Freedom Line Blog

“Transaction costs” are a familiar concept to any Economics 101 students today. Simply put, transaction costs are the costs other than the price that are incurred in trading goods or services. (Time and energy are two of the most obvious transaction costs.)

Given the universal acceptance of the idea of transaction costs, it might come as a surprise that the term wasn’t coined until the 1930s by Nobel Prize-winning economist Ronald Coase.

Coase died last week at age 102, spurring a number of glowing and well-deserved tributes. Perhaps none was more useful in explaining Coase’s impact to economics than an op-ed featured in The Times of London by author and Wall Street Journal columnist Matt Ridley:

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 was not the tireless defender of free markets and competition that contemporaries such as Milton Friedman or Friedrich Hayek were, but his research led to a tremendous amount of skepticism about government’s ability to produce, manage or regulate efficiently and effectively. For that, all devotees of freedom and individual liberty owe Coase a debt of gratitude.