Coase Cost

When you enter the realm of a modern micro-economic classroom, it is more than common to spend a semester immersed in price theory and doing everything short of worshipping the supply and demand curve. While Smith and his "invisible hand" revolutionized economic theory and laid the foundation of knowledge for quite some time, Coase was one of the first to start asking questions of the assumptions behind such models; and transaction costs were the result of such inquiry. In this essay I take sides with Coase and attempt to show, through his knowledge, that while the price system may work, there are costs associated with using the pricing mechanism and those today (thanks to Coase) are known as transaction costs.

"Nonetheless, [transaction costs] once included in the analysis, they will, as I believe, bring about a complete change in the structure of eco-nomic theory, at least in what is called price theory or microeconomics."

Let's get down to basics. Price theory states that the price of which a good or service will be sold for is determined by the forces of supply, demand, and competition; the function of the market in itself driven by prices can allocate resources efficiently. Coase points out that historically this theory has ignored the transaction costs that actually lead to the existence of firms.

"I argued in "The Nature of the Firm" that the existence of transaction costs leads to the emergence of the firm. But the effects are pervasive in the economy. Businessmen in deciding on their ways of doing business and on what to produce have to take into account transaction costs. If the costs of making an exchange are greater than the gains which that exchange would bring, the exchange would not take place and the greater production that would flow from the specialization would not be realized. In this way transaction costs affect not only contractual arrangements, but also what goods and services are produced." (Coase, Nobel)

Coase uses the discussion of firms and institutional arrangements (namely contracts) to expose the true costs associated with market transactions that have traditionally been ignored in history. Price is not the only thing that drives a transaction. As stated, one will only enter into a said transaction if the costs of doing so do not exceed the benefits derived from exchange. Firms exist because they can provide a good or service at a lower cost than "the market" or competitors; firms incur the costs of finding reliable suppliers, creating working contracts, planning, production and management. It is examples such as these costs that have been ignored in the past when dealing with microeconomic theory, Coase discovered these major insufficiencies when he was just 21. Let us continue this analysis by showing how transaction costs were the driving force in the need for currency.

Adam Smith is the father of the "invisible