Colloque de l’ACGEPE, Nice, juin 2012
A Key to Coase’s Thought: The Notion of Cost
Elodie Bertrand1
The use of Ronald Coase’s early reflections on cost during the 1930s as a key to read some of his main
works brings to light one neglected aspect of the nature and origin of his novel approach. I shall show
what his theoretical insights owe to his taking into account the subjectivity of decision-making and to
his definition of the cost associated to choice as an opportunity cost. First, I shall bring to light two
dimensions of the notion of cost that Coase developed in 1938: a cost is an opportunity cost and it is
subjective. Then I shall show that both these dimensions pervade his main theoretical insights, and do
so in two directions. On the one hand, his insistence on the subjective aspects of the choice of the
businessman fuels his works on the theory of the firm, especially on the monopolist’s choice (1937a)
and the choice between make and buy (1937b). On the other hand, the importance of reasoning in
terms of opportunity cost shapes his criticisms of standard economic policies, such as marginal cost
pricing for natural monopolies (1946b) or policies aimed at equalizing private cost and social cost
(1960). Coase progressively abandoned the subjective dimension of his analysis, an evolution for which
I provide some elements of explanation.
Keywords: Ronald H. Coase, opportunity cost, subjectivity, firm, social cost, marginal cost pricing,
accounting
1. Introduction
During the 1930s, as described by Buchanan (1969) in his reconstruction of the notion of subjective
opportunity cost, Ronald H. Coase participated to the development of a subjectivist tradition in
economics, specific to the London School of Economics and integrating Hayek’s subjectivism to Arnold
Plant’s concern for practical applications. In particular, Coase wrote a series of articles titled “Business
Organization and the Accountant” (Coase 1938) in which he explained to accountants recent
developments of economic theory on the notion of opportunity cost, insisting on the subjective
dimension of this cost. Some authors had the intuition that this article on cost had influenced others
of his works, or at least brought up some themes that he raised elsewhere. Buchanan, without
developing his idea, asserted that Coase’s developments on cost (Coase 1938) influenced his works
on the marginal cost controversy (Coase 1946b) (Buchanan 1969, ch 2, fn 362) and social cost (Coase
1960) (Buchanan 1973, 1.18). However, criticizing Coase’s “presumably objectively-measurable”
approach in this last article, Buchanan (1984, 11) will later turn Coase (1938) against Coase (1960).
Medema (1994) established a link between Coase’s reflections on cost (still Coase 1938) with, on the
one hand, his work on monopoly price (Coase 1937a) and, on the other, the theory of the firm (Coase
1990). Finally, Arena (1999) showed that the subjective dimension of entrepreneurial decisions can be
found in Coase’s works of the 1930s on duopoly (Coase 1935), monopoly pricing (Coase 1937a),
expectations (Coase and Fowler 1935; 1937; 1940) and accounting (Coase 1938).
I wish here to deepen and enlarge these intuitions. First, I shall bring to light two dimensions
of the notion of cost that Coase develops in the 1938 text: a cost is an opportunity cost and it is
1
CNRS (PHARE – University Paris Pantheon-Sorbonne). E-mail: [email protected]. I thank Steven Medema for
his precious comments and suggestions on earlier versions of this paper, presented at the 2010 HES Conference, 2011 ESHET
Conference, and the ERMES-PHARE seminar (March 2011); this paper also benefited from remarks made by the participants
to these seminars. Errors and omissions remain mine.
2
Our references to Buchanan (1969; 1973) and Coase (1938 [1973]) are to the electronic version available at
http://www.econlib.org/library/classics.html and therefore contain no indication of pages, but refer to chapters and
paragraphs.
A Key to Coase’s Thought: The Notion of Cost 2
Elodie Bertrand
subjective. Then I shall show that both these dimensions pervade his main theoretical insights, and do
so in two directions. On the one hand, his insistence on the subjective aspects of the choice of the
businessman fuels his works on the theory of the firm: this will be seen in his analyses of the
monopolist’s choice (1937a) and of the choice between make and buy (1937b). On the other hand,
the importance of reasoning in terms of opportunity cost shapes his criticisms of standard economic
policies, such as marginal cost pricing for natural monopolies (1946b) or policies aimed at equalizing
private cost and social cost (1960). This time, what is examined is public decision, and the subjective
dimension of the decision is lost. Therefore Buchanan’s claims are made consistent: the subjective
dimension of Coase’s 1938 article disappears in the “Problem of Social cost”, but not its other
dimension, that of opportunity cost.
This new reading of Coase’s main theoretical works through his reflection on the notion of
cost will not only allow me to characterize the origin and novelty of Coase’s approach, but also raises
other issues. First, although it is usually accepted that the “revolutionary” feature of Coase’s
approach comes from the fact that he was not trained as an economist (Medema 1994, 3)3, my
interpretation complementarily argues that Coase owed a part of his originality to a concept of cost
that is derived from highly theoretical debates among economists. Second, while Buchanan (1969,
2.25) and Medema (1994, 58) have regretted that Coase’s 1938 article had no influence on
economists, my conclusion leads to reconsider this influence : it had existed if we consider its two
different aspects, the subjectivity of entrepreneurs’ decision through “The Nature of the Firm” and
the opportunity cost reasoning through “The Problem of Social Cost”. Finally, if Coase’s articles of the
1930s examined here stress the subjectivity of producers’ decisions, this subjectivity is forgotten in his
criticism of standard policies written later: these criticisms, and the method he suggests for the
design of policy, are based on the idea that costs are objective and measurable; which poses the
question of Coase’s abandonment of subjectivity.
Section 2 details the formation of Coase’s view on cost during the 1930s, and brings to light two
dimensions in this view: a cost is an opportunity cost and it is subjective. Section 3 and 4 show how
the latter dimension is to be found in Coase’s analysis of the choice of the businessman and the
former in his analysis of the choice of policy. Section 5 concludes and suggests some elements to
explain why Coase progressively abandoned the subjective dimension of his analysis.
2. Linking cost with choice: from economics to accounting
Three notions of cost will be here distinguished (cf. Buchanan 1969):
The classical notion of real cost, independent from utilities, adopted by Marshall (1890), who
follows Smith and Ricardo.4
The objective opportunity cost (OOC below) notion developed by the Austrian marginalists
(Wieser 1884 ; 1889, but also Menger and Böhm-Bawerk), who define the cost of a product as
the objective market value of the alternative product that could be produced with the same
resources in alternative uses. This opportunity cost is therefore equal to a market price
determined by marginal utilities; it eventually depends on subjective evaluations: this is the
subjective theory of value, also developed by Jevons and Walras. But the opportunity cost,
3
Which is confirmed by Coase (1990, 3) himself: “I did not take any course in economics while I was a student at the London
School of Economics, a circumstance which I believe gave me a freedom in thinking about economic problems which I might
not otherwise have had.”
4
But see Buchanan (1969, 1.29-39).
A Key to Coase’s Thought: The Notion of Cost 3
Elodie Bertrand
defined as a price, is objective in the sense that it is measurable by an external observer. At
equilibrium, this OOC is equal to money outlays since the price of the alternative product is
reflected in the price of the resources (Buchanan 1969, 3.10). In his criticism of Marshall,
Wicksteed (1910; 1914), also influenced by Jevons, asserted the superiority of the Austrian
conception of cost and diffused their theory in the English language, alongside with
Davenport (1908; 1913) and his student Knight (1921; 1924; 1928). The conception of cost as
OOC became dominant, named by Buchanan (1969) as orthodox, or neoclassical.
The subjective opportunity cost (SOC below) defined by Buchanan (1969), who criticizes the
notion of OOC as not implying an actual choice: if the individual just minimizes her cost, she is
an “automaton” (ibid., 3.11). On the contrary, if choice is introduced, argues Buchanan: “Cost
becomes the negative side of any decision, the obstacle that must be got over before one
alternative is selected. Cost is that which the decision-taker sacrifices or gives up when he
makes a choice. It consists in his own evaluation of the enjoyment or utility that he
anticipates having to forego as a result of selection among alternative courses of action”
(ibid., 3.12). Six features of the SOC follow: it is exclusively borne by the decision-maker; it is
subjective in the sense that “it exists in the mind of the decision-maker and nowhere else”; it
cannot be measured or observed by someone else than the decision-maker; it is “forwardlooking”, or ex ante; it is never realized since the alternative not taken is not by definition; it
can only be dated at the moment of choice (ibid., 3.13). Buchanan details on several
occasions (ibid., 2.21; 3.28-29; 5.9-10; ch 6) the conditions under which the SOC is equal to
the remuneration of resources: equilibrium, no alternative, no uncertainty, “economic
behavior” (that is, in Buchanan’s thought, absence of non monetary consideration and of
consideration for someone else than self). Buchanan names his concept as “London-Austrian”
since he built it under the influence of, on the one hand, the subjectivist philosophy of Mises
and Hayek and, on the other, the works developed at the London School of Economics during
the 1940s and 50s.
2.1. The LSE tradition on cost
The thought on the notion of cost during the 1920s and 30s was the chance for economists to deepen
the consequences of the marginalist revolution and involved several important debates, among which
those on planning and on the cost function of the entrepreneur (which will lead to the theory of the
firm). The London School of Economics was at the center of these debates. It was founded in 1895 by
personalities closed to the English Historical School and in opposition to the domination of Marshall
and Cambridge, but the arrival of Robbins in 1929 transformed its economics department in highly
deductive and theoretical, thus far from the historicists, albeit still opposed to Marshall.5
Buchanan (1969) argues that LSE developed a specific notion of cost, at the crossroad of different
traditions. The first is made of these authors who progressively introduced the dimension of choice
when speaking of cost, thus introducing a subjective dimension, but not taking into account its full
consequences on the notion of opportunity cost and the differences that it could make with orthodox
OOC: Wicksteed (1910, 380; 1914), who occasionally lectured at LSE in the 1910s, Davenport (1913,
60) and Knight (1921, 63; 1924, 592; 1934; 1935) in the United States and finally, at LSE, Robbins
5
On the history of the LSE, see the symposium published in the Atlantic Journal in 1982, articles and books by former
professors, as Coase (1982), Hayek (1946) and Robbins (1971), or directors, as Beveridge (1960), Caine (1963) and
Dahrendorf (1995).
A Key to Coase’s Thought: The Notion of Cost 4
Elodie Bertrand
(1934, 2), who recognized the influence of Wieser, Wicksteed, Davenport and Knight. The second
tradition is Austrian, Robbins having invited Hayek at LSE in 1931 and having him appointed as
Professor until 1950.6 Hayek (1937), following Mises (1933), gave the LSE tradition the subjectivist
“underlying methodological basis” (Buchanan 1969, 2.16): data are individual perceptions
unknowable by anyone else.
All these ingredients precipitated thanks to Arnold Plant, Professor of Commerce and head of the new
Department of Business Administration at LSE since 1930, who, as a former student of Edwin Cannan
(the first chief teacher of economics at LSE), kept his commonsense approach (Coase 1982, 33).7 Plant
wanted to treat actual problems, specifically those really faced by entrepreneurs. His research group
aimed at applying theoretical research in economics to the management of firms, and was composed,
among others, of Ronald Coase, Ronald Fowler, Ronald Edwards and George Thirlby. Specifically, they
were mainly working on introducing the opportunity cost concept into practical management. Coase
(1938) synthesized their reflection on how this economic concept has to thoroughly modify the
practice of accounting so that it can actually help the entrepreneur’s decision. Buchanan commended
him for his link between cost and choice, but regretted that he did not “fully incorporate the
‘subjectivist economics’ of Hayek and Mises into his analysis, nor did he draw the distinction between
his concept and that embodied in neoclassical orthodoxy” (Buchanan 1969, 2.31). Thirlby (1946a;
1946b) further integrated subjectivist economics and described a SOC: inspired by Wicksteed and
Hayek, he asserted that the opportunity cost exists “in the mind of the decision-maker” and is
“ephemeral” (1946a, 33 and 34).8 This tradition, pursued by Thirlby (1952; 1960) and Wiseman (1953;
1957), helped to recognize that “if cost is introduced in a logic of choice, it is obviously subjective”
(Buchanan 1969, 3.22), and developed a notion close to Buchanan’s SOC. This tradition is the “LSE
tradition” as Buchanan puts it; he and Thirlby edited its main essays in LSE Essays on Cost (Buchanan
and Thirlby 1973). This LSE tradition did not last: “The concept of opportunity cost which emerged
from both the subjectivist-Austrian and the common-sense approaches—the concept that blossomed
for two decades at LSE—seems to have lost in its struggle for a place among the paradigms of modern
economics (Buchanan 1969, 2.43).9
Buchanan provides several reasons that could explain why this LSE tradition did not fully draw the
implications of the subjectivist perspective in terms of cost, and specifically the differences that it
made with OOC. First, as long as economists focused on individual decisions and interactions on the
market, the distinction between subjective and objective opportunity cost was not so important
(ibid., 2.19). Second, usual theoretical assumptions are the conditions under which SOC is equal to
OOC, and to money outlays (choice in equilibrium, between monetary alternatives, no uncertainty,
etc.) (ibid., 2.21). Third, the debate on socialism (to which Hayek, Mises and Robbins participated)
focused attention on the impossibility of socialism due to problems of information rather than on the
fundamental criticism based on subjectivism (ibid., 2.22 and 6.26). Finally, Buchanan (1973, 1.16-17)
6
Coats (1982, 25) writes: “During the 1920’s, Robbins arrived at Austrian economics via Gustav Cassel, Irving Fisher, and
Frank A. Fetter, and, as in Plant's case, [via] meetings with Ludwig von Mises in Vienna… On Robbins's invitation, Hayek gave
a series of lectures at LSE early in 1931, and accepted a permanent chair later the same year. From that time, Robbins's
seminar became… the Vienna seminar of Menger and Mises… So swift was the translation of the LSE ethos in economics that
Plant was not surprised, on visiting Kiel in 1933, to find LSE described as… ‘a suburb of Vienna’.”
7
On Plant, see Coase (1986; 1987). Robbins was also a student of Cannan, but of course became more of a theorist.
8
Mises (1949) developed a conception of SOC close to this one (see Buchanan 1969, 2.40-41).
9
Coase (1990, 8) seems to accept the genealogy that Buchanan (1969) suggests: “The opportunity cost concept developed
at LSE was of course derived from Knight and Wicksteed as expounded by Lionel Robbins and was also no doubt influenced
by Hayek who would have added an Austrian flavour.”
A Key to Coase’s Thought: The Notion of Cost 5
Elodie Bertrand
explains the failure of the LSE tradition to build a subjectivist school by the fact, on the one hand, that
Mises and Hayek were too isolated at LSE and, on the other, that Plant’s group was too focused on
specific applications, while the economics department of LSE was increasingly devoted to high theory.
2.2. The exportation of the notion of cost to accounting (Coase 1938)
Coase enrolled in a commerce degree at the London School of Economics in 1929.10 There, he was
very much influenced by his professor Plant, who initiated him to economic reasoning and the
benefits of a competitive system. Even when Coase was a teacher at the Dundee School of Economics
(1932-34) and at the University of Liverpool (1934-35), his “association with LSE never ceased” (Coase
1982, 31) and he came back to teach at LSE from 1935 until 1951 (when he left for the United States).
Though he was not directly working with economists, he was under Robbins’ influence, thanks to
whom he had read in 1933 Wicksteed (1910) and Knight (1921), two books whose close study gave
him and his colleagues “such a firm hold on cost theory” (Coase 1982, 33).
Coase was working within Plant’s research group on industrial organization. They were interested in
the new developments of economic theory at LSE, but even more so in the use of these analyses to
understand the operation of the real economic system (ibid., 33)11, specifically in the application of
the economic notion of cost to business problems, and its implications for accounting. Coase wrote a
series of twelve short articles published in The Accountant in 1938, and titled “Business Organization
and the Accountant”, which were the results of this collective work (with Edwards and Fowler in
particular)12; a reprint was published in Buchanan and Thirlby’s collection in 1973, with minor
modifications. Coase thought of these essays as just “an exposition of views which were generally
accepted by economists” (Coase 1938 [1973], 5.2), or at least “views which were the common
property of the economists at LSE or, at any rate, of those with whom [he] was associated”, such as
Edwards, C. L. Paine and David Solomons (Coase 1990, 7).13
This 1938 work aims at modifying accounting so that it can help business decisions. Entrepreneurs,
Coase argues, have to know how costs and revenues will vary if a specific decision is taken (for
example a variation of output), therefore “business decisions depend on estimates of the future”
while cost accounts report past operations (Coase 1938 [1973], 5.4). Coase defines production cost as
10
For a biography of Coase, see Coase (1995) and Medema (1994).
Coase (1970, 114-5) describes the coexistence of two distinct groups at LSE (those of Robbins and Plant): “Lerner was a
member of that group which consisted of Robbins, Hayek, Hicks, Allen, Kaldor and others, who, at the London School of
Economics, were making great strides at that time in the development of economic theory. I was, however, associated with
another group of economists who, on the commerce side, were working under the leadership of Professor Arnold Plant. The
Plant group was keenly interested in cost analysis and pricing problems,.. and so on, and therefore we paid great attention
to Lerner's work [on marginal cost pricing] and to the other theoretical work being done on cost and pricing. But we thought
of it in practical terms. We were influenced but not converted by work such as Lerner's. In our discussions we stressed the
practical aspects of these theoretical developments. We treated them seriously, but we treated them as ideas to be applied
in the real world.”
12
On the collective work of Coase, Edwards and Fowler on accounting, see Coase (1990). They wrote two books together
(1938; 1939) that used published accounts as a source of statistical information on firm behavior “to show economists that
the accounts provided valuable source material for economic research” (Coase 1990, 5). This is the first aspect of their work,
the second (to which pertains the 1938 series of article) being “to persuade accountants to change their practices so as to
make the accounts more valuable for this purpose” (ibid., 5).
13
And Coase argues that this is these series of articles being a result of a collective work that gives them some importance:
“Perhaps because the outbreak of the war diverted economists from their academic studies, these articles came to
represent the only extended statement in print of the approach to costs, particularly as applied to business problems, which
was the common property of economists at L.S.E. in the 1930s. If Professor Buchanan's thesis about the special character of
the L.S.E. approach to costs is correct, it is the fact that these articles do not represent a personal view which gives them
their historical significance” (Coase 1938 [1973], 5.2).
11
A Key to Coase’s Thought: The Notion of Cost 6
Elodie Bertrand
an avoidable cost: “The businessman might produce nothing. If he produces some output certain
additional costs will be incurred. These we may term the avoidable costs of that output because they
can be avoided by not producing it” (ibid., 5.6). It can be noted that this avoidable cost is an
opportunity cost if the only alternative is to do nothing at all.
The assessment of costs and revenues encounters three “analytical difficulties” (ibid., 5.10). First, the
non-pecuniary elements of the decision (such as the ethical preferences of the businessman) are not
reflected in accounts, whereas “without a knowledge of the preferences of the businessman no
decisions on questions of business policy can be reached” (ibid., 5.11). Second, uncertainty is
unavoidable, some events may not be assigned a probability (ibid., 5.12-13); and businessmen differ
in their risk-aversion, which is “purely subjective” (ibid., 5.15). Third, revenues and costs will be paid
in the future, and therefore have to be actualized, subjectivity coming from the preceding elements:
uncertainty and attitude to risk-taking (ibid., 5.14-15). Consequently, the decision is unpredictable by
an external observer, who, in other words, cannot measure the cost: “Since no method of accounting
can reproduce on paper the mental processes of a businessman, the decision to be taken is one which
no mechanical process of discounting can disclose” (ibid., 5.15). The subjectivity of cost here depends
on uncertainty and non monetary elements of the producer’s choice, which a thought ‘in practical
terms’ cannot neglect. 14
Coase then details the very nature of cost as lost opportunity: “The notion of costs which will be used
is that of 'opportunity' or 'alternative' cost. The cost of doing anything consists of the receipts which
could have been obtained if that particular decision had not been taken… This particular concept of
costs would seem to be the only one which is of use in the solution of business problems, since it
concentrates attention on the alternative courses of action which are open to the businessman”
(ibid., 5.16). Cost is here linked to the process of choice and differences with the accountant’s vision
of cost as expenditures (ibid., 5.17) are stressed through the consequences of this definition.
This notion of cost first encompasses non-monetary elements (ibid., 5.16).
Second, it implies, by definition, that the entrepreneur maximizes his profit: “Costs will only
be covered if [the businessman] chooses, out of the various courses of action which seem
open to him, that one which maximizes his profits. To cover costs and to maximize profits are
essentially two ways of expressing the same phenomenon” (ibid., 5.16). Buchanan (1969,
2.27) makes this statement Coase’s “most significant” contribution to the history of the
construction of the subjectivist notion of cost: “Any profit opportunity that is within the realm
of possibility but which is rejected becomes a cost of undertaking the preferred course of
action”. Given its context, Coase’s assertion can only refer to a subjective profit in the sense
that the businessman chooses his subjectively preferred option among the several
alternatives that he considers.
Third, the opportunity cost concept is “forward-looking”: “It is useless to look back at the
past, except as an object lesson” (Coase 1938 [1973], 5.17). Coase here means that the cost
influencing the decision is the ex ante opportunity cost estimated before the decision is
taken, not after: “Of course one can say that one might have made a wiser decision and that
in this sense costs were not covered. But to employ the term in this way does not seem to be
14
When Coase writes on accountants’ costs and the actual decision process of businessmen, he has no doubt in the back of
his mind the results of his observations made during his trip in the United States in 1931-32, during which he was
investigating integration and costs functions (see Coase 1988b).
A Key to Coase’s Thought: The Notion of Cost 7
Elodie Bertrand
very helpful, for as Jevons reminded us, 'Bygones are forever bygones'. The only course which
is open to a businessman is to make the best choice given the knowledge at his disposal, and
in this task I hope to show that the concept of opportunity cost can be of considerable
assistance” (ibid., 5.17).
Finally, Coase insists that costs are calculated in reference to a specific decision and cannot,
therefore, be classified, as fixed and variable for example: “One can discuss the meaning of
the term 'avoidable costs' but what costs are avoidable and their actual measurement can
only be determined with reference to a particular decision… This linking of cost analysis to
particular decisions makes any mechanical classification of costs almost impossible. The costs
whose variations are of significance for one decision will be of no significance for others”
(ibid., 5.54-55, his emphasis).15
The notion described by Coase is not exactly that of SOC developed by Buchanan, but we can draw
from it two dimensions: the opportunity cost dimension, and the subjective dimension, both coming
from a concern for realism in the analysis of producers’ decisions. 16 The subjective dimension can be
found in other theoretical works on the producer’s decisions written by Coase in the 1930’s, and
particularly on the decisions regarding vertical integration and the price of a monopolist.
3. The choices of the businessman: applications of the thought on cost to the theory of the
firm
Make or buy: the decision of vertical integration (Coase 1937b)
In two occurrences, Coase himself related his 1938 reflections on accounting to his approach of
vertical integration, but both links he put forward are not based on the subjective dimension I wish to
bring to light.
The first link is to be found in “Business organization and the accountant” (Coase 1938), about which
Coase will later assert that “understanding cost accounting and opportunity costs within a firm was
tied to understanding the organization of firms” (Coase 1990, 3). The first draft of this article precisely
dealt with the choice between make or buy, but “Edwards complained bitterly that the accountants
for whose benefit the articles were supposedly written would not understand what [he] was talking
about, as the concepts and terminology [he] used would be completely foreign to them.” Coase
“therefore decided to write an introductory section in which [he] explained the character of [his]
approach. However, the introductory section came to occupy the whole of the twelve articles, and
business problems were not discussed except as illustrations of the value of [his] approach” (Coase
1990, 7). In this illustration with the vertical integration decision, Coase examines how an electricitysupply business owning a coal mine chooses the amount to produce itself, by comparing the (total
and marginal) avoidable cost of producing to the cost of buying. He admittedly envisages these costs
15
The remaining of Coase’s article consists in applying this cost concept to the businessman’s decision of accepting a specific
task, thus calculating the opportunity costs of materials, assets and capital: “The 'opportunity' cost of using materials in
stock we found to be either the price if sold minus the cost of selling, or the expense that would be avoided if the material
were used on some other job. Depreciation considered as an 'opportunity' cost could be taken to be depreciation through
use or the present value of the future profits lost through use. Interest on capital, if it is to be interpreted as 'opportunity'
cost, must be regarded as the alternative net receipts that could be obtained by the use of the machinery” (Coase 1938
[1973], 5.39).
16
For general studies on his views of the nature of economics, see Medema (1994, ch 6); Medema and Zerbe (1998); Mäki
(1998b) and Wang (2003). Some specific issues have been raised: his realism (Mäki 1998a; 1998c; Pratten 2004; Bertrand
2012), his views on the roles of market and regulation (Medema and Samuels 1997; 1998; Pratten 2001; Campbell and Klaes
2005), or the tension between orthodoxy and heterodoxy (Foss 1994).
A Key to Coase’s Thought: The Notion of Cost 8
Elodie Bertrand
as “avoidable costs”, but they are measurable by an external observer (Coase 1938 [1973], 5.56-60).
The richness of the analysis regarding the link between cost and choice disappears, likely because it
does not add anything essential to the understanding of the choice between make or buy.
Coase linked a second time accounting and vertical integration, in “Accounting and the Theory of the
Firm” (Coase 1990), a lecture addressed to accountants on the occasion of the fiftieth anniversary of
the publication of “The nature of the firm”. In this lecture, Coase stresses that “the theory of the
accounting system is part of the theory of the firm” (ibid., 12) in the following sense. When most of
the production is operated within firms, most of the transactions arise inside firms and not on the
market, therefore the institutional structure of production depends more on “the relative costs of
different firms in organizing particular activities” than on transaction costs (ibid., 11). Now, these are
the accounting systems of the different firms that (mis)calculate these (opportunity) costs of the
factors and therefore determine the efficiency of the firms: “The costs of organizing clearly depend on
the efficiency of the accounting system” (ibid., 11). Ultimately, the activities of the firms, and
therefore the institutional structure of production, partly depend on accounting. Here again, the
subjective dimension of cost emphasized by Coase in his 1938 article does not permeate his approach
of vertical integration; this permeation appears in “The nature of the firm.”
Coase’s thought on vertical integration was nurtured by his investigation led in the United States
during the year 1931-32. He found the explanation of integration by transaction costs in the summer
of 1932 and wrote a draft of the article on the firm in 1934. Right from the start, Coase formulated
the question of the existence of the firm in terms of a choice of the producer, as in this letter to
Fowler written in May 1932: “Assume a producer of some finished product finds he needs a special
part. Then, he has two alternatives. One, to produce it himself and two, to let a supplier produce it”
(quoted in Coase 1988b, 15). This idea of choice appears also in the final article: “We have to explain
the basis on which, in practice, this choice between alternatives is effected” (Coase 1937b, 389). And
this way of thinking is confirmed in the 1988 lectures: “I thought about the firm in terms of a choice of
contractual arrangements” (Coase 1988b, 29).
However, Coase (1937b) does not insist on the sacrifice dimension of the choice as a renunciation to
other alternatives; he insists on the contrary on the cost, somewhat real, of each institutional
arrangement (firm or market). In other words, it does not seem that because there is choice, there is
cost, but on the opposite that because there is cost then there is choice. Resorting to the firm is thus
explained by the greater cost of its alternative: “The main reason why it is profitable to establish a
firm would seem to be that there is a cost of using the price mechanism” (ibid., 390). But if the market
alone were costly, there would be no choice; this implies that the firm is also costly: there are
“diminishing returns to management” (ibid., 395).
Coase’s introduction of the notion of cost allows him to use standard economic tools, namely
Marshallian tools of substitution at the margin (ibid., 386-7), in order to induce “formal relations
which are capable of being conceived exactly” (Robbins 1932, 66 quoted by Coase 1937b, 387,
Robbin’s emphasis). As with factors of production, at the equilibrium, marginal costs of the market
and of the firm are equal, which determine the size of firms (Coase 1937b, 404). And this equilibrium
is optimal: “Firms arise voluntarily because they represent a more efficient method of organising
production. In a competitive system, there is an ‘optimum’ amount of planning!” (ibid., 389, fn 3).17
17
See also Coase (1992, 715-6). Another formulation is this one: “This results in the institutional structure of production
being that which minimizes total costs for the output produced” (Coase 1988b, 39). The idea of substitution implies that, for
A Key to Coase’s Thought: The Notion of Cost 9
Elodie Bertrand
Thanks to the notion of cost, “the whole of the ‘structure of competitive industry’ becomes tractable
by the ordinary technique of economic analysis” (ibid., 398). It is in this sense that Coase was already
writing to Fowler in October 1932 that he had “certainly succeeded in linking up organization with
cost” (quoted in Coase 1988b, 4).18 This straightforward formulation, used four times in his lectures
on “The Nature of the Firm” (also pp. 17, 24 and 26), translates Coase’s concern of thinking about a
new subject – organization – in a way that could nevertheless involve traditional economic analysis.
Coase’s study of the choice between make and buy therefore refers to a notion of cost traditionally
used by economists. The “scientific meaning” of the firm’s size (1937b, 393), or the efficiency of the
entrepreneur’s decision, bring to light the “orthodox” dimension of Coasean analysis. However, as
noted by Foss (1994), to this “orthodox” dimension of “The Nature of the Firm” is added a more
“heterodox” dimension in which uncertainty plays a major role. Now, this “heterodox” dimension of
Coase’s work falls within the subjectivist tradition and it appears in Coase’s discussion on the origin of
transaction and organization costs. First, transaction costs result, at least partly, from uncertainty
(Foss 1994, 47), which is a major source of the subjectivity of decisions. Coase (1937b, 391) writes, for
example, that uncertainty makes impossible to completely specify a contract: “Owing to the difficulty
of forecasting, the longer the period of the contract is for the supply of the commodity or service, the
less possible, and indeed, the less desirable it is for the person purchasing to specify what the other
contracting party is expected to do.” He infers that: “It seems improbable that a firm would emerge
without the existence of uncertainty” (ibid., 392). Second, organization costs are also linked to the
subjective dimension, on the one hand, of the entrepreneur’s decisions, partly due to his cognitive
limits19, and, on the other hand, of the preferences of workers in favor of small firms: “It is sometimes
said that the supply price of organising ability increases as the size of the firm increases because men
prefer to be the heads of small independent businesses rather than the heads of departments in a
large business” (ibid., 395, fn 1).20
It seems, consequently, that if transaction and organization costs are considered as traditional costs
by Coase, their origin nevertheless lies in the subjectivity of the decisions of entrepreneurs and
workers in an uncertain context. The explanation of the existence of firms and of their limits
therefore depends on the subjective dimension, even if this dimension is somewhat forgotten by
Coase in his analysis of the decision between firm and market: the trade-off between costs of
organization and costs of transaction is for its part assumed to be objective, efficient, predictable and
subject to formalization. This is a new way of bringing to light the internal tension of this article,
between “orthodoxy” and “heterodoxy” in Foss’s language (1994), or between neoclassical and
institutionalist elements in Medema (1996).
Coase, the market and the firm play the same role of allocation of resources and that they are perfectly substitutable (cf.
Coase 1937b, 392).
18
“In saying that my concept of the firm was manageable, what I had in mind was that, looking at the firm in this way, we
could analyze its activities using standard economic theory. This is what I meant when I said in the letter to Fowler in which I
described my Dundee lecture that I had succeeded in linking up organization with cost” (Coase 1988b, 24).
19
Coase (1937b, 394-5) writes: “As the transactions which are organised increase, the entrepreneur… fails to make the best
use of the factors of production.”
20
Coase (1988b, 32) later confirmed this argument: “This ‘rising supply price’ has nothing to do with the rising supply price
of factors to an industry as normally thought of in economic theory, but relates to the fact that people working in a large
firm may find the conditions of work less attractive than in a small firm and therefore will require a higher remuneration to
compensate them for this.”
A Key to Coase’s Thought: The Notion of Cost 10
Elodie Bertrand
The monopolist’s choice: The subjectivity of entrepreneurial decision (Coase 1937a)
The subjectivity of entrepreneurial decision and the uncertainty of its context are more obvious in
other works written by Coase in the 1930s, as stressed by Arena (1999). First, in his article on
duopoly, Coase (1935) explains that a duopolist, realizing that his competitor reacts to a modification
of his price, has then to anticipate her reactions, but the decisions “would be unpredictable – except,
perhaps, by a psychologist!” (ibid., 139, fn 2), which in itself adds to the already unpredictable
uncertainty. Second, the series of papers on the cycle of the pork price, written with Fowler (Coase
and Fowler 1935; 1937; 1940) progressively introduces subjective elements to explain the
expectations of pork producers.21 Finally, it is in “Some Notes on Monopoly Price” that Coase (1937a)
clarifies the subjective elements of the producer’s decision process. In this article, he criticizes
Robinson’s (1933) theory that a monopoly, in order to maximize its profit, chooses the price and
output combination that equalizes its marginal cost and marginal revenue. It is worth noting that this
is Coase’s concern for realism that leads him to question this still-accepted part of industrial
economics: “This paper aims at making monopoly analysis more useful by introducing certain of the
more important modifications which have to be made if Mrs. Robinson's theory is to be of use in
increasing our understanding of the working of the actual economic system” (Coase 1937a, 17).
Coase’s argument, which intends to take into account realistic elements of the monopolist’s decision,
stands at different levels.
First, the monopolist does not know that equating marginal cost and marginal revenue maximizes its
profit. An evidence is that his accounting books are “often prepared in a form which makes it very
difficult to discover marginal costs22; a surprising fact if business men thought that marginal costs
were such an important element in the determination of prices” (ibid., 18). The monopolist cannot
either find the point of maximum profit by tâtonnement, due to complexity and uncertainty: he
cannot determine if the variations of profit he goes trough are due to variations of price, of output, or
of anything else (ibid., 18). He hence contents himself with a satisfying solution: “So long, therefore,
as the fact that there is a divergence between the price he is charging and the monopoly ‘marginal
cost equals marginal revenue’ price does not become too obvious, the actual price that is being
charged is likely to be accepted as right or reasonable” (ibid., 19).
Second, were monopolists willing to equate marginal cost and marginal revenue, they would not have
“the knowledge necessary to enable them” to apply this rule (ibid., 19). On the one hand, necessary
information on costs will not be practically available since “there will be considerable difficulties in
calculating the cost curve for each product” (ibid., 19). Here again, “it is in any case doubtful whether
the cost accounts are prepared in a form which will enable the marginal cost curve to be obtained”
(ibid., 19). On the other hand, demand curves are even more difficult to know in an uncertain
environment, which brings in the picture the producer’s risk-attitude (ibid., 22).
21
Their first article insists on the uncertainty of demand (Coase and Fowler 1935, 160-2) whereas the second, demonstrating
that a determinate relationship between expectations and past and present prices and costs cannot be established,
introduces learning, which depends on psychological factors (Coase and Fowler 1937, 79). The third article explicitly
eliminates from calculus a specific subjective cost as too difficult to measure: “the psychological cost of change to the
producer” (Coase and Fowler 1940, 281), and argues that expected prices depend on the expected costs of production
factors and an expected normal margin profit, which itself depends, among other factors, on the producer’s attitude to risk
(ibid., 283-7).
22
This argument can also be found in Coase’s criticism of actual cost accounting: “The figures provided relate to average
rather than marginal cost” (Coase 1938 [1973], 5.56, his emphasis).
A Key to Coase’s Thought: The Notion of Cost 11
Elodie Bertrand
Third, Coase goes back to one of Hicks’ (1935)23 argument that brings to the fore two non-monetary
costs faced by the monopolist. The first is the subjective cost of increasing the output (of working
more): the monopolist “will be prepared to sacrifice some income if he can produce less or,
alternatively,… if he is to produce more and have an equal psychic income his money income must
increase” (Coase 1937a, 29). The second non monetary cost is a subjective cost of decision (of
searching the price/output that maximizes profit)24, which implies that “the best of all monopoly
profits is a quiet life” (Hicks 1935, 8 quoted by Coase 1937a, 30).
Consequently, at these different levels, Coase underlines the subjectivity of costs and of producers’
decisions. This subjectivity raises two issues.
On the one hand, Coase’s argument that the monopolist’s profit is not maximized could seem
inconsistent with his 1938 argument that a good understanding of decision implies that (subjective)
profit is maximized. One has therefore to recognize that this is the monetary, objective profit, as
defined by Robinson, which is not maximized by the monopolist.25 The latter does not know that
equating his marginal OOC to his marginal revenue will maximize his objective profit, he does not
even know how to calculate his marginal OOC. He is rather making his decision in a radical
uncertainty, the process of decision is costly and his decisions imply non monetary costs; in this sense,
he is considering his SOC and, by definition of choice, his subjective profit is maximized.
If this interpretation is right, it implies, on the other hand, that Coase argues that the marginal OOC is
not measurable by the producer. However, OOC is conceptually observable and measurable. We have
to insist, hence, that Coase here stresses a practical problem faced by the producer, a modification
that, as he will detail later, “must be made to the assumptions of simple monopoly theory if it is to be
used to explain monopoly pricing in practice” (1946a, 278, fn 3, my emphasis). It is a practical
problem that he sometimes neglect to study other aspects of imperfect competition theory: in his
articles on duopoly (Coase 1935), multi-products monopoly (Coase 1946a) or monopoly of a durable
good (Coase 1972a), he uses the rule of the equalization of marginal cost to marginal revenue, thus
developing more internal criticisms of imperfect competition theory.
This practical difficulty of measuring marginal OOC should logically imply that a government cannot
measure a marginal cost of a business and much less a social cost. Even more, that the producer takes
into account non monetary elements in his decision in uncertainty makes it impossible for a
government to perfectly determine the decisions of this producer by policies based on objective
costs, be they individual or social. A subjective conception of cost entails not only the impossibility of
applying policy rules that assume the existence and measure of objective costs, but also their
inefficiency, as emphasized by Hayek, Mises or, in Coase’s closer circle, Thirlby; and we could have
expected, from Coase’s part, a criticism of policies along these lines. His criticism, however, is based
on another dimension of his thought on cost elaborated in the 1938 article, the opportunity cost
dimension, and leaves aside the criticism based on the subjectivity of costs.
23
John Hicks was lecturer at LSE between 1928 and 1935. It is because Coase was given Hicks’ course on monopoly in 1935
that he became interested in this subject (Coase 1988b, 23).
24
Coase (1937a, 30) paraphrases Hicks’ (1935, 8) second argument that “the variation in monopoly profit for some way on
either side of the highest profit output may often be small…; and if this is so, the subjective costs involved in securing a close
adaptation to the most profitable output may well outweigh the meagre [sic] gains offered.”
25
This resolves the similar inconsistency that appears inside the 1938 article, in which Coase asserts: “We may… lay down as
a general rule that it will pay to expand production so long as marginal revenue is expected to be greater than marginal cost
and the avoidable costs of the total output less than the total receipts. It would be Utopian to imagine that a businessman,
except by luck, could manage to attain this position of maximum profit” (Coase 1938 [1973], 5.8-9).
A Key to Coase’s Thought: The Notion of Cost 12
Elodie Bertrand
4. The choices of the policy-maker: applications of the thought on cost to the criticisms of
standard policies
This section will focus on Coase’s criticism of two standard policies: the marginal cost pricing of
natural monopolies and the Pigovian policy that makes the polluter bear the social cost of an
externality.
Marginal cost pricing for natural monopolies (Coase 1946b)
One of Coase’s first criticisms of neoclassical remedies to “market failures” concerned natural
monopoly: in conditions of decreasing average costs, the traditional solution consists in setting a price
equal to marginal cost and compensating the firm’s loss (the difference between marginal and
average cost) by a subsidy financed out of taxation (Hotelling 1938; Lerner 1944 and Meade and
Fleming 1944).
In “The Marginal Cost Controversy”26, Coase (1946b, 172) begins by reminding the reader that the
pricing system has the advantage over the government, as a mode of resources allocation, of
conveying information on preferences that a central planner cannot afford and, more often than not,
at a lower cost.27 He then details the features of an optimal system of prices: “The price should be the
one which equates supply and demand and it should be the same for all consumers and in all uses”
(ibid., 172). In these conditions, the price of the good reflects the value of the best alternative use of
the resources employed to produce it, namely its opportunity cost. The preceding condition indeed
“implies that the amount paid for a product should be equal to the value of the factors used in its
production in another use or to another user. But the value of the factors used in the production of a
product in another use or to another user is the cost of the product. We thus arrive at the familiar but
important conclusion that the amount paid for a product should be equal to its cost” (ibid., 172-3).28
Coase is here restating the usual definition of OOC as the value of the alternative product, value that,
at equilibrium, is reflected in the price of the resources used to produce it, which allows measuring
OOC by money outlays. Coase falls within the “orthodox” tradition of OOC, and even makes explicit
that the cost faced by the producer is a cost for others: cost is not only the value that these resources
could have for the producer in question if they were used in another manner, but also the value that
they would have for another producer or consumer.29 According to Coase, the price system is efficient
26
The arguments of this article are also present in Coase (1945; 1947; 1970). The last of these articles (Coase 1970, 114-5)
precisely begins by mentioning the reflections on cost at LSE in the 1930s with Plant’s group, which confirms that the two
issues are tightly linked together. Coase asserts that their interest for multi-part pricing came from Plant, but that they
missed Hotelling (1938) publication because of the war; this is therefore the publication of Meade and Fleming (1944) that
initiated Coase’s (1945) reflection on this issue.
27
“No Government could distinguish in any detail between the varying tastes of individual consumers…; without a pricing
system, a most useful guide to what consumers' preferences really are would be lacking; furthermore, although a pricing
system puts additional marketing costs on to consumers and firms, these may in fact be less than the organising costs which
would otherwise have to be incurred by the Government” (Coase 1946b, 172).
28
The argument can be found again in 1990 (10), where Coase details the conditions of competition and zero transaction
costs under which it holds: “Leaving aside the effects of monopoly, the prices paid for resources must be equal or (slightly)
greater than they would yield in another use or to another user, cost (the price of the resources) is opportunity cost, and
resources will be employed in such a way as to maximize the value of production… It assumes that the operation of the
market is costless.”
29
This falls within Buchanan’s (1969, 3.19) description of the OOC notion: “In the orthodox price-theory conception where
cost is measured objectively by money outlays, it is helpful, for explanatory purposes, to equate these outlays to the values
that members of society place on the alternate end products that might have been produced by the same outlays differently
directed. In a certain ambiguous sense, therefore, cost here does reflect ‘opportunities lost.’ But it is noteworthy that the
‘opportunities lost’ in this context more accurately reflect the value of potential alternatives as judged by others rather than
by the chooser himself” (my emphasis).
A Key to Coase’s Thought: The Notion of Cost 13
Elodie Bertrand
because, in a competitive system and if transaction costs are nil, the price reflects the OOC of
resources.
These general conditions of optimality are then applied to natural monopoly. It is correct, argues
Coase, that to choose efficiently, the consumer must be confronted to the marginal value of the
resources used to produce the good, but, for the same reason, the consumer must also be confronted
to the total value of resources used: “A consumer does not only have to decide whether to consume
additional units of a product; he has also to decide whether it is worth his while to consume the
product at all rather than spend his money in some other direction” (ibid., 173). Coase hence
advocates, in his example where “all costs are attributable to individual consumers and… all costs are
currently incurred” (ibid., 182), a multi-part pricing based both on marginal cost and total cost, and
therefore which reflects the value of alternative uses of resources at the margin and in total. When
Coase enumerates the drawbacks of the marginal cost pricing for natural monopolies (ibid., 174-9), he
stresses that the government cannot obtain information on consumers’ preferences, that this tariff
would lead to redistribution benefiting consumers of goods produced under conditions of decreasing
average cost, and distortions inherent to a taxation policy.
Besides these criticisms, which he will latter make against “blackboard policies”30, Coase stresses a
theoretical issue: prices must reflect the values of the factors in their best alternative uses. This is
likely for this reason that, in a footnote, Buchanan (1969, ch 2, fn 36) emphasizes that Coase’s article
is “informed throughout by the conception of opportunity cost developed in his earlier papers”,
though “his opportunity-cost defense of multi-part pricing has been largely overlooked”. Buchanan’s
interpretation (like mine) is confirmed by the way Coase came back on this subject in 1970, making
the notion of opportunity cost the main element of his argument.31 Buchanan reminds us, however,
in this same footnote that Thirlby (1947) had criticized the objectivity of cost assumed by Coase’s
analysis, but does not draw any conclusion. It is true that in Coase’s criticism to marginal cost pricing,
subjectivity does not play any role. More precisely, Coase refers to the subjectivity of the consumer,
by stressing that the government cannot know her preferences that are not revealed but by her
choices. But, as far as all the subjectivity of the producer is concerned – this novelty of his thought on
cost which was in his articles on monopoly (Coase 1937a) and accounting (Coase 1938) – the insight
has disappeared. Coase even does as if the marginal OOC (of production) were calculable by
producers and government.
30
Coase (1970, 119) writes for example: “As I see it, the argument for marginal cost pricing, like many propositions in
modern welfare economics, is more concerned with diagrams on a blackboard than with the real effects of such policies on
the working of the economic system. I have referred to this type of economics as ‘blackboard economics’ because, although
factors are moved around and prices are changed, and some people are taxed and others subsidized, the whole process is
one which takes place on the blackboard. This is not the way in which one operates with a social system.”
31
Coase (1970, 123) indeed writes: “Let us examine the fundamental question of the nature of cost. The answer which an
economist gives to this question, the answer which I consider any sensible person must give to this question, is that the cost
of doing anything is what is given to do it.” Coase adds that this opportunity cost is normally reflected by the price of the
factors and therefore that the price system is efficient since it confronts this cost to the consumer’s willingness to pay: “The
cost of a resource represents its value in its best alternative use. The amount which consumers are willing to pay for it in a
particular use represents its value in that use. It is only possible to be sure that resources are used in those ways which
maximize the value of production if consumers are asked to pay an amount at least equal to the cost of the resources which
are used on their behalf. If consumers are willing to pay an amount greater than the cost, then we know that the value of
the product yielded by the resource is greater in this use than it would be in any other use” (ibid., 124).
A Key to Coase’s Thought: The Notion of Cost 14
Elodie Bertrand
The equalization of private cost to social cost (Coase 1960)
Still according to Buchanan, the only influence of the LSE tradition on cost would have gone through
“The problem of social cost” (Coase 1960, PSC below), that is to say the criticism of the Pigovian
analysis of externalities in terms of divergences between private cost and social cost and of the
remedies that follow (make the private cost equal the social cost). Buchanan (1973, 1.18) writes:
“Perhaps the most significant L.S.E. impact on modern economics has come through an indirect
application of opportunity-cost theory rather than through an undermining of basic cost conceptions.
‘Marginal social cost', enthroned by Pigou as a corner-stone of applied welfare economics, was
successfully challenged by R. H. Coase a quarter-century after his initial work on cost. His now-classic
paper on social cost, which reflects essentially the same cost theory held earlier, succeeded where
the more straightforward earlier attacks on the marginal-cost pricing norm – attacks by Coase
himself, by Thirlby [1946a] and by Wiseman [1957] – apparently failed.” However, Buchanan will later
criticize that the examples of the PSC refer to costs and benefits that are objectively measurable and
identical whoever measures them, in other words, independently determined: “These relationships
become identical in the perception of all parties to any potential exchange of rights. Hence, the
unique ‘efficient’ (benefit maximizing or loss minimizing) allocation of resources exists and becomes
determinate conceptually to any external observer… despite [Coase’s] own earlier contribution to
what may be called the subjectivist theory of opportunity cost” (Buchanan 1984, 11, his emphasis). It
is true that Coase’s criticisms of the Pigovian analysis could have been logically deduced from the
subjectivity of costs and decisions that he brought to light in the 1930s, but this kind of criticism does
not appear in the PSC.32 However, Buchanan’s first intuition was valid, even if it has to be detailed:
the subjective dimension admittedly does not exist in the PSC, but the main insights of this paper are
based on a new understanding of the notion of opportunity cost, in the line of Coase’s early
reflections on cost.
Coase’s criticism of the traditional analysis of externalities, and the renewal he suggests in the PSC, is
based on a change of approach that is threefold (Bertrand 2010). Each aspect of this change depends
on a reflection on what kind of cost has to be considered, and the notion of (objective) opportunity
cost is each time essential.
1) Coase first brings to light that nuisances are reciprocal problems, dismissing the responsibility
vocabulary in economics. Taking the example of a plaintiff whose chimneys begun to smoke after his
neighbor rebuilt his house, with higher walls, he asserts: “The smoke nuisance was caused both by
the man who built the wall and by the man who lit the fires. Given the fires, there would have been
no smoke nuisance without the wall; given the wall, there would have been no smoke nuisance
without the fires. Eliminate the wall or the fires and the smoke nuisance would disappear” (Coase
1960, 13, his emphasis). The presence of the “victim”, if a policy protecting her is instituted, harms
the “responsible” of the nuisance, i.e. imposes a cost upon him. Reiterating his prior analysis of the
Sturges v. Bridgman (1879) case that concerned a doctor who could no longer practice because of the
32
The criticism that Coase addresses to the Pigovian tax (imposed on the nuisance-maker and equal to the marginal
damage) is partly based on the difficulties of obtaining the necessary information for its computation, but, on the one hand,
this criticism falls above all within the reciprocity perspective (it can be less costly for the pollutee than for the polluter to
avoid the damage) (Coase 1960, 41), and, on the other hand, by mentioning these information difficulties, Coase is referring
to the usual argument of subjectivity of preferences (and not of subjectivity of the producers’ decisions): setting up such a
tax “would require a detailed knowledge of individual preferences and I am unable to imagine how the data needed for such
a taxation system could be assembled” (ibid., 41).
A Key to Coase’s Thought: The Notion of Cost 15
Elodie Bertrand
noise generated by his neighbor, a confectioner (Coase 1959, 26-7), Coase writes: “To avoid harming
the doctor would inflict harm on the confectioner. The problem posed by this case was essentially
whether it was worth while, as a result of restricting the methods of production which could be used
by the confectioner, to secure more doctoring at the cost of a reduced supply of confectionery
products” (Coase 1960, 2, my emphasis). The sacrifice dimension of the decision to impede the
confectioner from harming the doctor is here clearly indicated, as it is in the famous example of the
rancher whose cattle destroys neighboring crops: “If it is inevitable that some cattle will stray, an
increase in the supply of meat can only be obtained at the expense of a decrease in the supply of
crops. The nature of the choice is clear: meat or crops. What answer should be given is, of course, not
clear unless we know the value of what is obtained as well as the value of what is sacrificed to obtain
it” (ibid., 2, my emphasis). Reciprocity therefore defines an opportunity cost since it implies that the
cost of an alternative be equal to the sacrifice of the alternative that is not chosen.33 However, the
sacrificed alternative is sacrificed by the community; in other words, what is at issue is a social choice
made by a policy maker (or a judge), who compares different solutions, and not an individual choice:
“The real question that has to be decided is: should A be allowed to harm B or should B be allowed to
harm A? The problem is to avoid the more serious harm” (ibid., 2).
2) The second major change of the approach to externalities initiated by Coase was to consider
property rights as any other factors of production (and conversely), including rights (or factors) the
use of which implies external effects. Consequently, the cost of such a right is, such as the cost of a
factor of production, an opportunity cost: “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” (ibid., 44, my emphasis). This opportunity cost, corresponding to the social choice that has to
be decided, is a social cost in the sense that it includes external costs.34 A property right whose use
implies external effects will thus have, such as any other factor of production, and if transaction costs
are nil, a price equal to its objective opportunity cost, this one including potential external effects.
This is what Coase indicates with his examples suggesting the “Coase theorem” 35:
In the case in which the cattle-raiser is liable for the damage caused by his herd on the
neighboring corn culture, his production cost includes the value of the damage. Coase takes
an example where total damage for two steers is $3 whereas the farmer’s net profit is $2, and
suggests that the cattle raiser and the farmer will sign an agreement by which the latter
abandons his culture in exchange for a payment by the former between $2 and 3 (ibid., 4).
The price of the right (which in this example has to be included in the production costs of the
cattle-raiser) thus reflects the external effect, which permits that the value of the production
be maximized: this is the efficiency thesis of the Coase theorem.
The independence thesis of the “theorem”, i.e. the conclusion that the final amount of
externality does not depend on the initial attribution of the right, also rests on the use of the
33
The link between cost and choice is reminiscent of the influence that Knight (1924) had on Coase (1960) (see Coase, 1993,
250 and Kitch 1983, 215). Knight (1924) criticized, among other things, the notion of cost used by Pigou (1932) in his
treatment of external economies and asserted that “the cost of any value is simply the value that is given up when it is
chosen… the universal meaning of cost is the sacrifice of a value-alternative” (Knight 1924, 592-3).
34
It is defined by Coase (1988a, 158): “Social cost represents the greatest value that factors of production would yield in an
alternative use.”
35
As is well known, Coase did not formulate any “theorem” in his “Problem of Social Cost” and focused on the positive
transaction costs world (see Coase 1988a). For a review of the debate on the theorem, see Medema and Zerbe (2000) and
for a study of its roles in Coase’s works, see Bertrand (2010).
A Key to Coase’s Thought: The Notion of Cost 16
Elodie Bertrand
opportunity cost notion. Still in the cattle example, Coase assumes that the value of the
marginal damage on the corn caused by a third steer is $3. Either the rancher has to pay for
all damage and he adds these $3 as a marginal production cost, or he does not have to pay
compensation and the farmer would pay him $3 so that he diminishes his herd to two steers.
“Whether the $3 is a payment which the cattle-raiser has to make if he adds the third steer to
his herd (which it would be if the cattle-raiser was liable to the farmer for damage caused to
the crop) or whether it is a sum of money which he would have received if he did not keep a
third steer (which it would be if the cattle-raiser was not liable to the farmer for damage
caused to the crop) does not affect the final result. In both cases $3 is part of the cost of
adding a third steer, to be included along with the other costs” (ibid., 7). In both initial
allocations of rights, the rancher faces the same marginal production costs, so the physical
result – the level of the externality – is invariable, and the reason is that “a receipt foregone
of a given amount is the equivalent of a payment of the same amount” (ibid., 7).36 We find
again here the idea that, thanks to the price system, the right is a cost for both parties, or the
reciprocity idea. In Coase’s words: “It is one of the beauties of a smoothly operating pricing
system that… the fall in the value of production due to the harmful effect would be a cost for
both parties” (ibid., 13).
In both these examples, the price of the right includes the external effect, hence reflects the social
OOC, and this explains the efficiency of the price system, if its operation costs are nil, to solve the
problem of externalities, and thus the pointlessness of Pigovian solutions. This interpretation is
confirmed by Coase’s reformulation of the “theorem” in his “Notes on the Problem of Social Cost”, in
which he wants to show that Stigler’s (1966, 113) statement of the theorem37, corresponds to what
he meant in the PSC: “Social cost represents the greatest value that factors of production would yield
in an alternative use. Producers, however, who are normally only interested in maximizing their own
incomes, are not concerned with social cost and will only undertake an activity if the value of the
factors employed is greater than their private cost (the amount these factors would earn in their best
alternative employment). But if private cost is equal to social cost, it follows that producers will only
engage in an activity if the value of the product of the factors employed is greater than the value
which they would yield in their best alternative use. That is to say, with zero transaction costs, the
value of production would be maximized” (Coase, 1988a, 158, his emphasis). This argument is the
same as that of the 1946(b) article on the efficiency of the price system, but adapted to factors of
production whose use creates external effects. The “Coase theorem” thus depends on the use of the
notion of OOC.
36
Coase (1997) will later say that this is this argument that convinced the economists of Chicago who first had rejected the
“Coase theorem” idea: “I said I'd like to have an opportunity to discuss my error. Aaron Director arranged a meeting at his
home. Director was there, Milton Friedman was there, George Stigler was there, Arnold Harberger was there, John McGee
was there – all the big shots of Chicago were there, and they came to set me right. They liked me, but they thought I was
wrong. I expounded my views and then they questioned me and questioned me. Milton was the person who did most of the
questioning and others took part. I remember at one stage, Harberger saying, ‘Well, if you can't say that the marginal cost
schedule changes when there's a change in liability, he can run right through.’ What he meant was that, if this was so, there
was no way of stopping me from reaching my conclusions. And of course that was right. I said, ‘What is the cost schedule if a
person is liable, and what is the cost schedule if he isn't liable for damage?’ It's the same. The opportunity cost doesn't shift.
There were a lot of other points too, but the decisive thing was that this schedule didn't change. They thought if someone
was liable it would be different than if he weren't.”
37
“Under perfect competition… private and social costs will be equal” (Stigler 1966, 113).
A Key to Coase’s Thought: The Notion of Cost 17
Elodie Bertrand
3) The third and last change of approach of externalities concerns the definition of the economic
problem, which “in all cases of harmful effects is how to maximise the value of production” (Coase
1960, 15). Coase criticizes Pigou for comparing, in a given institutional arrangement, private cost and
social cost and choosing the arrangement in which they are equal, for example that in which a tax is
present. Coase’s argument is the following: the institutional arrangement in which private and social
costs are equal is not necessarily that in which the value of production is maximized. What has to be
done is to compare the value of production yielded by different arrangements and choose that in
which it is maximized, taking into account the costs of operation of these arrangements: this is the
comparative institutional method.38 The arrangements compared in the PSC are the market (with
initial allocation of the right to the pollutee or the polluter), the firm, direct regulation, tax and
nothing at all. Rather than the Pigovian comparison between different products of the same
arrangement, Coase prefers “to use the opportunity cost concept and to approach these problems by
comparing the value of the product yielded by factors in alternative uses or by alternative
arrangements” (ibid., 40). The comparative institutional method is thus based on the opportunity cost
concept; the policy-maker (or the judge or the economist) has to think like a producer, in terms of
allocation of his factors of production of the total value, therefore in terms of opportunity cost:
“Economists who study problems of the firm habitually use an opportunity cost approach and
compare the receipts obtained from a given combination of factors with alternative business
arrangements. It would seem desirable to use a similar approach when dealing with questions of
economic policy and to compare the total product yielded by alternative social arrangements” (ibid.,
43). The policy-maker has to choose between meat or crops, the cost of meat being crops and
conversely. Here can be seen the parallel between private decision and public decision, the choice of
the businessman and that of the policy-maker, but, going from the former to the latter, Coase makes
subjectivity disappear.
Coase reintroduces choice in policy (in opposition to the automatic policy of standard theory), as he
had reintroduced the choice of the producer (in opposition to the automaton who maximizes his
profit), but he does not introduce the subjectivity of the policy choice. At the same time he assumes
that the decision-maker takes into account the costs of a decision that he will not bear, thus objective
costs39, and that these costs are measurable in practice. Eventually, like the trade-off between firm
and market in “The nature of the firm”, the choice between institutional arrangements is studied as a
choice that depends on objective costs.
5. Concluding remarks: Coase’s abandonment of the subjective dimension of decision
It is a concern for realism that led Coase to start in the 1930s a reflection on the notion of cost that
irrigates a large thrust of his works. Coase’s 1938 article on accounting participates to the
construction of the notion of subjective opportunity cost, and its influence becomes obvious if we
distinguish in it two dimensions – subjectivity and opportunity aspects – which Coase applies to two
domains of analysis – the choice of the producer and the choice of policy. The first dimension appears
in some of his articles on the theory of the firm, in which Coase underlines the subjectivity of costs
and decisions of the producer, subjectivity which partly explains the costs of transaction and
38
On Coase and the comparative institutional approach, see Medema and Samuels (1998, 163) and Medema (1996).
On the contrary, Buchanan (1969, 5.4.) argues that external costs are subjective and cannot be known: “Since the persons
who bear these ‘costs’—those who are externally affected—do not participate in the choice that generates the ‘costs,’ there
is simply no means of determining, even indirectly, the value that they place on the utility loss that might be avoided”.
39
A Key to Coase’s Thought: The Notion of Cost 18
Elodie Bertrand
organization. Coase thus stresses radical uncertainty or routines, these elements that are
fundamental in recent theories of the firm. The second dimension, that of opportunity cost, was
brought to light in the Coasean approach of policy problems, which are analyzed as problems of
allocation of factors. However, whereas Coase paralleled, very early in his works, the producer’s
decision and the policy decision40, the subjectivity of the former is forgotten in the analysis of the
latter. Even more remarkable, in this analysis, the subjectivity of costs that are supposed to be
measured by the policy-maker is neglected: the production values yielded by the arrangements and
the costs of operation of these arrangements are assumed to be objective and measurable. The
articles on marginal cost pricing and social cost avoid any element of subjectivity (other than that of
demand) and use a notion of objective opportunity cost, as confirmed by the interpretation
eventually favored by Buchanan (1984).
This abandonment of subjectivity when policy is at issue is surprising for the following reason. As
Buchanan explains (1969, 2.19-21; 1973), in the 1930s and 40s, the consequences of subjectivity were
not understood since economists were focused on the problems of the producer, for which it was
sufficient to envisage costs as an obstacle, its objectivity or subjectivity not mattering much. On the
contrary, and still according to Buchanan, subjectivity becomes essential – as Hayek, Mises or Thirlsby
realized – to question welfare economics and its policies based on market fallacies, policies that
require, to be applied, that costs are objectively measured, and, to be efficient, that agents do not
take into account anything else than these monetary costs in their decision. Now it seems, after what
has been shown in the present article, that Coase is doing the opposite: he touches on subjectivity
regarding the producer, but his criticisms of standard policies are not based on this issue. There are,
at least, two ways of understanding this evolution.
First, Coase’s evolution may be understood as chronological since the works on the theory of the firm
studied here were published in the 1930s and those on policy in 1946 and 1960: Coase would have
progressively abandoned the subjective dimension of his thought, around the 1940s. This
interpretation is supported by the fact that, when Coase will later come back on his notion of cost
elaborated in 1938, or on Buchanan’s interpretation (1969), he takes care of avoiding any reference
to subjectivity, and even seems to doubt the specificity of his approach.41 I here suggest just a few
directions, not necessarily independent, which would require further investigation, to explain Coase’s
abandonment of subjectivity around the 1940s.
If it can be noted that the abandonment of subjectivity coincides with the progressive
abandonment of Coase’s Socialist ideas (see Coase 1988b; 1996), the latter abandonment
cannot explain the former. On the contrary, it strengthens the surprise: why was the Socialist
40
As soon as in “The Nature of the Firm”, Coase (1937b, 389, fn 3) writes: “It is easy to see when the State takes over the
direction of an industry that, in planning it, it is doing something which was previously done by the price mechanism. What
is usually not realised is that any business man in organising the relations between his departments is also doing something
which could be organised through the price mechanism.” See also Coase (1946b, 171-2 and 1960, 17).
41
In his 1990 recollection of the 1938 article on accounting, Coase (1990, 8) approvingly quotes some of the elements that
Buchanan (1969) retains from him (his link between cost and choice and the refusal of any classification), but does not refer
to any subjectivist element. Moreover, Coase does not seem to fully recognize the specificity of the LSE tradition on cost
brought to light by Buchanan; speaking of the tradition developed at LSE and in particular of his own vision, Coase writes:
“Whether Buchanan is right in his thesis that these views on cost were not those normally held by economists elsewhere I
do not know” (Coase 1990, 9), and he also says that their study of Wicksteed and Knight gave them “such a firm hold on cost
theory, leaving aside whether what emerged should be considered, as Buchanan contends, as a view special to LSE” (Coase
1982, 33).
A Key to Coase’s Thought: The Notion of Cost 19
Elodie Bertrand
Coase insisting on subjectivity, which condemns any form of Socialism, whereas the liberal
Coase puts aside this type of argument?
Coase may have not realized to what extent his subjective approach was different from
standard theory, which would explain his doubts on the specificity of the LSE tradition.
At the end of 1939, Britain declared war on Germany, and Coase was mobilized for service
until 1946, a period during which he was mostly involved in statistical works in public
agencies. When he came back to LSE, he and his colleagues had moved away to other
subjects: “The war intervened in 1939, and when it ended we did not return to this work”
(Coase 1990, 6). For him, Coase focuses on his criticism of standard policies, his criticism of
public intervention having been reinforced during the war, by working in public agencies.42 It
is possible that Coase put aside the subjective dimension of his previous analyses, which was
the newest and the most inserted in a collective work, the most related to a group that does
no longer exist.
The intellectual influences on Coase progressively changed, and he turned to Smith and
Marshall.43 In the 1930s, he was not so much influenced by Marshall44, but his articles on
Marshall written in the 1970s (Coase 1972b; 1975) make obvious that Coase was at this time
a great admirer of this economist. The use of an objective opportunity cost, equal to money
outlays under some conditions, would then be a mean to get closer to his intellectual hero.
Nevertheless, the opposition between the subjective dimension of the analysis of producer and the
objective dimension of the analysis of policy can be interpreted differently. I have mentioned that
Coase was referring to the practical impossibility for a producer to calculate his marginal cost (in
Coase 1938 and 1937a), but that, in some criticisms of imperfect competition theory, he disregards
this practical problem. The objectivity assumed by his criticisms of standard policies is akin to the
same kind of internal criticisms: Coase wants to question policies prescribed by welfare economics on
its own (objectivist) basis. “The problem of social cost” is indeed an internal criticism of Pigovian
policies; Coase writes about the taxation of the polluter, for example: “The proposal to solve the
smoke-pollution and similar problems by the use of taxes bristles with difficulties: the problem of
calculation, the difference between average and marginal damage, the interrelations between the
damage suffered on different properties, etc. But it is unnecessary to examine these problems here. It
is enough for my purpose to show that, even if the tax is exactly adjusted to equal the damage that
would be done to neighboring properties as a result of the emission of each additional puff of smoke,
the tax would not necessarily bring about optimal conditions” (Coase 1960, 42, my emphasis). In the
same line, the criticism of the marginal cost pricing for a natural monopoly is an internal criticism,
Coase wanting to critically examine different solutions in the same framework than the advocates of
the marginal cost pricing.45
42
“This war-time experience did not significantly influence my views but I could not help noticing that, with the country in
mortal danger and despite the leadership of Winston Churchill, government departments often seemed more concerned to
defend their own interests than those of the country” (Coase 1996, 107).
43
This explanation was suggested to me by Steven Medema.
44
“As a student of Plant's, I studied Industry and Trade rather than the Principles but we did not slavishly adopt Marshall's
views. In fact, we thought his views on cost confused and his analysis of business practices questionable” (Coase 1982, 34).
45
“Now it is, I think, extremely significant that none of the advocates of the Hotelling-Lerner solution should have examined
the possibilities of multi-part pricing as a solution of the problem they are considering. They write as though the only
possible method of pricing is to charge a single price per unit and that the problem they have to solve is what that price
should be. It may be that their reason for not examining multi-part systems of pricing was that they were sure they had in
A Key to Coase’s Thought: The Notion of Cost 20
Elodie Bertrand
These two interpretations are not incompatible: it is possible that Coase realized that his criticisms
based on subjectivity were not heard and then focused on other types of criticisms. Eventually, one
must not neglect a continuity in the analysis of the decisions of the producer and the policy-maker:
both choose between institutional arrangements. This choice is, in “The nature of the firm”, analyzed
as objectively as in “The problem of social cost”, even if costs of these arrangements are related to
subjectivity. These interpretations have to be put to the test of a reading of other Coase’s works,
including his empirical studies.
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