By Andrew Sheng and Xiao Geng/Hong Kong

His legacy – insights into the role of firms, financial institutions and the state in shaping the market and driving economic development – will prove crucial as China works to achieve high-income status.

With two seminal papers, Coase changed the way economists view institutions’ impact on an economy.

His 1937 paper “The Nature of the Firm” introduced the concept of transaction costs into discussions of a firm’s structure, function, and limitations.

And his 1960 paper “The Problem of Social Cost” proposed that the state could manage the negative externalities, such as pollution or traffic, of economic activities through well-defined property rights.

In his final years, Coase shifted his focus to the emergence of capitalism and the creation of markets in China.

According to Coase, since the period of reform and opening up began in 1979, China has been a living experiment in institutional evolution, shaped simultaneously by the central government and by local governments and enterprises.

This evolution is at the centre of a case study of Foshan – a city of 7mn people located near Guangzhou, at the heart of the Pearl River Delta – launched last year by a team of Chinese researchers (of which we were a part). As it turns out, Foshan may well be the ideal example to test Coase’s views.

Given Foshan’s proximity to Hong Kong, it is firmly embedded in global supply chains – a fact that has helped to drive rapid nominal GDP growth, from roughly ¥1.3bn in 1978 to ¥670.9bn ($109.7bn) last year.

The private sector – focused on the production of home appliances, machinery equipment, construction materials, textiles, and food – accounts for more than 60% of Foshan’s GDP. Foshan is also home to the world’s largest wholesale lighting and furniture markets, and its products are exported internationally.

According to the Chinese Academy of Social Sciences, Foshan is China’s most competitive prefecture-level city, and its eighth most competitive city overall, owing partly to institutional innovations by local governments at the township, district, and prefecture levels.

These innovations enabled Foshan to create markets that were largely defunct before 1979, while coping with rapid urbanisation, industrialisation, and globalisation.

Foshan’s development offers important insight into the core problem that China is now facing: how to transform a low value-added, manufacturing-based economy into a high value-added, innovation-fueled economy.

While the previous model brought 30 years of success in terms of GDP growth, it generated considerable risks and imbalances – including environmental degradation, social inequities, excessive debt, industrial over-capacity, and a bloated state sector.

As Foshan’s experience demonstrates, cities can play a pivotal role in correcting these imbalances and driving China’s economic transition.

The Chinese city evolved as a walled-in seat of power centered around a marketplace. Indeed, the two characters that comprise the Chinese word for city mean “castle” and “market”  – an apt juxtaposition, which endures today in the form of the relationship between collective state-led action to build strong markets and private-sector competition within and among cities.

In terms of physical infrastructure, China’s most dynamic cities – such as Beijing, Shanghai and Foshan – already resemble Western metropolises like Paris and Chicago. But this “hardware” is inefficient without the “software” needed to manage it – namely, as Coase suggested, an efficient property-rights infrastructure (the laws, procedures, and administrative capacity needed to support efficient, fair, and innovative markets).

The convergence of consumer lifestyles and preferences driven by globalisation has enabled the world’s major cities to specialise production for global markets. But, given regional differences in political, social, and economic arrangements – often reflecting the particularities of local history and culture – significant divergences in citizens’ attitudes remain.

Responsibility for ensuring the smooth functioning of markets despite these disparities falls to the state. In other words, markets are global networks, which depend on cities to serve as hubs; cities, in turn, require state coordination of supply chains to deliver market-enabling public goods effectively.

China’s growth story has entailed the orchestration of at least four supply chains: a global production supply chain, run largely by the private sector; a logistics supply chain, run by state-owned enterprises; a finance supply chain, mainly comprising state-owned banks; and a government-services supply chain.

Cities like Foshan have benefited substantially from the effective co-ordination of these networks. But a fifth supply chain – that of human talent – has largely been neglected, and cities cannot achieve their potential unless they can attract the best human talent.

A Coasian analysis of China’s development would centre on the complex interaction between the locally-minded state and the globally-minded market, with the key lesson being that, contrary to free-market ideology, less government does not necessarily mean more market. Rather, an expanding market needs a strong government, but with a more targeted approach that emphasises, for example, developing the property-rights infrastructure, building the human talent pool and implementing macroeconomic policies that support high-quality growth.

Neither capitalism nor socialism has fully revealed how to achieve efficient GDP growth, an inclusive society and ecological sustainability simultaneously.

If China applies Coase’s institutional insights to develop an effective development framework, it may well manage to strike this crucial balance. - Project Syndicate

♦ Andrew Sheng, president of the Fung Global Institute, is a former chairman of the Hong Kong Securities and Futures Commission, and is currently an adjunct professor at Tsinghua University in Beijing. Xiao Geng is director of Research at the Fung Global Institute.