Ronald Coase is easily my favorite economist, and one of my favorite thinkers in general. Among his many insights was the idea of “transaction costs”, or the cost of an economic transaction which may or may not be higher than the benefit accrued from that transaction.

Coase’s classic example was the firm. Under standard models of perfect competition, he pointed out, firms have no reason to exist. If the free market is always on average more efficient than centralised, command-and-control allocation of tasks and the means of production, it should be cheaper for an employer to contract out for a service rather than hire and organise a group of people to do it. Yet it is clear that a world where every internal task of a firm, from ordering to the mail room to payroll management, had to be accomplished by a tangle of individual contracts would rapidly grind to a halt.

The key, said Coase, are the transaction costs: the cost of organising each individual transaction with a private contractor is greater than the cost of hiring somebody to do it for you, even if hiring may result in a slightly less efficient worker. Coase also pointed out that there is a maximum limit where the decreased efficiency cost begins to exceed the transaction cost, which is why firms still outsource a lot of their activities. It is not efficient, for example, for a private school to run the graphite mine to make its pencils.

In this week’s episode of the EconTalk podcast, internet and organisational guru Clay Shirky describes how the internet is lowering Coasean transaction costs for many exchanges, to the point where ‘products’ that were previously impossible due to the cost of organisation can emerge. The value of this podcast is more in the lucid examples than in the insights, which are not entirely original. I particularly enjoyed Shirky’s description of the process by which Flickr co-ordinates individual activities to produce collections of photography which would have been prohibitively expensive in the pre-internet era. His analysis of Wikipedia also goes deeper than the usual vague references to ‘crowd-sourcing’, and he cleverly uses the unexpected success of voluntary, collaborative activities such as many open source software projects to point out the importance of new behavioural economics insights. Unfortunately, the podcast ends with a strange and poorly explained hope that creative commons-like vehicles can be used to better organise collective action in the real world. Isn’t that where the high transaction costs we are trying to escape were to begin with?