Kurt Laitner | My Amplify

During the two centuries since the publication of The Wealth of Nations the main activity of economists, it seems to me, has been to fill the gaps in Adam Smith's system, to correct his errors and to make his analysis vastly more exact. A principal theme of The Wealth of Nations was that government regulation or centralised planning were not necessary to make an economic system function in an orderly way.

Harold Demsetz has said rightly that what this theory analyses is a system of extreme decentralization.

" It suggests that from the point of view of the economist 'organisation' is a matter of internal industrial (or agricultural) arrangement - if not internal to the firm, at any rate internal to 'the' industry. At the same time it tends to leave out completely the governing factor of all productive organisation - the relationship of prices and cost..."2. What this comes down to is that, in Robbins' view, an economist does not interest himself in the internal arrangements within organisations but only in what happens on the market, the purchase of factors of production and the sale of the goods that these factors produce. What happens in between the purchase of the factors of production and the sale of the goods that are produced by these factors is largely ignored.

The firm and the market appear by name but they lack any substance. The firm in mainstream economic theory has often been described as a "black box". And so it is. This is very extraordinary given that most resources in a modern economic system are employed within firms, with how these resources are used dependent on administrative decisions and not directly on the operation of a market.

If we knew more about our own economy we would be in a better position to advise them.

The view of the pricing system as a co-ordinating mechanism was clearly right but there were aspects of the argument which troubled me. Plant was opposed to all schemes, then very fashionable during the Great Depression, for the co-ordination of industrial production by some form of planning. Competition, according to Plant, acting through a system of prices, would do all the co-ordination necessary. And yet we had a factor of production, management, whose function was to co-ordinate. Why was it needed if the pricing system provided all the co-ordination necessary?

I found the answer by the summer of 1932. It was to realise 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 co-ordination, 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 co-ordination normally analysed 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). In my 1937 article, I argued that in a competitive system there would be an optimum of planning since a firm, that little planned society, could only continue to exist if it performed its co-ordination function at a lower cost than would be incurred if it were achieved by means of market transactions and also at a lower cost than this same function could be performed by another firm. To have an efficient economic system it is necessary not only to have markets but also areas of planning within organizations of the appropriate size. What this mix should be we find as a result of competition

the explicit introduction of transaction costs into economic analysis.

In this way, transaction costs affect not only contractual arrangements but also what goods and services are produced.

I know of only one part of economics in which transaction costs have been used to explain a major feature of the economic system and that relates to the evolution and use of money.

Exchange in a barter system requires what Jevons called "this double coincidence". 1 Clearly the search for partners in exchange with suitable qualifications is likely to be very costly and will prevent many potentially beneficial exchanges from taking place. The benefit brought about by the use of money consists of a reduction in transaction costs. The use of money also reduces transaction costs by facilitating the drawing up of contracts as well as by reducing the quantity of goods that need to be held for purposes of exchange.

Pigou's conclusion and that of most economists using standard economic theory was, and perhaps still is, that some kind of government action (usually the imposition of taxes) was required to restrain those whose actions had harmful effects on others, often termed negative externalities.

The significance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion; let us study the world of positive transaction costs.

If we move from a regime of zero transaction costs to one of positive transaction costs, what becomes immediately clear is the crucial importance of the legal system in this new world. I explained in The Problem of Social Cost that what are traded on the market are not, as is often supposed by economists, physical entities but the rights to perform certain actions and the rights which individuals possess are established by the legal system. While we can imagine in the hypothetical world of zero transaction costs that the parties to an exchange would negotiate to change any provision of the law which prevents them from taking whatever steps are required to increase the value of production, in the real world of positive transaction costs such a procedure would be extremely costly, and would make unprofitable, even where it was allowed, a great deal of such contracting around the law. Because of this, the rights which individuals possess, with their duties and privileges, will be, to a large extent what the law determines. As a result the legal system will have a profound effect on the working of the economic system and may in certain respects be said to control it. It is obviously desirable that these rights should be assigned to those who can use them most productively and with incentives that lead them to do so and that, to discover and maintain such a distribution of rights, the costs of their transference should be low, through clarity in the law and by making the legal requirements for such transfers less onerous.

It makes little sense for economists to discuss the process of exchange without specifying the institutional setting within which the trading takes place since this affects the incentives to produce and the costs of transacting.

Second, Williamson has also pointed out that although I was correct in making the choice between organization within the firm or through the market the center piece of my analysis, I did not indicate what the factors were that determined the outcome of this choice and thus made it difficult for others to build on what is often described as a "fundamental insight". This also is true. But the interrelationships which govern the mix of market and hierarchy, to use Williamson's terms, are extremely complex and in our present state of ignorance it will not be easy to discover what these factors are. What we need is more empirical work.

my own feeling is that the inspiration is most likely to come through the stimulus provided by the patterns, puzzles and anomalies revealed by the systematic gathering of data, particularly when the prime need is to break our existing habits of thought"*.

However, I have come to the conclusion that the main obstacle faced by researchers in industrial organization is the lack of available data on contracts and the activities of firms.

nough.

But a scholar must be content with the knowledge that what is false in what he says will soon be exposed and, as for what is true, he can count on ultimately seeing it accepted, if only he lives long Read more at nobelprize.org