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Forever Contemporary
The Economics of Ronald Coase
By Cento Veljanovski The Institute of Economic Affairs
Copyright © 2015 The Institute of Economic Affairs
All rights reserved.
ISBN: 978-0-255-36712-7
CHAPTER 1
THE ECONOMICS OF RONALD COASE
Cento Veljanovski
Ronald Coase based his economics on the real world, on the study of the firm and the market, and his application of simple economics artfully applied to came to novel conclusions which he said were 'so simple' as to make them 'truths' which were 'self-evident' Coase (1988: 1).
I trace here the development of Coase's economics, describing his contributions (a full list of his publications appears at the end of this volume), and the essence of the law and economics enterprise he fostered.
What Coase did
In two articles separated by over two decades, the last written over half a century ago, Coase used one theme to change the way economists and lawyers think about the nature of economics, and how it should be applied.
In his 1937 article 'The nature of the firm' Coase asked the elementary question: Why are there firms? Economics provided no convincing explanation since in perfect competition tasks carried out by the firm could just as easily be undertaken in the market by means of contracts between independent suppliers, manufacturers and jobbers. The firm was simply represented as a cost schedule as in Marshall's 'representative firm'. The answer Coase offered was that the firm was a cheaper way of organising production. In the market there were transaction costs – the costs of negotiating, bargaining and enforcing contracts. When these costs became excessive, the market was replaced by the firm (the 'non-market') because it was cheaper. Other institutions arose for the same reason. Coase's article was largely ignored for the ensuing three decades.
In 1959 and 1960 Coase wrote two articles, 'The Federal Communications Commission' and the follow-up 'The problem of social cost', respectively. Transaction costs again featured prominently. 'Social cost' is the more important of these articles, although Coase's study of the FCC could be said to have had the greater policy impact, as I show below.
'Social cost' is one of the most cited and most misunderstood of articles. It develops a number of themes in an informal way, using simple descriptive economic logic. But at its heart is an attack on the concept of market failure as a framework for policy analysis, which at the time was associated with A. C. Pigou's The Economics of Welfare (1920). Economists then habitually used, and still use, the competitive market as a benchmark to evaluate economic performance. They declared that a market has failed when there is any departure from the competitive model's assumptions, and recommended corrective government intervention. Coase criticised this approach on several grounds – that it was wrong in theory, failed properly to diagnose the cause of 'market failure', and assumed costless efficiency-motivated government intervention. In highlighting these issues he offered a profound critique and alternative to the market-failure approach which Demsetz (1969) called the 'comparative institutions' approach.
Coase's first criticism was that at the heart of the textbook model of perfect competition was a contradiction – it implicitly assumed zero transactions costs – which ruled out the possibility of market failure. If coordinating economic activity was costless, then markets could not fail; just as costless central planning, socialism and regulation could not fail. Indeed, subsequent research showed that many of the examples used by economists to illustrate market failure – such as bees pollinating apple orchards (Chueng 1973), trespassing cattle and the provision of lighthouse services (Coase 1974) – were completely misleading, as in the real world firms and individuals had negotiated solutions (see the articles collected in Spulber (2002)).
Coase went on to show that in the unreal world of zero transactions costs the initial legal position, or property rights, did not affect the efficient outcome. The parties would bargain to efficiently resolve otherwise putatively external harmful or beneficial incidental effects. This became known as the 'Coase Theorem', a term coined by George Stigler (1966: 113) though disdained by Coase, which said that 'under perfect competition ... private and social costs will be equal', or to use the words Coase's words (Coase 1959: 27):
the delineation of rights is an essential prelude to market transactions; but the ultimate result (which maximizes the value of production) is independent of the legal decision, when transactions costs are zero.
The logic of the Coase Theorem rides on the rails of the opportunity cost concept 'that a receipt foregone [sic] of a given amount is equivalent to a payment of the same amount'. This concept, while central to modern economics, derived from a different view of costs then circulating at the London School of Economics (LSE) which had not influenced mainstream economics at the time.
The theorem is easy to explain. Suppose that there is a factory belching out smoke causing discomfort, illness and irritation to the surrounding residents. If the law bans the factory emitting smoke without the agreement of the residents, the polluting factory must negotiate permission from the residents or pay compensation. The factory's profit and loss account directly takes into account the monetary costs of the harm. If the factory owner has the right to belch out smoke, the market failure approach claimed that he would not bear the costs of the harm – there would be a divergence between private and social costs, and the market will have failed. Coase pointed out that if bargaining was costless and the parties acted rationally, the victims would pay the factory to reduce the level of smoke to the point where the payment offered equalled the marginal profit that the factory gained from belching out less smoke. At the margin the factory owner would face the costs of the incremental harm in terms of the forgone payment from the residents to reduce the level of smoke a further unit. In each case the social costs of smoke are taken into account by the factory owner and residents.
The Coase Theorem generated considerable controversy (Veljanovski 1977, 1982). It strikes nearly everybody on first hearing as wrong, and subsequently as a tautology or theoretical special case. But its logic is impeccable. Most commentators never got beyond treating the theorem as an extreme market manifesto – that markets would resolve all social evils – so long as government clearly defined property rights. While Coase is largely known for the Coase Theorem, a fact that perplexed and disappointed him, and as setting out a market manifesto, his work points to the power of private solutions, and against the abstract and unreflecting support for government intervention.
Notwithstanding the counterintuitive and novel nature of the theorem, it was emphatically not central to Coase's economics. He was merely showing that the standard approach was flawed. As Coase (1998: 174) said: 'The world of zero transaction costs has often been described as a Coasian world. Nothing could be further from the truth. It is the world of modern economic theory, one which I was hoping to persuade economists to leave'.
The 'world of zero transactions costs' was the springboard for a more profound and, as Coase argued, fairly obvious reorientation of applied economics (Coase 1960: 27):
A better approach would seem to be to start our analysis with a situation approximating that which actually exists, to examine the effects of a proposed policy change and to attempt to decide whether the new situation would be, in total, better or worse than the original one. In this way, conclusions for policy would have some relevance to the actual situation.
It would clearly be desirable if the only actions performed were those in which what was gained was worth more than what was lost. But in choosing between social arrangements within the context of which individual decisions are made, we have to bear in mind that a change in the existing system which will lead to an improvement in some decisions may well lead to a worsening of others. Furthermore we have to take into account the costs involved in operating the various social arrangements (whether it be the working of a market or of a government department) as well as the costs involved in moving to a new system. In devising and choosing between social arrangements we should have regard for the total effect. This, above all, is the change in approach which I am advocating.
'Social cost' developed other very important propositions and implications which have, in my view, largely been overlooked.
The first is the principle of reciprocality. Coase emphasised that the typical problem of law and economics is a reciprocal one. Resources are scarce, activities clash; interests conflict, and to protect A's interest is to limit B's interests. 'The problem we face in dealing with actions which have harmful effects,' stated Coase (ibid.: 1), 'is not simply one of restraining those responsible for them. What has to be decided is whether the gain from preventing the harm is greater than the loss which would be suffered elsewhere as a result of stopping the action which produces the harm'.
A corollary of the principle of reciprocality is the irrelevance of causation. The question 'who caused the harm or accident' is from an economic viewpoint irrelevant. Both parties 'caused' the harm, in the sense that if one withdrew from the interaction there would have been no harm. Harm is the result of the confluence of two or more activities at a particular point in time. This contrasts with the approach of economists prior to Coase's analysis (and still today) who based their policy prescriptions on physical cost (or benefit) causation. The Pigovian approach took the view that if A harmed B, then the external costs were attributable to A. This overlooked the fact that the better response may be to remove B from being a victim. For example, a bridge collapses onto a house. It would be extreme to suggest that the victim was responsible or could have prevented the accident. But the issue is not the immediate question of who could have prevented the accident but whether the losses would have been less had the house not been built close to the bridge. This is not to dispute the importance of physical causation or moral precepts surrounding harm, only that from an economic viewpoint causation is not the key factor in determining whether the two incompatible activities should co-locate, and which party should take any avoidance action.
This view of the legal and economic problem leads to two important subsidiary tenets:
• Joint costs. Since an accident or harmful activity is jointly caused, the loss is the joint cost of both activities. The implication is that efficiency requires both activities, either explicitly or in the opportunity cost sense, to bear the full costs of external harmful actions.
• Cheapest cost avoider need not be the cost bearer. The party who can most efficiently avoid harm need not be the one who bears the cost of doing so. This falls out of the Coase Theorem, which shows that the efficient outcome occurs irrespective of which party must pay for the reduction in harm. In the pollution example above, the party best able to reduce the level of pollution did so whether required to pay compensation or offered payment by the victims. That is, there was an economic symmetry between the polluter pays and victim pays approaches. Real-world examples of the latter abound: governments pay subsidies to industry to abate pollution, and bounties to farmers to cut back excessive production. In this sense economics has no notion of 'harm' and 'benefit', suggesting that these notions really reflect distributional values.
Coase's impact
Coase's work did not lead to a revolution in economics or public policy in the same sense that Keynes' General Theory did. Yet it did progressively stimulate two distinct intellectual developments: New Institutional Economics on the one hand and the economic analysis of law on the other. As Coase commented in his 1991 Nobel Prize acceptance speech, while Social Cost had a considerable impact on legal scholarship, it had been largely neglected by economists. Nonetheless, even though Coase effectively stopped writing over four decades ago and his contribution rests on two articles, he remains the most cited economist in law and economics, and his influence the most durable.
Notwithstanding this, arguably one of Coase's greatest contributions came as editor from 1964 to 1982 of the Journal of Law and Economics, where he fostered a generation of scholarship based on his research agenda. In March 1993 the Journal of Economic Literature, published by the American Economic Association, introduced 'Law and Economics' as a separate classification formally recognising the field among economists.
New Institutional Economics (NIE)
Coase's work was picked up most notably by Douglass C. North (1999) and Oliver Williamson (1975, 1985, 2009a,b), both of whom went on to receive Nobel Prizes in 1993 and 2009 respectively; North with Fogel 'for having renewed research in economic history by applying economic theory and quantitative methods in order to explain economic and institutional change' called the New Economic History or Cliometrics; and Williamson (and Elinor Ostrom) 'for his analysis of economic governance, especially the boundaries of the firm'.
Williamson's work in particular examined the organisational structure of firms and contracts through the prism of transaction costs. He observed that Coase had left his central transaction cost concept 'non-operational'. Although Coase gave transaction costs a practical definition, they remained something of a theoretical artefact, almost tautologically defined as the frictions that prevented efficient outcomes. Coase (1998b: 6) later said that: 'Dahlman crystallized the concept of transaction costs by describing them as "search and information costs, bargaining and decision costs, and policing and enforcement costs"' (Dahlman 1979). Williamson expanded the taxonomy of transaction costs (to include information costs, risk and uncertainty, asset specificity, strategic behaviour and opportunism) in order to investigate firm behaviour and institutional arrangements. Like Coase's work on the firm, his analysis showed that real-world institutions and contracts could be explained as efforts by the parties to reduce transactions costs. This has led to the type of 'microanalytical' empirical research advocated by Coase.
It should be added that others contributed to the NIE agenda, in particular the work on property rights associated with Furubotn and Pejovich (1974), Demstez (1964, 1968), Alchian (1961, 1967), Alchian and Demsetz (1973), Dale (1968), and others.
Even within the NIE school, Coase proved a renegade. The work of Oliver Williamson expanded Coase's work on the firm and contract to focus particularly on asset specificity, which he argued led to 'large switching costs', 'lock-in', 'holdout' and 'opportunism'. Williamson's idea is simple. Assume that in order to win a contract a firm must invest in capital equipment specific to its customer's requirements – such as a specialised press which can only be used to make a component for this customer. Ex ante the parties negotiate and reach a set of terms and price which reflects a commercial balance between the two. During the negotiations the supplier has committed no funds and has the option of walking away. But once the firm invests in the specific asset, it is locked into the arrangement in the sense that the salvage value of the asset is much less than its initial capital costs. Anticipating lock-in, the parties should frame their contract to reduce ex post opportunism, but the supplier will always be vulnerable with a real risk of contract failure and inefficiency.
(Continues...)
Excerpted from Forever Contemporary by Cento Veljanovski. Copyright © 2015 The Institute of Economic Affairs. Excerpted by permission of The Institute of Economic Affairs.
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