Ronald Coase’s Method of Building
More Realistic Models of Choice
(With Bingyang Hsiung, National Taiwan University, November 4 2000)
Abstract
This paper argues that Ronald Coase’s major contributions to economic theory are best
understood in terms of the distinct method he used to build more realistic models of choice. We
call his method the benchmark-comparison method. It consists of building models of choice and
then using them as benchmarks in the further investigation of economic interaction, either by
comparing the benchmark models with observed interaction or by building additional models of
choice which may themselves function as benchmarks. The paper first describes the method then
demonstrates how Coase used it in his two most famous papers. We go on to show how an
understanding of the method confirms Coase’s own statements about the continuity of his
thought. Finally, we assess Coase’s critique of Milton Friedman’s positivist methodology and
discuss a recent paper on Coase’s methodology.
The goal of this paper is to present and defend the thesis that a good way to understand
Ronald Coase's major contributions to economic theory is to identify the distinct method he used
to build more realistic models of choice. We call his method the benchmark-comparison method.
It consists of building models of choice that serve as benchmarks in the further investigation of
economic interaction. The further investigation entails (1) comparing the benchmark models with
observed interaction and (2) building additional models of choice which may themselves function
as benchmarks.
In his two most famous papers, Coase used this method at two levels of aggregation. At
the first level the number of interactors is small, as in the classic dyads of the employer-employee
and farmer-rancher; the second level concerns large numbers of interactors as in the equilibrium
models of the market economy. We show how he used the method in both of these cases.
It is necessary at the outset to dispel some misconceptions that may arise from a cursory
reading of what Coase has written about the logic of choice. Alluding to Gary Becker’s work on
the economic approach to human behavior (Becker 1976), Coase has criticized economics for its
sterile models of choice. He writes that this approach is so far out of touch with reality that it can
rightfully be applied to rats, cats, and octopi (Coase 1988: 3).
Coase is not criticizing the use of
choice models per se, but Becker’s simplistic definition of choice. In Becker-type optimizing
models, “[t]he consumer is not a human being but a consistent set of preferences” while the firm
“is effectively defined as a cost curve and a demand curve, and the theory is simply the logic of
optimal pricing and output combinations” (Slater, 1980, p. ix; quoted by Coase, 1988, p. 3).
Coase acknowledges that “existing economic theory...embodies the logic of choice and is of wide
applicability….” His project is to “employ this economic theory to examine the role which the
firm, the market, and the law play in the working of the economic system” (ibid., p. 5). What is
required is “a theoretical system capable of analyzing the effects of changes in these arrangements.
To do this, it is not necessary to abandon standard economic theory, but it does mean
incorporating transactions costs into the analysis.” (ibid., p. 30). Since Coase defines transactions
costs by referring to the alternatives that choosers would have to forego (i.e., to costs in the
opportunity cost sense), his point is that economic theory ought to specify these alternatives and
include them in its models of choice.
A second misconception is that Coase’s criticism of economic theory is based on the view
that individuals are not always choosers. For example, Richard Zerbe and Steven Medema place
Coase’s method in what they call the British tradition. That tradition stresses realism. As they
describe this tradition, it
...emphasizes understanding, rather than prediction, as the first function of theory. It stresses the use of
inductive methodology in the building of theory rather than the development of a theory largely by
deductive means. The focus on induction in turn leads to an emphasis on the understanding of the
behavior of individuals and institutions rather than their treatment as black boxes which carry out
certain functions (Zerbe and Medema 1997: 210).
In a footnote they define “understanding” as “the knowledge of the underlying structures and
causal mechanisms of the economic system and their role in generating economic outcomes”
(ibid.: 232n5). They give an example in which they refer to understanding the cause of the
sunrise.
Ultimately, Zerbe and Medema assert that traditional, or neoclassical models of the
economic system are unrealistic because they only employ rational choice models. When they
write about the importance of understanding the behavior of individuals and institutions, they are
not referring only to understanding the chosen behavior and to the chosen institutions, like
Coase’s firm. They argue that to understand behavior, one must employ findings from
psychology, and that to understand institutions, one must employ a concept of institutions that
transcends the assumption that the institution is a means that rational actors choose in order to
avoid or minimize transactions costs.
On the basis of our reading of Coase’s work, we believe
that he never made such an assertion. In his economic system, as we shall see, subjects are
assumed to make choices. Coase criticizes the lack of realism in the standard models of the
economic system and government action because they do not include the choices and alternatives
that economic actors really face.
Finally, it is also worthwhile to note here that there is no reason to believe that Coase is
deeply interested in methodological issues.
His position on method is straightforward and simple:
all that is needed to do good economics is the appropriate mix of theory and reality.
Since
transactions costs and the institutions that deal with them are part of reality, we should recognize
this. He accepts standard economic theory as an appropriate way of doing this, but he does not
reflect deeply on economic method, nor does he put his own method under the microscope, as we
aim to do here. As to how one incorporates transactions costs into the analysis, he only writes
about using standard economic theory as a theoretical system.
The purpose of this paper is to describe the benchmark-comparison method and to show
how Coase used it. Part one describes the method that we claim Coase employed. Part two shows
how he used it at the level of small numbers interaction. Part three shows how he used it to deal
with interaction in the economic system. Part four explores Coase’s hypotheses about the
development of his thought. Coase has asserted a continuity in his theoretical work during the
fifty-odd years that he has been writing. We affirm this continuity and attribute it mainly to his use
of the benchmark-comparison approach to build increasingly complex, yet more realistic models
of economic interaction. Part five presents a conclusion.
1. The Benchmark-Comparison Method
The benchmark-comparison method appears to be used in all science and, indeed, in all
rational thought. However, we do not intend to deal with it from an epistemological perspective.
Its relevance to Coase stems from the fact that it is commonly used for building models of choice.
The basic model in this field is that of the actor or, somewhat redundantly, the rational actor. The
actor possesses limited means for achieving his ends and, as a consequence, must make choices.
To be realistic, a model of choice must incorporate time and uncertainty. However, the realism
introduced by Coase is not based on these limitations of the model. So, following Coase's lead, we
assume timelessness and certainty.
The model of the solitary rational actor functions as a benchmark for building a model of
the interaction of two rational actors. In the latter model, the alternatives available to each
depend on the choices that are made by the other. We compare the benchmark with what we can
understand about the choices of individuals in two-person interaction. We use what we learn from
our comparison as a basis for building a model of each actor’s choice in the two-person context.
What does this two-person model look like? If we make some conventional assumptions
about preference orderings, homogeneity, and divisibility, one possibility is the model represented
by the Edgeworth-Bowley diagram. This diagram assumes an initial distribution of two goods and
describes the possible outcomes under the assumption that each aims to reach her highest level of
indifference. This two-person model can be used as a benchmark for building more complex
models. One example is the general equilibrium model that Francis Bator used in his simple
exposition of modern welfare economics (Bator 1957). Bator compared the benchmark
Edgeworth-Bowley model with a part of what we know from experience and intuition about
many-person interaction; his production possibilities frontier and utilities possibilities frontier
correspond to the contract curve in the Edgeworth Bowley box model.
The benchmark-comparison method can be used to build models of economic interaction
between producer-sellers and buyers in a particular market. We begin by assuming that the
economy contains two goods, as in the Edgeworth-Bowley model. The difference is that one of
them is money. If we assume also that there is only one producer-seller who has already
produced a given quantity of the good, we can build a bidding model in which competition among
buyers drives the price up to the level at which the quantity demanded by the highest bidders
equals the quantity that was produced. This simple bidding model can be used as a benchmark for
a model of zero-cost monopoly supply by assuming that the producer must choose a level of
output, that his costs are zero, that he maximizes profit, and that the demand is linear. A model
built on these assumptions yields a profit-maximizing price equal to the point on the demand line
at which the price elasticity of demand is one. By extension, one can use the benchmark-comparison method to build models of different kinds of market structures given positive
production costs.
It should be evident that the benchmark-comparison method described here is nothing
new. Economists who build rational choice models have always utilized it, albeit intuitively. We
shall argue that Coase’s inventive application of this method is precisely what enabled him to
arrive at his noteworthy contributions to economics, and that the continuity in Coase’s thought is
best understood in this light.
2. Use of the Method to Build Models of Two-Person Exchange
Coase’s use of the benchmark-comparison method in his two most important papers can
be divided into two classes: two-person (and other small number) exchange benchmarks and
economy-level benchmarks. He used two-person exchange benchmarks to help describe
interaction that he later incorporated into his models of the market economy. In this Section, we
discuss the two-person exchange benchmarks.
The Nature of the Firm
An examination of Coase’s theory of the firm shows that he began with a model of an
individual’s choice and then expanded on this by comparing it with three successive dyads. He
began with an individual who faced a choice of where to allow her factor to be employed in a
model of zero transactions costs. Recognizing the costs of making exchanges, he built a model of
a dyad in which the employer and factor owner faced positive transactions costs. He then used
this as a benchmark for building a model of the employer-employee relationship, or firm. Finally,
he contrasted the latter relationship with another dyad – the master-slave relationship.
The choice of where to employ a factor corresponds to what he called the allocation of
factors by means of the “price mechanism”:
[I]n economic theory we find that the allocation of the factors of production between different uses is
determined by the price mechanism. The price of factor A becomes higher in X than in Y. As a result, A
moves from Y to X until the difference between the prices in X and Y, except in so far as it compensates
for other differential advantages, disappears (Coase 1988: 35).
He uses this as a benchmark for building the first dyad model – the positive cost exchange. In this
model, positive-cost exchanges are necessary to allocate factors in a real market economy. Coase
defines these exchange costs by contrasting the zero-cost allocation with his image of the
exchange of factors as it occurs “in reality.” This enables him to identify what he calls the costs of
using the price mechanism. He identifies two or three of these: (1) costs “of discovering what the
relevant prices are,” (2) “costs of negotiating and concluding a separate contract for each
exchange transaction,” and possibly (3) the costs associated with making long term contracts
(ibid.: 38-40).
Coase’s listing of the costs of exchange is a preliminary exercise designed to help him
build the second dyad, which uses the first dyad as a benchmark. This is a contract
whereby the factor, for a certain remuneration (which may be fixed or fluctuating), agrees to obey the
directions of an entrepreneur within certain limits. The essence of the contract is that it should only state
the limits to the powers of the entrepreneur [employer]. Within these limits, he [the employer] can
therefore direct the other factors of production (ibid.: 39).
He calls the allocation of factors by means of contracts such as this the firm. He contrasts
allocation by means of the firm with allocation by means of the price mechanism. He writes that
“[outside the firm,] price movements direct production, which is co-ordinated through a series of
exchange transactions on the market” (ibid.: 35). Inside the firm, a “factor of production (or the
owner thereof) does not have to make a series of contracts with the factors with whom he is co-operating...as would be necessary, of course, if this co-operation were as a direct result of the
working of the price mechanism” (ibid.: 39). He goes on to write that “a firm will tend to expand
until the costs of organizing an extra transaction within the firm become equal to the costs of
carrying out the same transaction by means of an exchange on the open market or the costs of
organizing another firm” (ibid.: 44). His aim, according to his reflections over forty years later,
was to account for individuals’ choices among contractual relationships, given the reality of costs
of making exchanges. (Coase 1991: 56-8).
The third dyad is that of the master-slave, in which the entrepreneur’s powers to give
orders are not limited (ibid.: 39n, 53-4). His purpose in introducing this relationship is to highlight
the limited powers of the employer over the employee in the relationship that comprises the firm.
Thus, the master-slave relationship is used as a benchmark to underscore the voluntary nature of
the employer-employee relationship.
Recently, Coase has extended his discussion and, in the process, has provided hints of a
more elaborate model. He suggests that what he had in mind regarding the firm was an
arrangement of production that "takes place without the need for bargains between the owners of
the factors of production." Instead, the firm acquires legal rights to the use of the factors of
production that enable it to arrange production by means of an administrative decision. (1991: 66)
Thus the "alternative to an interfirm transaction is to bring it within the purview of a firm..."
(ibid.: 67) He goes on to emphasize an element that he omitted in his earlier paper, namely, that
the firm emerges "only when the organizer has contracts with several factors whose activities he
coordinates" (ibid.: 68, italics added). He thereby extends what was previously a dyad contract
model into one of a contract between the organizer and the initial owners of several factors. In
this extension, the dyad contract model functions as a benchmark for the model that includes
owners of several factors.
We see from this discussion that the zero-transactions cost employment choice model
functions as a benchmark for the positive-transactions cost dyad, that the positive-transactions
cost dyad functions as a benchmark for the employer-employee dyad, that the master-slave dyad
functions as a benchmark for helping to understand the voluntary nature of the employer-employee dyad, and that the employer-employee dyad functions as a benchmark for the model of
an employer who hires several factors.
Social Cost
Coase begins his 1960 paper with an extended discussion of the farmer-rancher
transaction, in which the rancher’s straying cattle destroy the farmer’s crops. He shows that under
the assumption of zero transactions costs, regardless of who owns the right to control the
rancher’s action of allowing the cattle to stray, “the final result [abandoning cultivation, in
Coase’s example] would be the same and would maximize the value of production.” There is “no
long-run effect on the allocation of resources”(Coase 1988:100-1). This final result is achieved by
means of exchange, if it is necessary. Coase later wrote that his aim in using the unrealistic model
“was not to describe what life would be like in such a world but to provide a simple setting in
which to develop the analysis and, what was even more important, to make clear the fundamental
role which transaction costs do, and should, play in the fashioning of the institutions which make
up the economic system" (ibid.: 13). In his theory of the firm, Coase’s use of the zero exchange
cost model as a benchmark had to be inferred from his use of the employment choice as a
benchmark. Here he states outright that the zero transactions cost model is a benchmark that he
used to help derive the role of the institutions in the economic system.
Having identified the implications of the benchmark zero-cost transactions model, he goes
on to consider transactions under realistic conditions. To do this he presents a series of four real
legal cases that contain external effects of the farmer-rancher type. He compares the rulings in
each of these with the outcome of the benchmark case in order to demonstrate that because of the
presence of transactions costs, the judge or an outside evaluator of a case might have cause to
believe either that the exchange required to maximize the value of production would not occur, or
that if it were to occur, it would entail substantial costs. Under these conditions, it is possible that
other forms of organization, by which he means the firm and government, would be superior to
the market in utilizing resources.
Having already discussed the firm in his 1937 paper,
he
focuses here on government organizations.
For the two-person case Coase does not recommend any specific government action.
Instead, he proceeds to use the two-person positive transactions costs model as a benchmark for
analyzing a more complex case, one that involves a number of parties. First, he discusses the case
of a smoke nuisance, suggesting that as the number of parties involved increases, transaction costs
may prevent the parties from reaching a voluntary agreement and that, under this circumstance,
governmental regulation is a possible solution (1988 [1960] 116-17). Then he considers the case
of Adams v. Ursell, where a fried fish shop was set up near houses of "a much better character"
(ibid.: 123). In this case the court issued an injunction against the fish shop. Finally, he considers
the case of Delta Air Corporation v. Kersey, Kersey v. City of Atlanta, a case involving the
airport and the residents living nearby. In this case, the court allowed the airport to continue to be
noisy and to spew out dust but enjoined it from allowing its planes to fly too low on the grounds
that this external effect could be cheaply avoided (ibid.: 128-31).
We see two uses of the benchmark-comparison method here. First the zero transactions
cost, two-person exchange is used as a benchmark to build an image of two-person exchange
under the assumption of positive transactions costs. Second, the two-person case (one faces one)
is used as a benchmark for building a many-person case (one faces many). It is with respect to the
latter case that Coase seems to believe that some sort of government intervention may be
warranted.
Use of the Method to Build Models of an Economy
In this part we demonstrate Coase’s use of the benchmark-comparison method to model
economic systems. Here he begins with simple models and proceeds to incorporate (1) the costs
of making transactions, (2) institutions that are created as a means of reducing or avoiding these
costs, and (3) government institutions to which economists might assign the task of correcting for
problems associated with external effects.
The Nature of the Firm
In his paper on the firm, Coase makes reference to Arthur Salter’s model of an economic
system in which “supply is adjusted to demand, by a process that is automatic, elastic and
responsive” (Coase, 1937, p. 34). The methodological foundation for models like Salter’s may be
traced to John B. Clark’s so-called static state, in which the same production, buying and selling,
consumption and saving behavior in a set of markets is repeated again and again (Clark, 1899a,
Chapter 3; 1899b). There is no change and no real time, although time is simulated by the
hypothetical, repeated behavior.
Clark’s static state might be considered a benchmark for Salter’s model. The static state is
a model in which supply is fully adjusted to demand in all markets. Starting with this model, we
use our intuition and experience to contemplate a variety of changes in demand or cost conditions
which, if they are not immediately accommodated, would lead to a situation in which supply is not
adjusted to demand. We proceed to catalogue these changes. Then we assume that the catalogued
changes are occurring continuously. At the same time, we assume that all agents instantaneously
identify and adjust to them. In this way, we can conceive the Salter model as a Clarkian static
state that is continuously disarranged by changes in the conditions of demand and supply,
whereupon a new static state is established which reflects these changed conditions. The model’s
conception of equilibrium is identical to that of new classical economics.
Coase uses the Salter model as a benchmark for building his own, more complex model.
He begins by interpreting the automatic adjustment mechanism as a process that entails no price
mechanism costs, in the sense described above. On this interpretation he characterizes Salter’s
model as an ‘incomplete’ image of the economic system that fails to capture what happens ‘within
a firm’. A workman within a firm does not automatically adjust to a change in demand as he
would if he were an independent contractor; instead, he follows the instruction of his boss (1937,
p. 35). Coase points out that when we take account of the costs of using the price mechanism,
two kinds of coordination become evident: the sort that occurs in the Salter model, and the kind
associated with the entrepreneur. Thus, one can say that Coase developed a new classical
equilibrium model in which the concept of the entrepreneur, as exhibited by the
employer–employee relationship, embodies all the organization or coordination that occurs
outside of the Salter model.
The presence of transactions costs gives entrepreneurs incentives to
form firms. A firm, which consists of a contract with employees in which the latter agree to shift
their work from one project or location or type to another without requiring a new contract,
enables entrepreneurs to avoid the costs of using the price system (or to circumvent the full
impact of these costs).
Like the Salter model, Coase’s model contains automatic and instantaneous adjustment to
change. The difference is that some of the automatic and instantaneous adjustment takes place in
firms, as employers alter their instructions to employees without negotiating a new contract.
Moreover, the Coase model includes the formation of new firms and, one must assume, the
breaking up of existing firms by means of instantaneous adjustments to changes in transactions
costs.
Recently Coase has extended his model by recognizing a substitution relationship between
vertical integration and firm-to-firm transactions (Coase, 1991, pp. 65–67). In making this
extension, he uses his own 1937 model as a benchmark for his newer model. In his recent
reflections on this work, he points out:
The analysis cannot be confined to what happens within a single firm. The costs of coordination within
a firm and the level of transaction costs that it faces are affected by its ability to purchase inputs from
other firms, and their ability to supply these inputs depends in part on their costs of coordination and the
level of transaction costs that they face, which are similarly affected by what these are in still other
firms. What we are dealing with is a complex interrelated structure (Coase 1995: 245, partly quoted in
Coase 1998).
Presumably the instantaneous adjustments in the expanded model would include choices
by business units to merge and divide, and agreements among firms to alter the nature and amount
of firm-to-firm transactions. This quote also suggests that even though Coase has never explicitly
acknowledged and therefore may not be aware of the use of benchmarks in his thought, they
nevertheless play an important part in it.
Social Cost
In his 1960 paper, Coase begins with the Salter model and quickly introduces the firms of
his 1937 paper. Then he proceeds to extend the model. To see how he accomplishes this, consider
his assumption that firms arise because coordination by means of the employer-employee compact
is superior, under some circumstances, to coordination by means of the price system. On
analogous reasoning he introduces three possible ways that government action may improve
matters. First, he considers the courts in their handling of nuisance law:
In a world in which there are costs of rearranging the rights established by the legal system, the courts,
in cases relating to nuisance, are, in effect making a decision on the economic problem and determining
how resources are to be employed (ibid.: 132-133).
Second, he considers statutory enactments. Statutory enactments affect the delimitation of
rights (ibid.: 133). Third, he discusses regulation. He writes that organization by means of
government regulation may sometimes be superior.
Instead of instituting a legal system of rights which can be modified by transactions on the market, the
government may impose regulations which state what people must or must not do and which have to be
obeyed...The government is able, if it wishes, to avoid the market altogether, which a firm can never
do...[Although] direct governmental regulation will not necessarily give better results than leaving the
problem to be solved by the market or the firm...there is no reason why, on occasion, such governmental
administrative regulation should not lead to an improvement in economic efficiency (ibid.: 117-8).
We see from these statements a broader vision than was evident in his paper on the firm.
He expands the 1937 model to include the possibility (1) that the courts may change legal rights,
(2) that the legislature may enact laws, and (3) that the legislative or administrative arm of
government may impose regulations.
Although he does not again refer to the instantaneous adjustment of the Salter equilibrium,
his reference to firms in the above quotation and his recent discussion of the continuity of his
thought suggest that he conceives of his new model in this way also. Thus, any change in property
titles or direct regulation is incorporated with the other changes in the conditions of demand and
supply. All such changes trigger immediate adjustments through the price mechanism and within
firms. Adding these ‘variables’ to the choice calculus to those that have already been added on the
basis of Coase’s 1937 paper on the firm complicates the initial Salter model quite a bit. A full
presentation is beyond the scope of this paper. It is sufficient to point out some examples of
choices that would presumably be included. First, regulatory agencies would presumably try to
take account of the market and firm adjustments that are likely to occur as a consequence, or even
in anticipation of, some regulatory actions. Second, managers of firms would presumably try to
take account of responses to and anticipations of their actions on the part of courts, the legislature
and regulatory agencies. Third, courts would presumably try to take account of how their
decisions are likely to affect and be anticipated by the legislators in their decisions to delimit
rights. A new classical equilibrium model that included all of these elements would be complex
indeed. The point to be emphasized here, however, is that in blazing the trail toward the building
of such a model, Coase systematically employed the benchmark-comparison method.
Fundamental Alterations in the Salter Equilibrium
We could end the discussion of Coase’s models here if his critique of Pigou had not led
him to question the implicit assumption of the Salter model – or, more generally, of neoclassical
economics – that entitlements refer to rights to own and use real, tangible property. In our view,
one of the most important contributions of the “social cost” paper was his recognition that to
properly deal with the problem of external effects, one ought to frame the analysis not in terms of
physical factors of production but in terms of rights “to perform certain (physical) actions” (ibid.:
155). In other words, one should define a factor of production not in physical terms but in terms
of the rights to act in certain ways. Defining it in these terms helps us form a clearer
understanding of the opportunity cost concept.
The cost of exercising a right (of using a factor of production) is always the loss which is suffered
elsewhere in consequence of the exercise of that right) – the inability to cross land, to park a car, to
build a house, to enjoy a view, to have peace and quiet or to breathe clean air (ibid.).
There is some ambiguity in his statements since he writes that we should think of factors of
production as rights and then writes about the “right of using a factor of production.” However,
his meaning seems clear. The notion of a physical factor of production should be replaced by the
notion of a right to act in a particular way, including a way that has external effects.
Like the
physical factors of production and like consumers’ goods, these rights are exchangeable.
This conception of the choices faced by actors in the economic system may explain how
Coase came to view the entrepreneur’s production of institutions as part of the market process.
The relevance of Coase’s exchange costs and transaction costs become evident when Salter’s
notion of equilibrium is applied to the trading of rights to command actions instead of physical
factors of production. The creativity of the human actor in producing institutions becomes
important as soon as one realizes that the production of particular configurations of rights reduces
the costs of transactions and helps to solve incentive problems. It is this insight that makes up the
bulk of Coase’s legacy, as expressed in the work of writers like Armen Achian, Benjamin Klein
and Harold Demsetz. Thus, while Coase used a benchmark-comparison methodology that is
comparable to that of other economists, he used it in a new way.
The Continuity of Coase’s Thought
We have suggested that there is a continuity in the development of Coase’s thinking about
the market economy. The source of this continuity is his consistent use of the benchmark-comparison method of building more realistic models of economic choice.
A concern in both of
his major papers is whether neoclassical models of choice are relevant to the problems economists
want to address. To deal with this concern, he employs the benchmark-comparison method. In his
paper on the firm, he uses this method first to expand the traditional Edgeworth-Bowley choice
model to include the employment relation and then to expand the Salter equilibrium to cover an
economy with costs of using the price mechanism. He asks whether the traditional models of
choice reflect the choices that real actors make. His answer is yes but only up to a point. They
neglect alternatives that Coase’s intuition and experience reveal to him are important. When he
compares the benchmarks with his own insight into the alternatives faced by real actors, he
discovers (1) the potential gain from the employment agreement that specifies the employees’
tasks only within broad limits and (2) costs of using the market mechanism. He uses these
discoveries to expand the traditional models so that they include additional alternatives.
In the social cost paper, the problem is to realistically represent public policy choices and
the choices of the market participants affected by them. As before he employs the existing models
as benchmarks. This time his insight helps him identify choices of market participants in response
to a particular set of rights to control actions, and choices of policy regulators, judges and
legislators. Regarding market participants, he discovers that they can ‘contract around’ an initial
delimitation of rights. This suggests to him that in the zero-transactions costs world, resource use
(i.e., the actions performed by agents in the production of goods) will be the same under any
initial delimitation of rights. Regarding policy choices, he recognizes how the various types of
state-controlled coercion are related to each other. Most importantly, the effects of each can be
best understood by considering the intervention as a delimitation of rights to act in particular
ways.
The most important elements of Coase's life work life work represent two successive
expansions of the fundamental neoclassical model of choice, with the earlier expansion functioning
partly as a benchmark for the later expansion. Seen in this light, his social cost paper is a natural
extension of his paper on the firm. His 1937 paper also contains a glimpse of his later idea of
defining a factor of production as a right to control actions. Consider the problem Coase faced. In
economic theory, the concept of a ‘factor of production’ includes all marketable inputs into the
production process. In traditional theory, these were the material inputs land, labor, and capital
equipment. Yet Coase had observed that the entrepreneur regards the right to control another
person’s action, within limits, as valuable. How can this fact be incorporated into the theoretical
framework of economics? The answer is to change radically the concept of a factor of production
so that it means rights to control actions.
Conclusion
We have described how Coase used what we call the benchmark-comparison method to
identify shortcomings of the typical models of (1) the employer-employee relationship, (2) the
adjustment of the actors to a change in the delimitation of rights, (3) the market mechanism and
(4) government intervention in the price system. We also showed how he incorporated his
discoveries into existing models to build more comprehensive models that can themselves serve as
benchmarks. Our assumption that he used the benchmark-comparison method enabled us to affirm
Coase’s claim about the continuity in his thought. Finally, we showed how our interpretation was
consistent with Coase’s own discussion of methodological issues.
Our aim has been to demonstrate the usefulness of the benchmark-comparison method in
comprehending Coase’s contributions to economics. We also believe that the method is useful for
understanding a much broader set of economic ideas, including developments in post-Keynesian
economics, public choice theory, constitutional economics, and of course the various traditions
that have evolved from the work of Coase himself.
References
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Co-author
Bingyuang Hsiung
Department of Economics
National Taiwan University
Taipei, Taiwan R.O.C.
(886) 2 394-4861 (o)
Fax (886) 2 351-4526
Email: hsiung@ms.cc.ntu.edu.tw
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