Introducing Transaction Costs

transaction costsWhat’s interesting about Ronald Coase’s famous article, The Problem of Social Cost, is that only about the first fifteen pages go over the Coase Theorem. The rest of the article focused on what Coase actually cared about, i.e. introducing transaction costs into economic analysis.

First a quick recap. The Coase Theorem says that given a set of assumptions (perfect competition, no transaction costs, no income effects, etc..), a market under the influence of externalities will maximize the value of production regardless of how property rights are assigned among the market participants. However, when we introduce transaction costs, this might not happen:

Once the costs of carrying out market transaction are taken into account, it is clear that such a rearrangement of rights will only be undertaken when the increase in the value of production consequent upon the rearrangement is greater than the costs which would be involved in bringing it about. When it is less, the granting of an injunction (or the knowledge that it would be granted) or the liability to pay damages may result in an activity being discontinued (or may precent its being started) which would be undertaken if market transactions were costless. In these conditions the initial delimitation of legal rights does have an effect on the efficiency with which the economic system operates. (Coase 1960: 15-16)

As Coase observed in his famous article, The Nature of the Firm, “there is a cost of using the price mechanism” (Coase 1937: 390).  One way to bypass these costs is to form an organization that directs resource use. We might call this organization a “firm” (this is Coase’s theory of the firm). The firm represents a different form of economic organization when compared to market transactions. Sometimes this form of organization can achieve the same result as the market at less cost, e.g. in the case of long term contracts. But there’s also a third option, direct government regulation:

But the firm is not the only possible answer to this problem. The administrative costs of organizing transactions within the firm may also be high, and particularly so when many diverse activities are brought within the control of a single organization. In the standard case of smoke nuisance, which may affect a vast number of people engaged in a wide variety of activities, the administrative costs might well be so high as to make any attempt to deal with the problem within the confines of a single firm impossible. An alternative solution is direct Government regulation. Instead of instituting a legal system of rights which can de modified by transaction on the market, the government may impose regulations which state what people must or must no do and which have to be obeyed. Thus, the government (by statute or perhaps more likely through an administrative agency) may, to deal with the problem of smoke nuisance, decree that certain methods of production should or should not be used (e.g. that smoke preventing devices should be installed or that coal or oil should not be burned) or may confine certain types of business to certain districts (zoning regulations). (Coase 1960: 17)

Unlike other firms, which are under pressure from competition, the government doesn’t have to deal with this constraint. It can just make a decree. Such powerful methods can enable the government to get things done a lower cost than either the market or a firm.

However, and this is one of Coase’s main points in the article, “the government administrative machine is not itself costless” (Coase 1960: 18). The government needs to gather information, which is costly. Certain regulations (e.g. restrictive and zoning regulations) might be subject to political pressure and used for purposes not intended. General regulations that apply to a wide range of cases might be used inappropriately for a particular case. These heavy costs can reduce efficiency in the economic system. So even if the firm or the market can’t deal with the harmful effects because of high transaction costs, government regulation might not be the answer. Sometimes it’s better to do nothing at all:

There is, of course, a further alternative, which is to do nothing about the problem at all. And given that the costs involved in solving the problem by regulations issued by the governmental administrative machine will often be heavy (particularly if the costs are interpreted to include all the consequences which follow from the Government engaging in this kind of activity), it will no doubt be commonly the case that the gain which would come from regulating the actions which give rise to the harmful effects will be less than the costs involved in Government regulation. (Coase 1960: 18)

While this framework is seriously inadequate for analyzing the costs of policy (Coase freely admits this), it does provide us with a useful warning. When we change the social and legal arrangements of the economic system, it comes with costs and benefits. In order to choose the appropriate social arrangements for dealing externalities, we need to properly weigh these costs and benefits. Coase isn’t against the use of government regulation per se, but he emphasized that we must look at the costs of such a social arrangement and “it would be unfortunate if this investigation were undertaken with the aid of a faulty economic analysis” (Coase 1960: 19).


1. Coase, R. H. “The Nature of the Firm.” Economica 4.16 (1937): 386-405.

2. Coase, R. H. “The Problem of Social Cost.” The Journal of Law and Economics 3.1 (1960): 1-44.

3. Coase, R. H. The Firm, the Market, and the Law. Chicago: U of Chicago, 1988. Print.

4. Madema, Steven G. “The Myth of Two Coases: What Coase Is Really Saying.”Journal of Economic Issue 28.1 (March 1994): 208-17.

5. Medema, Steven G. “Symposium on the Coase Theorem: Legal Fiction: The Place of the Coase Theorem in Law and Economics.” Econ. Phil. Economics and Philosophy 15.02 (1999): 209-233.


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