Ronald Coase, the Unexpected Economist

Coase’s fame was built on two articles, though he wrote a few more of great import. The first famous one was titled “The Nature of the Firm,”2 written when he was twenty-six. There he introduced the idea of ‘transaction costs’ or as he put it “that there is a cost of using the price mechanism,” to explain why there are islands of command organization within a sea of market exchanges. This is illuminating as a general thought but Coase was not content with that. The use of the concept of transaction costs by some economists seemed to him often to be circular. The kind of economics of the firm he wanted to see was along the lines of the research pursued by his disciple Oliver Williamson in The Economic Institutions of Capitalism,3 for example.

Thus, when accepting an honorary doctorate from the University of Missouri, Coase took as his theme “Why Economics Will Change.”4 He was unhappy that economists do not study the working of economic systems with all their interrelationships but were content with taking the social system as given. They were incapable of dealing with systemic change. Thus, they were seemingly impotent when trying to predict the size of firms after the great fall in transaction costs brought about by the Internet. On the one hand, cheaper information would help smaller firms prosper in the wide market; on the other hand, easier internal communications would allow large firms to become bigger. This was for him an indication that in such situations mere reasoning would not help. Foreseeing what would actually happen demanded much detailed empirical work on market structures, on service contracts, and on the internal organization of firms.

The trend of economics was towards applying price theory to explain social questions. The contrary was needed, he thought. Economics “is still the subject that Adam Smith created. It has the same shape, the same set of problems.” Empirical work was needed but of the kind that “actually changes the way we look at the problem.”

… transaction costs depend, as we learned from the new institutional economics, on the working of the legal system (the system of property rights, the enforcement of property rights, the ability to foresee what the legal decisions will be, and so on). They also depend on the political system, they depend on the educational system, and they are interrelated with other social systems. And in consequence, economists should enlist the support of lawyers, sociologists, anthropologists, and others in our work in order to understand why transaction costs are what they actually are. It’s the opposite of economic imperialism.

We shall see Coase apply this kind of vision to the analysis of China’s way towards capitalism.

The same down-to-earth kind of analysis he applied to the organization of the radio-electric spectrum. George Stigler once said that an economist justified the earnings of his whole life by delaying a bad law even for one day. Coase was material in undoing a bad law forever with his 1959 article on the Federal Communications Commission monopoly of the airwaves. As he was wont to do, he applied elementary microeconomics to solve an apparently intractable administrative question: how to administer a limited resource ‘fairly’ through direct state intervention rather than though a defective price system.

The administrative apportionment of the radio-electric spectrum started in 1927 with the “Radio Act.” It set up a Federal Commission to share out radio licenses on the basis of “public interest, necessity or convenience.” Those licenses were not tradable unless the Commission approved. Later this system was naturally extended to television.

This was the kind of problem he liked to tackle: untying an apparently intractable institutional knot with a piecemeal solution. Political life is riddled with attempts to steer society towards fairness, equality, happiness and leaving it the worse for the attempt—even when those aims are sincerely pursued. The way to sweep those cobwebs away is to free individual action and open the way to healthy self-interest. Coase proposed that licenses should be leased to the highest bidder and be made fully transferable. In the 1980s auctioning of radio waves was finally introduced.

The Coase Theorem

Coase’s most famous contribution to economics was his criticism of the idea of market failure caused by pervasive ‘externalities.’ Arthur Pigou (1877-1959), in his The Economics of Welfare,5 had posited the widespread existence in market economies of indirect effects of economic activity, not reflected in prices. Producers caused harms and consumers obtained benefits they did not pay for. This led to excessive production of ‘bads’ and too low a demand for ‘goods’ which distanced the economy from its optimum. The profession took it as an incontrovertible truth that a market economy would normally ail from the proverbial uncontrolled smoke-stacks and unrewarded research laboratory, calling for correction by taxes and subsidies.

In a past column I related the 1959 dinner at the house of Aaron Director where Coase convinced the luminaries of the Economics Department of the University of Chicago that Pigou was wrong.6 The market could be relied on to find a solution for such external effects through spontaneous agreements between the parties concerned. This idea Coase expounded in his other famous article “The Problem of Social Cost,”7 where he dealt with unprovoked harm inflicted on a third party. The case is well known. A doctor in his surgery is disturbed by the installation of an adjoining noisy confectionery workshop. The traditional reaction would be to restrain the late-coming confectioner from disturbing the doctor in his auscultation. But Coase shows that this could be a mistake; the situation should be taken whole and the less valued activity made to give way to the more profitable one—and this could well be the confectioner. A market transaction could solve the externality problem, with the doctor paying for a noise abatement contraption if he did not wish to move.8

The next step in Coase’s reasoning is that “the problem would be solved in a completely satisfactory manner when the damaging business […] has to pay for all the damage caused and the pricing system works smoothly (strictly this means that the operation of the pricing system is without cost).” (Coase, The Problem of Social Cost,” page 2.)

First, it is important to understand that who the ‘harming’ party is may not be evident. The value of both activities “has to be looked at in total and at the margin.” In the example above, the doctor could be the damaging business if the confectionery contributes most to the aggregate value.

Secondly, we must analyze the condition that ‘the pricing system works smoothly’ with great care. This clause implies that his reasoning is really applicable only to a perfectly competitive situation, where the contestants quickly come to an agreement because they can easily find alternative outcomes. Absent perfect competition, a game would start where the parties tried not to reveal their preferences, and the optimum, which, according to the received view, is clearly visible to an outside party, could not be reached. If indeed the optimum were clearly visible to an all-seeing arbiter, a Court could adjudicate the optimum outcome.

Thirdly and to confuse matters even more, Coase added in parentheses that another way of saying that the pricing system worked smoothly meant ‘that the operation of the price system is costless.’ This has generally and wrongly been understood as meaning that market solutions to correct externalities are conditional on transaction costs being zero, which can really never be the case.

Fourthly, textbooks add another condition to there being a market solution to externalities. This is that property rights be well defined previously to the conflict arising. It is assumed that a transaction to solve the externality cannot reach a definite conclusion if the doctor, in the case above, has no title to his surgery of the confectioner is a squatter.

Even Coase was sometimes heard to say that it had taken him years fully to understand his theorem. This must be so, because towards the end of his life, when he wrote his book on how China became capitalist with Ning Wang, he tacitly relied on an interpretation of the Coase theorem which does not assume perfect competition nor zero transaction costs nor well defined property rights!

Enter Buchanan

Before we understand how Coase widened his interpretation of the Coase Theorem, both in his article on light house economics and in his book on China, we must give the floor to James Buchanan. In 1984 he wrote an article titled “Rights, Efficiency and Exchange” with the subtitle “The Irrelevance of Transaction Costs.”9 Now, this is a real shocker! What could Buchanan have meant?

He started, as was his wont, by denying that optima were observable. The fallacy in ordinary formulations of the Coase Theorem was that the optimum can be objectively defined. It was wrong to define a situation as beset by externalities because an objective optimum had not been reached. “It is unfortunate [he said] that Coase presented his argument […] largely in terms of presumably-objectively measurable and independently-determined harm and benefit relationships.” It was a mistake to think “that an ‘efficient’ […] allocation exists and becomes determinate conceptually to any external observer.” An external observer could not determine whether a trade fell short of an optimum. Each transactor discovered what was an optimum for him or her and accordingly when he came or failed to come to an exchange. Realized trades, whether under conditions of perfect competition or not, must be optimal, though the institutional framework may not be. So that the clause in parentheses criticized above, adds Buchanan, should have been worded as a condition that “the pricing system works without interference,” not that “it is without cost.” (Note 13) Whether transaction costs are high or low is irrelevant for the decision to execute or not the trade in question: it will be optimal “given the institutional setting.” (Buchanan, page 264.)

Now, this seems to be a fiction out of Candide, where everything is for the best in the best of possible worlds. Not so, says Buchanan. When the parties to a transaction discover that they are not satisfied with the agreement reached they will try to change the institutional framework in which they operate, as long as they can negotiate without political interference. “If the initial [institutional] constraints are deemed to be ‘inefficient’ potential traders will, themselves, find it advantageous to invest resources in efforts to shift them.” (Pg. 268)

We must now see whether Coase himself came to see the conditions for the correction of externalities as evolving by agreement and custom when the authorities do not interfere unduly with deals in the market.

External effects illuminated

In his much debated article “The Lighthouse in Economics”10 Coase showed how the market could quite satisfyingly deal with external effects. He started by quoting quite a number of economists starting with John Stuart Mill and proceeding to Sidgwick, Pigou and Paul Samuelson, who considered that lighthouses should be subsidized or operated by Government as they supplied a useful service that went unrewarded because no compensation could be levied on ships at sea. Conclusion: no right thinking entrepreneur would dream of undertaking such a ruinous business. But Samuelson went even further: no toll should ever be charged, for even if they be levied on all ships benefiting from this service, the very fact of charging a price would discourage some ships from sailing in those waters when the marginal cost of sending signals to one more ship is zero.

With typical attention to detail, Coase went back into the history of lighthouses in Britain and showed that they mostly had been built and operated by private adventurers and that, when it was decided to nationalize them all through an institution called Trinity House, a goodly price had to be paid for they were good business pace Samuelson. Thus, in 1820, twenty-four lighthouses belonged to Trinity House and twenty-two were private; but many of those belonging to Trinity House had been originally built by private enterprise.

There remains the matter of tolls. How could ships at sea be charged for the service? Even if the marginal cost of serving one more ship was zero, somebody had to pay for the average cost. The answer was found by having the port authorities charge the ships by inspecting their logbooks when they berthed at port. Those that passed without stopping could be safely ignored since the marginal cost of servicing them was zero.

In sum, not all users of a service need be charged for that service to be profitable; and with a little ingenuity all concerned could agree on an institutional arrangement to make it possible to use and to pay for a service crippled by external effects.

Evolution towards capitalism in China

I warmly recommend Coase’s and Wang’s book for the extraordinary tale they recount. From the outside, China’s transformation is astounding; from the inside as told in this book it is nothing short of miraculous. There was not a moment when it could be taken for granted. The freeze after the Tianamen massacre in 1989 seemed to put the whole process in danger. The future is not free of danger, especially in view of the parlous state of Chinese banks—aside from the difficulties of moving towards more personal and political freedom.

From the point of view of this paper, the interest of the book lies in its thesis: that the transformation of China from a socialist tyranny into a sui generis capitalist economy was not planned by the Communist Party and the different Governments that ruled the country after Mao. It was the unintended result of a policy aiming at the preservation of socialism by fostering growth and the consequence of the unexpected expansion of what the authors call “the four marginal forces.” The Chinese leaders were content to tolerate a measure of private activity as long as they kept control of state enterprises; and thus “private farming, township and village enterprises, individual entrepreneurship, and the Special Economic Zones” enjoyed an increasing degree of economic freedom as long as they did not threaten official socialism. (Coase and Wang, page 164.)

The transaction costs for individual entrepreneurs in a communist society must have been almost insurmountable, especially in the beginning, when downright corruption and capitalist business were almost indistinguishable. Market solutions were found by agreements between private people. Also, as the authors underline:

China did not first delineate property rights, specify other relevant institutional rules and then allow market forces to allocate rights to the highest bidder. […] As economic conditions changed over time [… the] State was thus frequently called to revise and redefine the structure of rights. […] (Coase and Wang, pages 172-173.)

In sum: there were two parallel tracks of reform in China, both following unexpected paths. It is clear that Coase saw this book as an example of the kind of economics he hoped an increasing number of economists would follow: an open mind as to theory and close attention to real data. Whatever one may think of his research program there is little doubt that the world of economics is different for the long stay of Ronald Coase in our midst.