A Serious Misreading of Coase

Corey Robin is very insightful about a lot of things.  I think his take on conservatism, that the thread running through it is opposition to attempts to demolish pre-existing hierarchies, explains ideological twists and turns that would otherwise remain mysterious.  Don’t take this post as an expression of anti-Robinism.

But CR seriously misreads economic texts that abut political theory.  I felt this way about his analysis of Hayek, which simply ignores the centrality of his lifelong revulsion at Vienna-school-style positivism, with its echoes in a certain style of economic formalism.  (Yeah, Hayek bought into a lot of the elitism of the right, but so did nearly every other conservative; that’s not what made him consequential.)  And now he gives us a terrible interpretation of Coase.

According to CR, “Coase divides the economic world into two modes of action: deal-making, which happens between firms, and giving orders, which happens within firms.”  He then goes on to paint Trump as an über-Coasian, at least in his own self-presentation, since these are the only types of action he recognizes.  I won’t dispute the portrait of Trump, but Coase?  Not a chance.

Coase is proposing a theory of the make-or-buy decision which faces every firm.  (This is the case even for firms in a socialist economy, assuming they can transact in some way with other enterprises.)  What goods does a firm produce internally, and what do they acquire from the outside?  Do you hire your own accountant, or do you buy the services of some accounting firm?  Does Toyota make its own seat cushions for its cars, or does it get them from a supplier (or group of suppliers)?

Coase assumes that going out onto the market is always best, in the sense that someone out there can do it better and cheaper than you can (or at least no worse and more expensive)—this is the market creed, with competition and all that—so there must be some other consideration at work.  He says the missing ingredient is transaction costs: sometimes the cost of negotiating and enforcing a contract, which is what “buy” implies for inter-firm business, is so great as to negate the intrinsic benefits of using the market.  The reason firms exist and have the boundaries they have (the result of a myriad make-or-buy choices), according to Coase, is the variegated presence of transaction costs.

(Oliver Williamson goes one step further and identifies the most crucial such cost as that of ensuring that one’s counterparty doesn’t lie, cheat, steal or hold you hostage to exploit your reliance.  CR might take note that the Williamson interpretation of the authoritarianism of the firm is essentially the same as Marx’s, except that Williamson thinks the boss is the repository of virtue.)

What makes CR’s reading of Coase so strange is that, in a Coasian world, “deals”, understood as singular, complex transactions that absorb immense effort in negotiation and enforcement, should be rare.  Only a failure of competition, due for instance to barriers thrown up by a regime of intellectual property rights, would put firms in a situation in which they had to submit to deal-making rather than internal production.  Businesses, if they followed Coase’s formula, would shun deals to the maximum possible extent.

The core problem with CR is that he doesn’t see that, for Coase, a “deal” is a very different creature from a routine market transaction, and this difference is what the whole theory is about.

Incidentally, there are many problems with Coase’s formulation.  Here are the two I believe to be the most important: (1) Coase assumes a unitary entrepreneur who owns the firm, profits from its success, and is the fountainhead for the entire order-issuing apparatus.  This is the case for many small and medium-sized enterprises but fundamentally false for most of the corporate world.  To some extent, the transaction cost theory can be tweaked to adapt to the corporate economy, but in the process it loses much of its explanatory power.  (2) Coase focuses on what I regard as a secondary aspect of the existence (why do firms exist?) and boundary (make or buy) problems.  Transaction cost factors are real but pale in importance beside the role played by the presence or absence of interaction effects between activities.  Firms exist in the first place because they bundle activities that would have little value (and would therefore not be undertaken) separately.  Or, if you prefer formalism, they exist to internalize nonconvexities.  This is equally an explanation for make-or-buy choices.

Coase’s analysis was compelling for economists because it reconciled nonmarket organization (the internal coordination of firms) with the assumption of the efficiency properties of a competitive market.  The much stronger argument based on nonconvexities is a harder sell because it also calls into question the premise of market efficiency.