austrians. Coase cites Hayek once, but criticizes Hayeks emphasis on the centrality of the price

system. Coases criticism of Hayek might be expected in this paper since Coase focuses on the

role of the entrepreneur in supplanting the price system. As a former student of Coase,6 I do

not remember him ever referring to Hayek, von Mises, or other Austrians; certainly not

emphasizing their work or showing conceptual similarities.7

In contrast, Hayek, along with von Mises and others, emphasized the importance of the

accumulation of knowledge in the society, far greater than the knowledge possessed by

governments. This was the point of The Road to Serfdom and The Constitution of Liberty.

Coase, in The Nature of the Firm, published roughly a decade before The Road to Serfdom,

also emphasizes the importance of information about market conditions but, here, in contrast to

Hayekand beyond Hayekthe importance of private information exercised outside the

market: that of the entrepreneurmanagerwho at a local level can allocate resources more

effectively than can the market through comparative prices.

Coases point does not exactly conflict with Hayek, though the relationship is

complicated. As I shall explain, in The Nature of the Firm, Coase entertains the idea that a

governmental officer can serve as an entrepreneur. As also shall be explained, Coases view

of governmental decisions evolved over time. Perhaps, Hayeks more general emphasis of the

importance of information can be regarded as an elaboration of Coases The Nature of the

6
I was a student of Coase, and for him, a relatively close student, at the University of Chicago Law School from
1971-73. He appointed me a Research Fellow in his Antitrust Program in which I served from 1975-77.
7
For a discussion of the relation between British economists and the work of the Austrians, see Keith Tribe,
Liberalism and Neoliberalism in Britain, 1930-1980 at 68 in The Road from Mont Pelerin: The Making of the
Neoliberal Thought Collective (Mirowski & Plehwe, eds. 2009) (arguing that British economists did not subscribe to
the anti-statist views of the Austrians because they wanted to remain relevant to policy discussions in Britains
planned economy.)

Firm. I do not remember Hayek ever citing Coase (as explained below, Coases article was

obscure for many years). Hayeks analysis, of course, was broader and more inclusive. There

are analytical similarities between the two, but neither Hayek nor Coase exploited them.

Although later recognized as highly innovative, The Nature of the Firm seems to have

had little impact at the time. It seems not to have influenced the industrial organization literature

until discovered by the Chicago School in the late-1950s. Again, it seems not to have been

recognized by the Austrians. Admittedly, it was written by a 27-year old, with no prominent

academic position. And Coase appears not to have followed up on the idea. To my knowledge,

Coase published no further general articles on firm organization or behavior within a firm.8

III. Transaction Costs in The Problem of Social Cost

To my view, the conception of the effect of transaction costs is entirely different in

Coases The Problem of Social Cost, published 25 years later. As in The Nature of the Firm,

Coase recognizes the existence of the costs of market transactions, the link emphasized by the

Nobel Prize Committee. In The Nature of the Firm, the existence of the costs of market

transactions explains why firms exist: to execute administrative decisions facilitating the

allocation of resources through cost reduction. The achievement is the reduction of the costs of

market transactions.

In The Problem of Social Cost, in contrast, the existence of the costs of market

transactions limits the extent to which the market can correct the allocation of resources by

governments. In The Nature of the Firm, the firm exists to economize on the costs of market

transactions; the societal gain is cost reduction. In The Problem of Social Cost, the costs of

8
Coase, for some period, published a column in an accounting journal which obliquely addressed issues of firm
organization from a tax standpoint.

market transactions are the only limit on the extent to which the market can correct mistaken

judgments of governments as to the allocation of societal resources. The societal gain is the

reallocation of resources by the market from mistaken judgments of government.

Most scholars today read The Problem of Social Cost as emphasizing the role of

bargaining and limitations on bargainingnot unlike the basic point of The Nature of the

Firm. I believe that The Problem of Social Cost is more radical and constitutes both an attack

on governmental decisionmaking, but also Coases belief that governmental decisions effecting

the allocation of resources are ultimately futile and will be supplanted by market allocations,

limited only by transaction costs.

The radical political nature of The Problem of Social Cost has not been sufficiently

emphasized. The basic point of how we now describe the Coase Theorem: In the absence of

transaction costs, the assignment of liability will have no effect on the allocation of resources

is that, market transaction costs aside, courtsin Coases article, representative of government

decisionmakerscannot importantly effect how resources are ultimately allocated within the

society.

As an example, take one of among Coases many illustrations of this point: his

discussion of the railroad emitting sparks and the farmer whose crops are burned by sparks, with

which all are familiar.9 As Coase explains, putting aside transaction costs, the only question with

regard to the allocation of resources to maximize societal welfare is which userailroading or

farmingis relatively more valuable: the railroad emitting sparks and burning the crops or the

crops protected from the railroad? If the use by the railroad is more valuable and courts absolve

the railroad of liability for crop damage, railroad use will prevail. If, in contrast, the crops are

9
All of Coases examples in the article are similar, though I neglect here Coases important point about the
reciprocal nature of causation and his understanding of the wealth effects of different allocations of liability.

more valuable, but the courts still absolve the railroad of liability for crop damage, the farmer

will buy out the railroad because doing so will maximize total production. And the reverse.

The central point is that nothing that the courts door by extension, that the government

doescan upset the ultimate allocation of resources through the market in favor of the higher

valued use of the resource, subject to the transaction costs of bargaining between the contestants

for the resource.

According to the analysis of The Problem of Social Cost, market transaction costs are

important because, whatever their magnitude,10 their existence may limit transactions to

reallocate resources to higher valued uses. If the difference in value as between railroad use and

farmer usethe potential gain from the reallocation of resourcesis less than transaction costs,

then the ideal allocation of resources may not be achieved.

To Coase, this would not constitute a social welfare lossanother important contribution

of the article. This was Coases criticism of Pigou and the Pigovian traditionthe focus on

some ideal allocation of resourcesa theoretical construct that Coase devalued in many

writings as blackboard economics. A cost is a cost. Only by idealizing a perfect worldas he

shows, one innocent of market transaction costswould the perfect allocation of resources be

achieved. Coase never usedabjured from use ofterms such as optimal or even

efficiency. Given the existence of market transaction costs, the market outcome, taking into

account the real costs of market transactions, will always be optimal.

Coases idea here is a radical view and an extraordinary devaluation of the importance of

governmental decisions with respect to the allocation of resources versus those decisions made in

the marketplace. Note that the grounds for Coases devaluation of governmental decisions to

10
And neither Coase, nor any other scholar, has assigned them high magnitude, which has surely added to the
generality of the analysis, except in contexts where one activity affects masses of other activities.

allocate resources is quite different from Hayeks and von Misess. Hayeks and von Misess

point is that there will always be more aggregate information in the market than available to any

government decisionmaker, and thus that market decisions will be preferable. Coase, I believe

would accept this point as a precondition (again, to my knowledge, without ever relying on

Hayek or von Mises). Coase in The Problem of Social Cost, however, argues that the

accumulation of knowledge in the market as to how resources can be most effectively allocated

both will always be superior to governmental decisions and will be implemented despite

government decisions. In this respect, however, Coase, importantly, does not accept the road to

serfdom. Coase believes that bargaining in the marketplace where market transactions are

allowed to operate will evade that road.11

If I may present an anecdote concerning Mr. Coases radical view about the significance

of markets in overturning political decisions and the primacy of market decisions over any

political allocation: After one class, in which Mr. Coase had made this point strongly, I pursued

him after class and trailing him down12 asked him just outside his office (this is a paraphrase),

Mr. Coase, certainly the President of the United States has political influence over the allocation

of resources? Mr. Coase wheeled and replied to me (no paraphrase), The influence of the

President of the United States is $200,000. $200,000 was then the salary of the President, by

which Coase meant that the President could influence the economy only to the extent of the

Presidents personal purchasing power in the marketplace.

11
Note, in this respect, the extraordinary difference in approach as between Coase and Richard Posner. Coase
emphasizes that markets will correct judicial decisionmaking regarding the allocation of resources. Posners
efficiency-of-the-law theory imagines that there is nothing for markets to correct: judges adopt rules allocating
resources efficientlyjudges are perfectly efficient plannersmaking subsequent market transactions unnecessary.
12
In my experience, Mr. Coase was not particularly interested in interactions with students and would, typically,
bolt from the classroom at the end of class.

 IV. Coases Transition Regarding Government Interference in the Market and the
Minimal Role of Transaction Costs

Again, I believe that there is a severe conceptual disjunction between Coases treatment

of transaction costs in The Nature of the Firm and in The Problem of Social Cost. I am not

an intellectual biographer of Coase, but let me explain some benchmarks in the transition of his

thought, some revealed to me as his student. This transition, I believe, is revealed in differences

among the treatment of government decisionmaking in his articles The Nature of the Firm,

The Problem of Social Cost, and, not yet discussed, his articles importantly preceding The

Problem of Social Cost: The Marginal Cost Controversy,13 and The Federal

Communications Commission14

A. The Role of the Government in The Nature of the Firm

In The Nature of the Firm, Coases first important article, he is not hostile to

government decisions affecting the allocation of resources. As mentioned, his discussion of the

firm imagines the existence of an entrepreneur who is able to make decisions regarding the

allocation of resources more cheaply than can the market. In one passage in The Nature of the

Firm, Coase refers to government management as achieving the same end.15 It is not an

extended passage, but it suggests that Coase views government management as potentially

similar to firm management in reducing the costs of market transactions. This is an

extrapolation: Coases discussion is suggestive only of Coases then-seeming openness to the

possible advantages of government management.

13
R.H. Coase, The Marginal Cost Controversy, Economica, n.s., 13 (1946). Reprinted in Coase, The Firm, The
Market, and The Law at 75.

14
R.H. Coase, The Federal Communications Commission, 2 J. Law & Econ. 1 (1959).
15
The Nature of the Firm at p. 37, n. 4.

10

 B. The Role of the Government in The Marginal Cost Controversy16

Roughly a decade later, in 1946, Coase published an article, The Marginal Cost

Controversy. I believe Mr. Coase thought the article to be significanthe taught it in class and

reprinted it in his collected set of essays, The Firm, The Market and The Law. In this article,

Coases view of governmental activities is different and more developed.

Coase addresses the argument, current then among prominent economists as he describes

it, that prices for all services and commodities should be set equal to marginal cost. The

proposition is familiar to all who have studied economics. If a consumer values a product or

service and is willing to pay a price equal to the marginal cost of producing it, then economic

welfare given the resources in the society will be maximized.

This proposition of course was fully accepted by Coase with respect to increasing cost

industries. The more difficult question, addressed by Coase in this article, is how to deal with

pricing in decreasing cost industries, such as public utilities: industries in which, at the current

level of demand, the marginal costs of production are lower than average costs. As is well

known, in industries of this nature, charging a price equal to marginal cost will achieve the social

welfare end of equating consumer preference to the cost of production, but will fail to support

the industry because average costs are higher than marginal costs at that level of aggregate

demand.

Coase describes comprehensively that the prevailing approach among economists at the

time was to conclude that, for industries of this nature, the government should make up the

shortfall between prices set at marginal cost and necessary total revenue where prices would

16
The discussion in this sectionindeed, the discussion throughout, has benefited from an unpublished article by a
classmate with whom I took Mr. Coases seminar, Henry Mohrman, The Marginal Cost Controversy: Teaching
What Economic Policy is Really About (2014).

11

have to equal average cost. According to the seeming economic consensus at the time, the

government should achieve this end through subsidies to decreasing cost industries paid for

through general taxation.

Coase challenged this view. Coase argued, first, that consumers using a product or

service, decreasing cost or otherwise, ought to be required to pay the full costs of its production.

Coase was making an economic point: if consumers pay less than full costs, there will be

overconsumption from a societal point of view of the product or service characterized by

decreasing costs, though there seems to also have been a moral dimension to his emphasis.17

Second, Coase argued (and this was the heart of the paper) that there were other pricing

mechanisms that could achieve, somewhat roughly, the marginal cost principle, but still return

full revenues to the producer: multi-part pricing most prominently.

Most importantly to my mind, and related to what I am describing as Coases transition

from The Nature of the Firm to The Problem of Social Cost was Coases more general

criticism of policies that would substitute governmental decisions through its power of taxation

for market decisions with respect to the allocation of resources. Coase, as mentioned, criticized

the subsidization of decreasing cost industries as leading to overconsumption of their products

and services. But he also pointed out that to support these subsidies required taxation of other

societal activities that would lead to underconsumption, from a social welfare perspective, of the

products, services or activities taxed.18

Most significantly, he asked the question: How can the government or governmental

officials determine how to maximize societal welfare by subsidizing some industries and taxing

17
See Coase, The Firm at 81.

18
Note the similarity in this criticism to Coases later criticism in The Problem of Social Cost of Pigous
proposals to impose taxes on activities generating externalities.

12

other activities in the society? Coase, here, is entirely skeptical of the ability of government

officials to make such decisions consistent with the ambition of maximizing societal welfare.

Coases The Marginal Cost Controversy was published in 1946. Its skepticism of

governmental decisionmaking and its allusions to the effect of political interests in influencing

governmental decisions presages the public choice literature that would follow. But it is not

Hayek: Coase demonstrates not the road to serfdom, but the road to factor distortion from a

social welfare perspective.

The article, however, surely reflects that Coase is developing a different view of the role

of government from that he entertained in The Nature of the Firm. No longer are government

officials similar to entrepreneurs within a firm, exploiting a comparative advantage in

determining prices more cheaply than can the market and allocating resources appropriately.

Here, public officials authorized to subsidize some set of industries paid for by taxation on

general activities are most likely to distort the price system and reduce aggregate welfare.

C. The Role of the Government in The Federal Communications Commission

A further moment, to my mind, in Coases development of his understanding of market

transaction costs leading to his devaluation of government control over the economy as

illustrated in The Problem of Social Cost was Coases study of broadcasting, including his

1959 article, The Federal Communications Commission, the article just preceding The

Problem of Social Cost.

Coase, presumably encouraged by his mentor Arnold Plant, had studied broadcasting

earlier. In particular, Coase studied the monopoly of the British Broadcasting Corporation

(BBC) over British telecommunications, later published as a book, British Broadcasting: A

13

Study in Monopoly.19 In this work, Coase criticized the BBCs monopoly asking, why should a

governmental agency possess a monopoly of broadcasting to the exclusion of other available

private sources? Coases criticism (which is muted in the book; it is centrally a detailed history

of the establishment of the BBC monopoly) chiefly derives from freedom of speech and diversity

of speech grounds: that the BBC, like all monopolies, reduces output and, in particular, does not

cater to the interests of all citizens, favoring elite interests which an open market would not, and

has actively suppressed speech where critical of government positions, as a prominent example,

prior to World War II, Churchill and his criticisms of the Munich Accords.20

Aaron Director, as Editor of the Journal of Law & Economics, was surely aware of this

work. An idea at the time had been promoted among Chicago economistsI do not know its

precise origin; I presume Director (though it also sounds like Milton Friedman)that the

hostility in the U.S. among political liberals (not classical liberals) to government regulation of

broadcasting on free speech grounds could be exploited to lead these liberals to join the free

market movement that Director was leading. Less concerned about monopoly (the U.S. had

some level of competing telecommunications networks and Directors point, unlike Coases, was

not really aimed at maximizing speech), Director argued that, if liberals believed that

government regulation of telecommunications is harmful, why should they not believe that

governmental regulation of other industries in the society is harmful as well?21 Thus, Director

attempted to transform the opponents of government interference with free speech into allies

against government interference in the economy more generally.

19
Coase (1950). An interesting paper discussing Coases earlier work on this subject is David M. Levy and Sandra
J. Peart, Ronald Coase and the Fabian Society: Competitive Discussion in Liberal Ideology, (July 25, 2014).
20
See Coase, British Broadcasting at 166, 189; Levy & Peart, supra.
21
I do not know, but I do not believe that Director had any serious concern about the free speech issues involved.
At the time, government suppression of speech in the U.S. chiefly consisted of the prosecution of Communists,
pornographers, and civil rights activists.

14

 Coase was an implement to this strategy. It is not entirely clear, but I suspect that

Director solicited the article from Coase, knowing of his earlier study of British broadcasting.

Ning Wang, Coases literary executor and biographer, indicates that Coase submitted the article

to Director,22 but the contrast between liberal opposition to governmental interference with

broadcasting and liberal support for other forms of governmental interference in the economy

was certainly an element of Directors agenda.

In The Federal Communications Commission, Coase addressed the supposed

justification for government control of the spectrum: that, without government control, there

would be interference in transmissions that would reduce the total value of the spectrum. Coase

argued that the problem of potential interference did not require government ownership and

allocation of frequencies, but only the transfer of property rights to portions of the spectrum to

private entities in the market.23 Government ownership and subsequent allocation of frequencies

(without appropriate pricing) was necessarily ineffective. The market would allocate those rights

to maximize spectrum value.

Here is Coases view about the government and the relative superiority of the market

with respect to the allocation of spectrum from The Federal Communications Commission. I

quote this passage extensively because it shows Coases basic analysis; his evolving view of how

governments operate; and the role of transaction costs as limiting the ability of the market to

correct governmental allocation decisions:

This [Coases] 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. Quite apart from misallocations which are the result of

22
Ning Wang, Ronald H. Coase, December 29, 2010 September 2, 2013, at 1 Man and the Economy 125, 133
(2014).

23
Coase had not made this argument in his 1950 book, British Broadcasting.

15

 political pressures, an administrative agency which attempts to perform the function

normally carried out by the pricing mechanism operates under two handicaps. First of
all, it lacks the precise monetary measure of benefit and cost provided by the market.
Second, it cannot, by the nature of things, be in possession of all the relevant information
possessed by the managers of every business which uses or might use radio frequencies,
to say nothing of the preferences of consumers for the various goods and services in the
production of which radio frequencies could be used. In fact, lengthy investigations are
required to uncover part of this information, and decisions of the Federal
Communications Commission emerge only after long delays, often extending to years.
[fn.: It is inevitable that the industry will know more than the Commission.] to simplify
the task, the . . . Commission adopts arbitrary rules. For example, it allocates certain
ranges of frequencies (and only these) to certain specified uses. . . .
Commissioner Lee explained: I am finding it increasingly difficult to explain why a steel
company, desperate for additional frequency space cannot use a frequency assigned, let
us say, to the forest service in an area where there are no trees. [n. excluded.]
This discussion should not be taken to imply that an administrative allocation of
resources is inevitably worse than an allocation by means of the price mechanism. [Here
back to the analysis of The Nature of the Firm]. The operation of a market is not itself
costless, and, if the costs of operating the market exceeded the costs of running the
agency by a sufficiently large amount, we might be willing to acquiesce in the
malallocation of resources resulting from the agencys lack of knowledge, inflexibility,
and exposure to political pressure. But in the United States few people think that this
would be so in most industries, and there is nothing about the broadcasting industry
which would lead us to believe that the allocation of frequencies constitutes an
exceptional case.24

Coase would go on in this article to develop his idea of the reciprocal nature of the

causation of harmextrapolating from the frequency interference exampleand to explain that

it did not matter whether the government initially made mistaken allocations of frequencies,

since the market would later correct whatever the government did. These points Director

encouraged Coase to elaborate in greater detail, which Coase did in The Problem of Social

Cost.

Note that the heart of Coases analysis both in The Federal Communications

Commission and later, in The Problem of Social Costthe reciprocal nature of causation; the

effect of the market in overturning judicial allocations of resources; the lack of need of Pigovian

24
Coase, The Federal Communications Commission at pp. 18-19.

16

taxesdoes not derive at all from an understanding of transaction costs, quite unlike the role of

transaction costs in The Nature of the Firm. In The Federal Communications Commission

and The Problem of Social Cost, transaction costs cannot be ignored; they act as a brake on

subsequent market reallocations. But transaction costs in no sense motivate the analysis of the

problem.

V. Conclusion: Weaknesses in the Coasian Tradition

The radical character of The Problem of Social Cost has not been generally recognized.

The paper is the most cited in the economics and legal literature not because it is understoodas

I believe it should beas The Market Manifesto, in contrast to the Communist Manifesto, but

because of its emphasis on the potential of bargaining and the benefits of market decisions about

relative prices in the context of conflicting demands for resource use. This focus, however

available and appropriate, conceals the political nature of the paper.

Coase and his disciples bear some responsibility for how the academy has transformed

the paper. Coase, as mentioned, to my mind, viewed decisions of courts in the various examples

in The Problem of Social Cost25 as representative of government decisions. But all of Coases

examples involve what are known today as liability rules: decisions assigning liability for harm

to the railroad versus the farmer, the confectioner versus the dentist, and so forth. These are

rules which, in the Anglo-American system of law, can be subsequently bargained around to

achieve a superior allocation of conflicting resources.

There are many other governmental rules and regulations, however, that cannot

effectively be bargained around. Coase surely knew this and acknowledged it in the FCC article

25
All of Coases examples in the article are of judicial decisions, real or hypothesized.

17

whose principal message was, allow bargaining over the spectrum in place of the Commissions

peculiar form of administrative allocation of spectrum airwaves.26 This issue was later addressed

in an important paper by my colleague Guido Calabresi,27 though the matter, to my mind,

remains insufficiently explored.

As a further illustration of Coases transition from The Nature of the Firm to The

Problem of Social Cost, what did Coase do after the Social Cost article? He did not work out

its implications for understanding contract, tort and property rules in law, which his analysis

revolutionized. That work was left for important articles by Harold Demsetz, among others.

Coase did not address where transaction costs were likely to be important and where not.

Instead, Coase turned his attention to another government monopoly, like the BBC, whose

monopoly existence needed examination and whose services could be improved if market forces

were allowed to operate: The British Postal Service.

Coases interest in the monopoly of the British Postal Service was related to his interest

in the BBC monopoly. Initially, in Britain, broadcasting was regarded as a form of

communication and authority over broadcasting delegated to the Postal Service which possessed

a monopoly.28

26
The BBCs monopolization of the spectrum is another example. Another anecdote: After one class (in roughly
1972), I said to Mr. Coase, this analysisof the benefits of auctioning spectrum frequenciesseems so obvious,
why hasnt the Congress accepted it? Mr. Coase responded, Give them 30 years. Mr. Coase underestimated the
power of his ideas, and was off by maybe a decade. In the U.S., spectrum auctions began in 1994, though not
entirely as Coase recommended, and remain still subject to excessive administrative control from a Coasian
perspective.
27
Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules and Inalienability: One View of the
Cathedral, 85 Harv. L. Rev. 1089 (1972).
28
Coase, British Broadcasting, e.g., at 61. Another anecdote: I became involved in Mr. Coases interest in this
issue. Coase had talked Richard Posner into agreeing to write a history of the postal monopoly in the U.S.,
furthering Coases interest in the study of government monopolies. Posner hired me as a research assistant for the
project in 1972. Largely uninterested in the subject, Posner convinced Coase to allow me to take it over, resulting in
G.L. Priest, The History of the Postal Monopoly in the U.S., 18 J. Law & Econ. 33 (1975).

18

 Coases more important contributionto my mind insufficiently recognizedwas his

more general understandingdeveloped over timeof the role of markets in placing limits on

the extent of governmental influence on the allocation of resources. Coase recognized that there

were limits to the effect of the market in achieving this goal: transaction costs. But his more

profound contribution was the powerful demonstration that the freeing up of market processes

was the means to achieve the best possible allocation of resources in the society.

19