Thinking like Coase, not an economist

I have often railed against the economic approach to social organisation problems which can be described as ‘assume first ask questions later’.  There are too few good economists following more scientific methods of sound reasoning and the reliance on evidence in light of real world institutional structures.

The first approach is often called ‘thinking like an economist’.

Ronald Coase, who passed away at age 102 earlier this week, was in many ways an outlier in the economics profession.  He taught in the the University of Chicago’s Law School, rather than in economics, and was often misinterpreted by his economist peers on important and policy-relevant topics, such as what is known as the Coase Theorem.

We can see his views in an article he wrote in 2012, at age 101, in the Harvard Business Review.

Economics as currently presented in textbooks and taught in the classroom does not have much to do with business management, and still less with entrepreneurship. The degree to which economics is isolated from the ordinary business of life is extraordinary and unfortunate.

Coase’s scepticism is so important today, when the dominant ‘economic way of thinking’ is to apply marginalist equilibrium models to ever more obscure situations (a la Gary Becker). Unless one can be certain that the model is capturing the important characteristics of this particular market or social institution, the results of some manipulation to the model will have no relevance to the realities one is trying to understand.

One example of the original thinking that epitomised Coase’s career is his take on durable goods and the potential monopoly power of sellers in these markets. He raised these important questions a mere 41 years ago, yet almost none of the results from the research agenda that sprang up from it have entered the mainstream, and are certainly not found in most undergraduate textbooks.

You will notice the strong links Coase makes to his descriptive model and ‘business practices’, a phrase you may never read in a whole economics degree. Nor do you much read the phrase “in the twinkling of an eye” to describe the rather arbitrary conceptual compression of time into a single period in economic models.

One important feature of this and other work is that Coase did not make strong policy conclusions, but conditioned his results and explored reasons they may not hold in reality.

These reasons were picked up and explored later by Mark Bagnoli and others, who found that certain critical implicit assumptions in Coase’s model were leading to its conclusions.

Thus the assumption of a continuum of consumers-so innocuous and useful a simplification in other contexts-has proved misleading in the context of durable-goods monopoly.

They explain that the optimal seller of an infinitely durable good (land) will exercise full market power and perfectly price-discriminate, holding back new sales to the market till future time periods to maintain price levels. They label this strategy for sellers the Pacman Strategy “since the monopolist attempts to eat his way down the demand curve.”

This improvement and development of theory in the market for durable goods is still detached from empirical testing, but is at least an attempt to maintain links to “business practices” actually employed by land owners. That is doesn’t fit the mainstream narrative means it is all but ignored by most scholars of economics.

Unfortunately, like his work on The Problem of Social Cost, Coase has been repeatedly misinterpreted by other economists. When you read about the Coase Theorem, you are probably reading about George Stigler’s interpretation of Coase’s discussions around social costs (externalities).

As Coase explains in this interview (at the 0.50) –

It’s not about my work at all.  George Stigler, who is a very nice man, wanted to pay me a compliment.  So he invented the Coase Theorem, but he named it the Coase Theorem and not the Stigler Theorem.

The reason I don’t like it is that it is a proposition about a system in which transaction costs are zero.  Well, that isn’t the way they system actually is.  Therefore it is a theoretical proposition.  I don’t like that.

He later laments the difficultly in getting economists to understand reason during the now infamous meeting where he convince some Chicago colleagues of the merits of auctioning radio spectrum.

All I said that the FCC should award the right to transmit on a given frequency to the person who paid the highest amount for it.  To my astonishment this room, which one would of thought would have welcomed it in Chicago, was rejected by them.  We went on for, I don’t know how long, and hour or something like that.  At the end that time they all thought I was right.

They were very impressed by the fact the I had changed their views.  But I wasn’t particularly impressed because all I was doing was stating the obvious.

Coase relies extensively on real court cases and judgements to describe the apparent arbitrariness of property rights, when examining the judges ruling on Bryant v. Lefever he notes that

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.On the marginal principle it is clear that both were responsible and both should be forced to include the loss of amenity due to the smoke as a cost in deciding whether to continue the activity which gives rise to the smoke. (original emphasis)

Led by Stigler, economists took this logic and ran with it, turning it into the Coase Theorem, while not fully comprehending that the real contribution of this article is to consider the case where bargaining is costly.

The key point is that “In these conditions [costly bargaining] the initial delimitation of legal rights does have an effect on the efficiency with which the economic system operates”.  He goes on to note that every type of social arrangement, including regulation by means of the “special kind” of “super-firm” that is government, has costs and we should seek social arrangements that minimise costs of cooperation relative to the gains.

He explicitly says the perfect market model is irrelevant to almost all real social costs. The main message being that property rights are arbitrary constructions and we should consider the social costs and benefits of any changes from a given starting point.  Its message was very relevant for legal scholars considering rights for damage claims.

On his work about the Nature of the Firm, he recently noted that firm organisation is really a sociological problem, not an economic problem.  Which seems so obvious since internal firm decisions are rarely priced, nor do they take place within an environment of market-style contracts.

Rarely now do we see the type of common sense thinking that the ‘accidental economist’ Ronald Coase showed throughout his long career. In fact, I would be surprised if a Coase was beginning his career today that he would be able to break into the profession at all, given it’s obsession with formalisation of mathematical models, and disdain for verbal reason informed by real world conditions.

Comments

  1. “My contribution to economics has been to urge the inclusion in our analysis of features of the economic system so obvious that, like the postman in G. K. Chesterton’s Father Brown Tale ‘The Invisible Man,’ they have tended to be overlooked.”

    (Ronald Coase. Nobel Memorial Prize Lecture of 1991)

    The world need fewer economists and more Ronald Coases.

    • In adapting Coase’s ideas, conventional economists have tended to focus on the role of transaction costs (the importance of which were, indeed, identified by Coase).

      But there are two even more fundamental, qualitative aspects of Coase’s work which – like the postman – still tend to be overlooked.

      The first of these is what might be called “Coasian Symmetry”.

      In “The Problem of Social Cost”, Coase went to some pains to draw attention to the “Invisible Man”, that obvious fact that all allocations of rights come in ruthlessly symmetrical right-obligation pairs.

      Dr Sturges’s liberty to practice auscultation in his consulting room relies absolutely on abridging the liberty of Mr Bridgman to make confectionary using noisy mortars and pestles next door . . . and vice versa.

      Mr Lefever’s freedom to stack timber on his roof relies absolutely on imposing an obligation on Mr Bryant either to put up with a smoke-filled room or to pay for a new chimney . . . and vice versa.

      The liberty of farmers to grow corn near the railway relies absolutely on abridging the liberty of railway owners to use locomotives not fitted with spark-catchers . . . and vice versa: the liberty of railway owners to run any locomotive relies absolutely on abridging the liberty of farmers to grow corn near the tracks.

      We often hear people talking about “rights” and “liberty” and “freedom”. But the same ruthless symmetry applies to all putative “rights”. Each and every “right” necessarily creates an externality in the form of the elimination of its symmetrical right.

      And there is no self-evidently correct way to identify which way the right should be allocated.

      Coase’s symmetry encourages us to see terms like “right”, “freedom” and “liberty” for what they are – hollow rhetoric – and to question how and why “rights” should be allocated in particular ways.

      Sometimes a putative right may seem so obviously “correct” that some people forget to stop and consider its symmetrical obligations. The Problem of Social Cost highlights the way in which one judge would decide that a particular allocation was correct, only to have a higher court judge (or judges) decide that precisely the opposite allocation was correct.

      At a fundamental level, Coase invites us not to assume immediately that one or other allocation is correct. He invites us to consider how we might go about making the decision.

      The “right to life” relies on removing the right of others to kill. To a casual listener that may seem self-evidently correct. But does it, for example, outlaw self-defence? The “right to property” relies on removing the right of others to take. To the casual listener that may seem self-evidently good, but does it, for example, outlaw all taxation?

      And so it goes on. Any “liberty” necessarily relies on the creation of an externality in the form of removing the liberty of others to restrict that liberty.

      The next time someone starts talking about “rights”, remember Ronald Coase and make a conscious effort to identify the symmetrical “rights” that will need to be eliminated.

      (Coase’s second – and perhaps more important – qualitative insight lies in “The Nature of the Firm”. Perhaps later in the day.)

    • How about this for Coasianism taken to extremes:

      Conventional economists usually interpret Coase’s “Nature of the Firm” as differentiating between firms and states. They love to praise the advantages of flexible firms over rigid states.

      But Coase’s second great insight was actually identifying the essential similarity between firms and states.

      Let’s look at what the great man himself said about his 1937 work (Alfred Nobel Memorial Prize Lecture, 1991):

      “The Russian Revolution had taken place only fourteen years earlier. We knew then very little about how planning would actually be carried out in a communist system. Lenin had said that the economic system in Russia would be run as one big factory. However, many economists in the West maintained that this was an impossibility. And yet there were factories in the West and some of them were extremely large. How could the views expressed by economists on the role of the pricing system and the impossibility of successful central economic planning be reconciled with the existence of management and these apparently planned societies, that is, firms, operating within our own economy?”

      By 1937 Coase had identified the parallel between “public” planning by the state and “private” planning within a firm.

      The solution to the puzzle lies buried in footnote 14 to “The Nature of the Firm”:

      “It is easy to see when the State takes over the direction on an industry that, in planning it, it is doing something which was previously done by the price mechanism. What is usually not realized is that any business man in organizing the relations between his departments is also doing something which could be organized through the price mechanism. . . . . The important difference between these two cases is that economic planning is imposed on industry while firms arise voluntarily because they represent a more efficient method of organizing production. In a competitive system, there is an ‘optimum’ amount of planning!”

      Conventional, inside-the-square economists have always taken this to mean that firms and states are categorically different. Firms “arise voluntarily”. States don’t.

      But if we dare to step outside the square for a moment, it provides an insight into what could be far-and-away the greatest economic and political innovation of the 21st century.

      What if states did “arise voluntarily”???????????

      This back-to-front, upside-down interpretation of Coase leads to what might be called the “Coasian Polity Market”. The scale and scope of states would adjust – just as the scale and scope of firms adjust – to provide the “optimal amount of planning”. Governmental authority would be optimally sized and optimally distributed provided that governments could “arise voluntarily” in a competitive system.

      Governments and private firms are not categorically different. They differ only in that firms may arise voluntarily while governments are permanent regional monopolies.

      (The UN Charter even contains an anti-competitive market-sharing agreement – the recognition of sovereignty – under which the regional monopolists have divvied up the planet and agreed not to offer services to people living in another monopolists’ territory!)

      Remove that difference, and you remove the modern, artificial distinction between “public” and “private”. After all, what is a “state” other than a collection of private individuals tied together by legal rights and obligations? And, on the other hand, a private firm can legally coerce individuals who are under a obligation to it just as a state can.

      Now this might seem utterly unimaginable. But there are in fact provisions in some constitutions to allow for it.

      Article 29 of the German Basic Law contains mechanisms which allow minorities to present proposals for secession (under the umbrella of the Federal Republic) even if the remaining majority of a German Land (i.e. a “state” within the German federation) opposes it.

      On a much smaller scale it is what lies behind Texas’s “Municipal Utility Districts” which Leith van Onselen often writes about. These are special purpose “micro-states” which arise voluntarily to provide specific services to their “citizens”.

      In principle, such a mechanism could be scaled up to create a “polity market” for all of Europe, or the United States, or Australia – or the entire world.

      So, what might a Coasian “free market in government” look like?

      An essential element is the development of a “sovereignty market”, an institutionalised way of allowing the voluntary exchange and pooling of “rights to govern”. This is already seen in “multi-speed” or “variable geometry” Europe: the various “Lands” of Europe (Euroland, Schengenland, Dublinland and Bolognaland) pool specific governmental powers.

      Admittedly these have not always been efficient in scale or scope, but that’s because they’ve created by monopoly governments rather than free market forces.

      So the other element is a central meta-government, or “meta-state” (Washington or Brussels, or Canberra even) which is charged with – and limited to – overseeing the orderly incorporation of states, liquidation of defunct states, mergers and demergers, and the rules under which such states contracted into the voluntary pooling of responsibilities.

      Rather as ASIC oversees corporations but does not manage them, the meta-state would oversee states but not govern them.

      Intriguingly, corporations law itself contains statutory provisions to remedy “oppression of minorities”. The remedies include “secession” of the minority from the rest of the company under the oversight of the Courts!! The provision is rarely used, but it is used sometimes, and its mere existence constrains would-be oppressors.

      The two limbs (sovereignty markets and the right to incorporate) work together: just as an efficient market in factors of production allows for smaller firms (with less internal planning) so an efficient sovereignty market allows for smaller states.

      Intractable problems require imaginative solutions. On an increasingly crowded planet, improving the efficiency of collective decision-making is the biggest problem of all.

      Coase’s ideas still have a long way to play out.

      • That is an excellent post SM.

        The ‘optimal amount of planning’ could be a concept or criterion that bridges the gap between the binary positions that big government is good v big government is evil.

        I think it is much better having a discussion in those terms rather than the unproductive world of ‘faith substitute’ ideologies of government.

        A big role for government (planning/organisation) does not necessary require a big government.

  2. “The reason I don’t like it is that it is a proposition about a system in which transaction costs are zero. Well, that isn’t the way they system actually is.”

    Interesting. I heard that the costs of transportation were ideologically ignored in the old Soviet Union because commerce was “un-socialistic”. So they apparently did some pretty silly things like, e.g., transporting materials across Siberia at various stages of processing. No wonder they collapsed.

    • If you have seen a book in Russian, you will find that they have obviously studied at universities the transport task with matrix for optimization of transport costs across sectors and locations.

      The reason they collapsed is very different.

      • I do not read Russian. I heard the story above from a Russian friend who immigrated to the US about 12 years ago. I have no reason to suspect that he was making things up.

        I know that the direct “reason” they collapsed is different, but related. A joke he told me illustrates the real reason. It was about a trans-Siberian train which Stalin, Khrushchev and Brezhnev boarded. The train unexpectedly stopped in the middle of nowhere. Each of them gave the following order to his aid;

        Stalin; “Arrest the driver and shoot him”

        Khrushchev; “Send engineers to find out what is wrong with the train”

        Brezhnev; “Just pretend that the train is moving”

        Anyways, the point of my original post is that whenever you allow a doctrine or ideology or dogma to cloud your vision, you cannot expect anything decent to come out of your analysis. I could not help but notice the similarities between the old Soviet ideology-driven society and the state of the “economics” in the West detailed in the article.

        No wonder George Soros once said along the lines of “I do not know enough about economics to make an intelligent comment because I did not bother studying it”

    • Their “transit oriented development” cities were a disaster too. Read “Cities without Land Markets” by Alain Bertaud

  3. Hugh PavletichMEMBER

    The economics profession has much to learn about housing markets and bubbles, as I explained early 2009, with “Housing Bubbles & Market Sense” …

    http://www.scoop.co.nz/stories/BU0901/S00046.htm

    It will be a great day indeed, when the field of structural urban economics is developed and taught, so students start thinking and talking the language of the market again.

    There is also an urgent need for economists to better understand dysfunctional public bureaucracies and institutional failure. I touched on this recently with “Suffocating Bureaucracy & Institutional Failure” …

    Suffocating Bureucracy & Failed Institutions | Scoop News

    http://www.scoop.co.nz/stories/PO1307/S00134/suffocating-bureucracy-failed-institutions.htm

    Hugh Pavletich
    http://www.PerformanceUrbanPlanning.org
    Christchurch
    New Zealand

    • @Hugh Pavletich,

      Potable Water and Energy are the two greatest concerns going forward – globally – this is growth negative, regardless of market desire.

      As I see on your web site you cite Niall Ferguson whom directs readers to look at growth states like Texas and low regulatory states as economic winners. Not only Texas but a large swath of America is increasingly challenged by diminishing potable water supply. This is a man made scarcity event coupled with climatic change. This problem will only exacerbate under currant market ideology.

      As far as your “Suffocating Bureaucracy & Failed Institutions” meme goes I would point out my below comment and add – whom – has the greatest influence on these agency’s – comparaison n’est pas raison!

      skippy… it sure is not an informed voting constancy, cross that off the list and were left with ????

      Cheers

  4. Ahem…

    In 2009, in their seminal JEI article, Hahnel and Sheeran highlight several major misinterpretations and common assumption, which when accounted for substantially reduce the applicability of Coase’s theorem to real world policy and economic problems. First, they recognize that the solution between a single polluter and single victim is a negotiation—not a market. As such, it is subject to the extensive work on bargaining games, negotiation, and game theory (specifically a “divide the pie” game under incomplete information). This typically yields a broad range of potential negotiated solutions, making it unlikely that the efficient outcome will be the one selected. Rather it is more likely to be determined by a host of factors including the structure of the negotiations, discount rates and other factors of relative bargaining strength (cf. Ariel Rubenstein).

    If the negotiation is not a single shot game, then reputation effects may also occur, which can dramatically distort outcomes and may even lead to failed negotiation (cf. David M. Kreps, also the Chainstore paradox). Second, the information assumptions required to apply Coase’s theorem correctly to yield an efficient result are complete information—in other words that both sides lack private information, that their true costs are completely known not only to themselves but to each other, and that this knowledge state is also common knowledge. When this is not the case, Coasian solutions predictably yield highly inefficient results due to perverse incentives—not “mere” transaction costs.

    If the polluter has the ownership rights, it is incentivized to overstate its benefits from polluting, if the victim has the ownership rights, (s)he has the incentive to also misrepresent her/his damages. As a result, under incomplete information (probably the only state of knowledge for most real world negotiations), Coaseian yield predictably inefficient results. Third, if there are multiple victims, victims who would be required to pay have incentive to pretend that they are not harmed (freeriding) or understate their harm. If the polluter is required to pay, victims overpresent, overestimate their damage, and/or hold out.

    Hahnel and Sheeran emphasize that these failures are not due to behavioral issues or irrationality (although these are also quite prevalent (Ultimatum Game, Cognitive biases), are not due to transaction costs (although these are also quite prevalent), and are not due to absorbing states and inability to pay, rather it is due to fundamental theoretical requirements of Coase’s theorem (necessary conditions) that are typically grossly misunderstood, and that when not present systematically eliminate the ability of Coaseian approaches to obtain efficient outcomes—locking in inefficient ones. Hahnel and Sheeran conclude that it is highly unlikely that conditions required for an efficient Coaseian solution will exist in any real-world economic situations.

    Another criticism is that the relative value determinations of the parties cannot reflect the actual values sought by the parties unless the parties start off at equal economic positions. In reality, the parties are more likely to start off at economically disparate positions. The result is that a dollar may have more relative worth to the victim than the polluter. Additionally, Coase’s theorem assumes that anything of value can be characterized in economic terms. But some attributes of property simply cannot be reduced to monetary figures – snip

    Come on… is the world going to commit its self to Babylonian level discourse in perpetuity. When our fundamental understanding of our selves and our surroundings is completely and radically different.

    skippy… Information asymmetry alone is a huge fly in the ointment, is fraud an unpriced externality… shezz

    • Not sure where you are going with all that, but a good dose of books like “The State of Humanity” (Julian Simon); “The Rational Optimist” (Matt Ridley); and “The Skeptical Environmentalist” (Bjorn Lomborg) would help.

      We would have no progress to better overall conditions at all if “negative externalities” and the excessive complexity of bargaining were the over-ruling principle.

      I keep saying, for example, that decades ago, no-one was particularly worried about the “negative externalities” of cars and “sprawl” – because there were still plenty of people alive who remembered the world as it was before that; and in fact the transition was long enough that nodes of previous conditions continued to exist. That is just one example.

      One of the most beautiful points is that the amount of land that was once required to grow food for horses and draft animals, was greater than the amount of land that has been taken up with urban growth since.

      But there is also the insanitary nature of earlier-era “sprawl”, and a biggie – “the tyranny of rent”, which was far better understood decades ago than it is now, because it wasn’t a problem once automobile based development fixed it.

      • Its in the same vane as the L.A. Calif. pollution credit scam implemented during the 80’s (industry written). Firstly it created a new market which was easily gamed, negating its intended function ie. to mitigate a growing pollution problem – huge and growing cost to all sectors of the economy.

        Second it concentrated the problem by allowing the worst polluters, to not not only keep polluting but, increase this out put. Hell it even became a form of currency which was used to arb all kinds of laws and contracts.

        Thirdly it left out one agent in the negotiating process, and in my and others opinion – the most important – as it directly enables market functionality from day one – The Commons. And if all party’s are not represented at the negotiation, well, there is no equality (present and future tense).

        I can see by your suggested reading where you presently reside metaphysically. Personally I reject axioms and a priori foundations, that are plucked from thin air (Praxeology?), with out empirical data to support such opinions. I can wait till the hard data is in before cementing my position and hedge accordingly.

        BTW I did not see a substantive rebuttal to the JEI article, by Hahnel and Sheeran and their argument, more of a look over here at the dancing chicago – cato girls thingy.

        cheers

      • Sorry I don’t drink at the well of Praxeology or any other metaphysical axiom – a priori that is not empirical.

        A retort of the JEI article by Hahnel and Sheeran would serve better than look over here at the dancing cato girls IMO. I would also refer to the L.A. Calif. pollution credit scam in the 80s (industry written), highlighting the negotiation troubles ergo: the most important agent was not consulted in the negotiations i.e. the commons. Along with a hole plethora of negative economic externality’s.

        cheers

      • Ironically, the political systems that did everything in the name of “the people”, in which private enterprise and property did not exist, are the ones that have made the biggest messes of all of their environments.

        And there are parts of Russia now, where the locals literally have to choose between their jobs, and a cleaner environment. They are choosing the jobs.

        You have to be a lot more productive before you can start making trade-offs between food on the table, and cleaner air to breathe. Of course there is always the option of remaining in rural subsistence poverty, but people making observations from their armchairs in the western world mostly fail to relate to why people in these conditions voluntarily migrate en mass into “Victorian” urban conditions.

        At least under democratic mixed systems with some “capitalism” in them, a dynamic new economy can be created – eg California – which can then be regulated (with democratic approval) to reduce the external impacts on the “commons” without destroying the dynamic new economy. Trying to impose “rights” to an unspoiled commons too soon in the process just means going without the growth in productivity and the means of improved standards of living.

        When the regulation is over-done and an economy is strangled, there eventually has to be a reckoning that jobs for more people, and at higher incomes, is going to need a bit less obsession with “the environment”. Keeping the air clean probably is a “given” now. Preserving and even restoring the freshwater smelt’s pre-modern habitats is probably an unaffordable luxury.

        There is absolutely no lack of hard data in Julian Simon; “The State of Humanity” and Bjorn Lomborg, “The Skeptical Environmentalist”. In fact it would be hard to better the collation of data in the latter. Steven F. Hayward’s periodic “Index of Leading Environmental Indicators” is also excellent.

        It is not a question of “where I reside metaphysically”, but one of reason and objectivity. But I do suspect that many of the people with Reformation metaphysics rather than Enlightenment ones, are better adherents to reason and objectivity than those with values systems that have filled the vacuum left by the abandonment of the other.

        People with Reformation metaphysics, for example, are quite OK with quite big holes being dug into the surface of the planet miles away from anywhere where any humans will notice them. However, where this is not allowed, the reason invariably is some form of neo-paganism, whereby a “landform” itself has some intrinsic value and any disturbance of it by humans is a form of sacrilege. There is nil rational, objective, economic or scientific basis for it, ironically in a so called “secular” nation.

  5. “….The degree to which economics is isolated from the ordinary business of life is extraordinary and unfortunate….”

    One of the most glaring examples is the way economists assume that land is merely “allocated by the market to the best possible use”. Alan W. Evans, an honourable exception, has written a lot to try and address this, not that the rest of the profession takes much notice.