Ronald Coase, who has died aged 102, won the Nobel prize for economic sciences in 1991 for his work in discovering and clarifying the importance of transaction costs in the functioning of the economy. His substantial contribution to economics spanned eight decades. Coase challenged the idea that “externality problems” – in which the costs of an action are felt by those who are not party to it – necessitated government intervention in the form of taxes or regulation.

Well-defined property rights and low transaction costs could allow individuals to resolve problems themselves through voluntary exchange in a free market. If you do not like the fact that your neighbour plays his music too loudly, or allows his dogs to roam around your garden, perhaps you should pay him to stop. Or, if your neighbour strongly desires to continue to act in this way, perhaps he should pay you to allow him to do so. State intervention to solve these disputes – in the form of taxes, regulations and prohibitions – should not be wholly ruled out, but neither should they be considered the constant default option.

Coase was born in Willesden, northwest London. His father worked for the post office, as had his mother before their marriage. After attending Kilburn grammar school on a scholarship, he studied at the London School of Economics, receiving a bachelor of commerce degree and joining its staff in 1935. In 1937, he married Marion Hartung, from Chicago.

In the same year, Coase published his influential essay The Nature of the Firm. Coase understood that the institutional and legal framework of a society was vital to appreciating how economic activity would be conducted. In the entirely theoretical world of a perfectly functioning market, with no transaction costs and everyone in possession of correct information, we would all be self-employed and continually entering into new contracts with one another, seeing our salaries fall and rise with every passing minute depending on our productivity.

In the real world, of course, companies face the prohibitive costs of continually working out with whom to do business and which goods and services they need to obtain (transaction costs). Coase posited the theory that the amount businesses could grow by depended on how they coped with internalising these costs and how they minimised entrepreneurial errors. He correctly predicted that tech nological developments, including cheaper, faster transport and more cost-effective communication, would lead to companies expanding in size.

After moving to the US in 1951, Coase worked at the University of Buffalo and the University of Virginia. In 1964 he took a position at the University of Chicago, where he became editor of the Journal of Law and Economics. It was in this publication in 1960 that Coase published his most famous piece of work, The Problem of Social Cost, which gave rise to the “Coase theorem”, as his friend and colleague George Stigler dubbed it. He used the example of two farmers facing a situation in which one man’s cattle strays on to his neighbour’s field of crops. If the cost of restraining the cattle, ie the rancher paying to erect a fence, is less than the cost of the damage to the crops, this will be achieved irrespective of whether this is paid for by the arable farmer or the cattle rancher. Who picks up the bill will simply be determined by the allocation of property rights. The Coase theorem had practical applicability in the debate about the rights over the radio spectrum in 1960s America.

His work in this area continues to have relevance today. In the debate over climate change, Coase’s work provides the intellectual basis for favouring a trading scheme of carbon credits, rather than the state imposition of anti-emissions regulations. Similarly, his work informs the approach to auctioning the airwaves for mobile telecommunications – just as it did for radio half a century ago.

Throughout his career, Coase believed that economists were too prone to theorising about what might occur in an abstract and imaginary world. Indeed, he worried about the practical application of the Coase theorem itself. He is rightly considered to be the father of institutional economics, and the academic field of “law and economics” would not exist without him.

In the last years of his life, Coase turned his attention to the emergence of capitalism in China. His final great work in 2012, co-authored with Ning Wang, was How China Became Capitalist. Asked by a friend and colleague whether he thought the Chinese would be particularly receptive to his economic ideas, Coase quipped: “Not necessarily, but there are a lot of them.”

Coase and Wang argued that China’s move towards capitalism had essentially been an accidental byproduct of an attempt to bring about perfect socialism and sounded a warning that a continuing desire for economic and political control on the part of the Chinese authorities could derail the country’s long-term potential for growth.

Considered by his friends to be a generous and modest man despite his enormous academic achievements, Coase conceded that he had originally expected it to take a century or more for China to become capitalist. Asked why an economic legend such as himself could be so wrong about a matter of such global significance, Coase replied: “I’ve been wrong so often, I don’t find it extraordinary at all.”

He will, however, be remembered across a wide range of academic disciplines as a brilliantly insightful man who managed to get so many things right and who could explain real world economic behaviour with incision and clarity.

Marion died in 2012.

• Ronald Harry Coase, economist, born 29 December 1910; died 2 September 2013

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Mark Littlewood

Director General, IEA

Mark Littlewood is the Director General of the Institute of Economic Affairs and the IEA’s Ralph Harris Fellow. Under his leadership, the IEA has continued to communicate the benefits of free markets to an even wider audience around the world. In 2014, Mark was ranked 38th on The Times’ ‘Right-wing Power List’, and in 2011 was named ‘Liberal Voice of the Year’ by the Liberal Democrat Voice. Mark frequently comments on political and economic issues on television and radio including BBC Question Time, Any Questions, Newsnight, Channel 4 News, Sky News, Radio 4's Today Programme and LBC. Prior to the IEA, Mark was Head of Media for the Liberal Democrats before going on to found Progressive Vision, a classical liberal think tank. Mark was educated at Balliol College, Oxford.