This year marks the 100th anniversary of the publication of Ludwig von Mises’s seminal article, “Economic Calculation in the Socialist Commonwealth,” which marked the first salvo in what later became the socialist calculation debate. Though the contributions of F.A. Hayek to that debate, and to economic science more broadly, have been well recognized, what is somewhat forgotten today is that the fundamental contributions of another economist were also born out of the socialist calculation debate. I am referring to none other than Ronald Coase.
As Coase outlines in his Nobel Prize Address, he had been a student of Arnold Plant in the Department of Commerce at the LSE, who introduced him to Adam Smith’s invisible hand, and the role that the price system plays in coordinating the allocation of resources to their most valued uses without central direction. The insights of Coase, like Mises, were both motivated from the attempt by the Bolsheviks to implement central planning in Soviet Russia. As Coase writes, “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,” a claim first put forth by Mises in his 1920 article. “And yet there were factories in the West, and some of them were extremely large. How did one reconcile the views expressed by economists on the role of the pricing system and the impossibility of successful central economic planning with the existence of management and of these apparently planned societies, firms, operating within our own economy?” The answer put forth to this puzzle was what Coase referred to as the “costs of using the price mechanism,” (Coase 1992, 715). This concept, which later came to be known as “transaction costs,” was first expounded in his seminal article, “The Nature of the Firm” (1937) and later developed in subsequent articles, “The Federal Communications Commission” (1959) and “The Problem of Social Cost” (1960). But, it is interesting to note that Coase also states that “a large part of what we think of as economic activity is designed to accomplish what high transaction costs would otherwise prevent or to reduce transaction costs so that individuals can freely negotiate and we can take advantage of that diffused knowledge of which Hayek has told us” (1992: 716).
My point here is not to trace the historical origins of the parallel insights drawn by Mises and Coase, or other economists working in the Austrian tradition and the transaction-cost tradition for that matter. Rather what I wish to suggest here is that what Coase (not just Hayek) had been stressing in his insights learned from the socialist calculation debate cannot be fully appreciated without placing his contributions in the context of what Mises had claimed regarding the problem of economic calculation. Reframed within this context, I would argue that the concept of transaction costs can also be understood as the costs of engaging in economic calculation. However controversial my claim may seem, this reframing of transaction costs as the costs of associated with economic calculation has a precedent that can be found not only in Coase, but also in more recent insights made by economists working in the Austrian tradition (see Baird 2000; Piano and Rouanet 2018).
How do transaction costs relate to the problem of economic calculation? According to Coase, the most “obvious” transaction cost is “that of discovering what the relevant prices are” (1937: 390). The costs of pricing a good (i.e. transaction costs) are based, fundamentally, on the costs of defining and enforcing property rights in order to create the institutional conditions necessary for establishing exchange ratios, hence prices, in the first place. This also entails not only cost of negotiation and drawing up contracts between trading partners, but also discovering who are the relevant traders partners are, as well as discovering what are the actual attributes, such as quality, of the good or service being exchanged.
Carl Dalhman (1979) argues that all such transaction costs can be subsumed under the umbrella of information costs, but the nature of such information is not one that can be obtained only through active search per se, as if all such information is already “out there” and therefore acontextual. Rather, the very nature of such information is not just tacit and dispersed (Hayek 1945), but contextual (see Boettke 1998). The discovery of relevant trading partners, the valuable attributes of a good being exchanged, and the price to which trading partners agree, emerges only within a context of exchangeable and enforceable private property rights. This last point is precisely the argument that Ludwig von Mises had meant in his claim that economic calculation under socialism is impossible! Outside the context of private property, subjectively held knowledge cannot be communicated as publicly held information without first establishing the terms of exchange in money prices to allocate resources to their most valued uses.
In his Presidential Address to the Society for the Development of Austrian Economics, published in The Review of Austrian Economics as “Alchian and Menger on Money,” Charles Baird (2000) best illustrates the point I’m making here. Carl Menger (1892) and Armen Alchian (1977) had made distinct, though complementary stories as to why money emerges spontaneously, namely to reduce transaction costs. Menger argued that money emerges to avoid the costs associated with the double coincidence of wants between exchange partners. On the other hand, Alchian emphasized that money emerges to reduce the costs of calculating and pricing the value of the various attributes of a good, such as in comparing the quality of different diamonds. Money prices reduce the costs of pricing the quality of diamonds, thereby providing information, discovered by middlemen, to non-specialists about what kind of diamond they are purchasing (i.e. higher quality or lower quality). As Baird writes, “Menger’s story is incomplete. But so, too, is Alchian’s. On the other hand, both stories are complete on their own terms. Clearly what is needed is someone to put these two stories together” (2000: 119). Thus, reframing transaction costs from an Austrian perspective, money, firms and other institutional arrangements emerge to reduce the costs associated with economic calculation.
In a lecture written to honor F.A. Hayek in 1979, later published posthumously in The Review of Austrian Economics, James Buchanan boldly declared the following: “The diverse approaches of the intersecting schools [of economics] must be the bases for conciliation, not conflict. We must marry the property-rights, law-and-economics, public-choice, Austrian subjectivist approaches” (Buchanan 2015: 260). The link that “marries” these distinct schools, including the Austrian School, is the notion of transaction costs. However, this underlying link cannot be understood without first reframing, I would argue, the concept of transaction costs as the costs of engaging in economic calculation. The “marriage” of these intersecting schools, as Buchanan and others have suggested, highlights distinct aspects of the economic forces at work in the market process, as well as the alternative institutional arrangements that emerge to reduce the cost of transacting and thereby exploit the gains from productive specialization and exchange.
Rosolino Candela is a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics, and Associate Director of Academic and Student Programs at the Mercatus Center at George Mason University
References
Alchian, Armen A. 1977. “Why Money?” Journal of Money, Credit and Banking 9(1): 133–140.
Boettke, Peter J. 1998. “Economic Calculation: The Austrian Contribution to Political Economy.” Advances in Austrian Economics 5: 131–158.
Buchanan, James M. 2015. “NOTES ON HAYEK–Miami, 15 February, 1979.” The Review of Austrian Economics 28(3): 257–260.
Coase, Ronald H. 1937. “The Nature of the Firm.” Economica 4(16): 386–405.
Coase, Ronald H. 1959. “The Federal Communications Commission.” The Journal of Law & Economics 2: 1–40.
Coase, Ronald H. 1960. “The Problem of Social Cost.” The Journal of Law & Economics 3: 1–44
Dahlman, Carl J. 1979. “The Problem of Externality.” The Journal of Law & Economics 22(1): 141–162.
Hayek, F.A. 1945. “The Use of Knowledge in Society.”
Menger, Karl. 1892. “On the Origin of Money.” The Economic Journal 2(6): 239–255.
Mises, Ludwig von. [1920] 1975. “Economic Calculation in the Socialist Commonwealth.” In F.A. Hayek (Ed.), Collectivist Economic Planning (pp. 87–130). Clifton, NJ: August M. Kelley.
Piano, Ennio E., and Louis Rouanet. 2018. “Economic Calculation and the Organization of Markets.” The Review of Austrian Economics, https://doi.org/10.1007/s11138-018-0425-4
READER COMMENTS
Phil H
Jun 3 2020 at 9:03pm
This is a great argument:
“such information is…tacit and dispersed…emerges only within a context of exchangeable and enforceable private property rights.”
But it’s also a bit circular. Because if “The costs of pricing a good (i.e. transaction costs) are based, fundamentally, on the costs of defining and enforcing property rights” – but a system which did not seek to define and enforce property rights would not generate those costs.
I assume a socialist would respond: The capitalist first demands that we take perfectly ordinary information (“I would like to eat some chicken”) and recast it in the form of “property rights” (“I would like to purchase ownership of the property rights in this chicken”) and then devises a byzantine system of “market pricing” which she claims we must all participate in, because it is the only way to encode and decode information. But if we just talked to each other, none of this is necessary.
More within the political mainstream, the admission that the costs of a thing (or its property rights) are not independent of the system, but are an artifact of the system, is exactly what moderate lefties are getting at. The nature of money and the legal and economic systems around us affect prices, sometimes decisively, not human needs. So a society that aims to meet human needs will sometimes have to intervene to make sure that its economic systems are not skewing prices too much.
Jon Murphy
Jun 3 2020 at 9:43pm
Not really. Those costs still exist, but are significantly higher, as Rosolino (and Alchian, Coase, Demsetz, etc) explain,
Mark Z
Jun 4 2020 at 2:18pm
The cost of the transaction doesn’t disappear when you stop having prices or property. If a transaction is so costly that it’s not worth it to even try to market a good at a price anyone would be willing to pay, then it’s still not going to be worth it to try to allocate it by ‘just talking to each other.’ It’s not that having property, a market, prices, etc. is what makes the interaction burdensome, but that the burdensomeness of the interaction that adds to the cost and price. A hypothetical central planner (or subsidizer or regulator) faces the same issues with assessing the value of a possible transaction to participants as the frustrated market participant who refuses to provide a good because it’s not worth it to find out how much its worth, or just doesn’t bother pricing it and provides it for free auxiliary to some other good (e.g., Starbucks bathrooms).
Phil H
Jun 5 2020 at 12:19am
Mark, you’re probably right, but I’m trying to work within the framework that the OP set up. She writes:
”The costs of pricing a good (i.e. transaction costs) are based, fundamentally, on the costs of defining and enforcing property rights”
Mark Z
Jun 5 2020 at 1:43am
I read that as basically saying: in order for transactions to take place, we need enforceable property rights, so the higher the cost of enforcing property rights, the higher the transaction cost; not that imposing property rights increases the cost of a transaction, but that they are a cost that must be met for the transaction to happen at all. Of course that’s not entirely true, people buy and sell drugs despite not being legal property, but legalizing drugs would surely reduce the transaction costs and we’d see a much larger market.
Phil H
Jun 7 2020 at 11:27am
I mean… OK… maybe. The problem with the argument here is that she writes on behalf of a think tank. I think that the people who are paid to *think tank* should be *a lot* better at this. If she means what you said, she should have said it. If she means what she said, then there’s a fairly big hole in her logic, that I’ve pointed out.
You’re just an anonymous guy on the internet (as am I), and what you’ve said sounds… fine, for anonymous guys on the internet. I don’t expect any more precision out of you. But if she’s being paid to think like a tank, I want to see a lot more firepower in her thinking.
SaveyourSelf
Jun 4 2020 at 9:50am
Phil H’s comment about Rosolino Candela’s argument sounding circular felt near the mark and got me thinking.
“Property rights” define who has the authority to ration particular resources.
Money is an extremely complex and confusing tool. Fortunately money is not required to understand transaction costs or prices so I will dispense with it for this discussion.
Say I want to buy oranges and I have straw to sell. Finding one or more growers of oranges is a transaction cost. Further narrowing them down to growers who are willing to trade their oranges for my straw is another transaction cost. Traveling to each grower to communicate or exchange goods contains multiple costs including time and energy, which are also rightly thought of as costs of the transaction (even if no trade ever occurs). And this list of transaction costs is nowhere near comprehensive. I suspect the list of transaction costs for any single transaction is literally infinite. The take home is that transaction costs include everything that I must give up in order to make a trade of oranges for straw occur including the straw. This definition is identical to the concept of opportunity cost in economics.
It seems to me that Rosolino Candela has relabeled rationing, both from the center and from individuals, as economic calculation. I find the phrase “economic calculation” inherently confusing, so I’ll use “rationing” instead, which I believe–after reading her paper a couple of times–has the same meaning. Thus Candela’s argument, rephrased, comes out “The concept of transaction costs can also be understood as the costs of engaging in rationing.” Which is not a controversial claim at all. It is a restatement of the definition of transaction costs. And this makes Cadnela’s later statement clearer as well. “Thus reframing transaction costs from an Austrian perspective, money, firms and other institutional arrangements emerge to reduce the costs associated with rationing.”
Given the above definitions, this sentence “The costs of pricing a good (i.e. transaction costs) are based, fundamentally, on the costs of defining and enforcing property rights in order to create the institutional conditions necessary for establishing exchange ratios, hence prices, in the first place” doesn’t make sense. And not just because it is confusing, but because, at least in some circumstances, it is wrong. The costs of pricing goods are, indeed, transaction costs, but the costs of defining and enforcing property rights is not the basis of those transaction costs. Defining and enforcing property rights is simply additional transaction costs in an infinitely large set of costs associated with rationing said good. A separate concept included in the same sentence relates to exchange ratios. In order to have an exchange, there must be at least two parties, each with individual property rights. It makes no sense to consider an exchange ratio with yourself over two items you already own. Such an “exchange” has no meaning. For an exchange to have meaning, there must be at least two parties each with distinct property rights. Thus “defining and enforcing property rights” is necessary for “establishing exchange ratios, hence prices, in the first place,” but “the cost of defining and enforcing property rights” is not a comprehensive basis for defining all transaction costs.
For similar reasons, Candela’s sentence “The discovery of relevant trading partners, the valuable attributes of a good being exchanged, and the price to which trading partners agree, emerges only within a context of exchangeable and enforceable private property rights,” is also at least partly wrong. Transaction costs are opportunity costs. And opportunity costs are present even in the absence of exchangeable and enforceable private property rights. To give an extreme example, if there were only a single person alive on an island, foraging for food on that island would still count as opportunity costs even in the absence any exchange, rights, or property. None of those terms have meaning in a world with only one person. But opportunity cost still does!
Jon Murphy
Jun 4 2020 at 10:10am
Transactions like that occur all the time. They’re called “savings.” The interest rate is the exchange ratio.
SaveyourSelf
Jun 4 2020 at 11:37am
Pay interest to yourself? I’m not following.
Also, an exchange is a transaction but a transaction is not necessarily an exchange. Your use of different words makes your statement true but does not contradict mine.
Jon Murphy
Jun 4 2020 at 12:35pm
No. The interest rate is the opportunity cost of saving just like the price is the opportunity cost of consuming. It’s whatever you have to give up
SaveyourSelf
Jun 4 2020 at 1:24pm
“The interest rate is the opportunity cost of saving.”
That’s deep. I’ve never thought about it that way. It is a unique and practical perspective. Thanks for sharing the concept.
Jon Murphy
Jun 4 2020 at 10:13am
Well, no. There are still exchanges (through time), rights, and property. As you stated earlier, property rights decide who has control over what. On the island, the single person has property rights over the island because they decide how to use the resources. They are not formalized but that doesn’t mean they do not exist. Indeed, much of property is informal.
SaveyourSelf
Jun 4 2020 at 12:02pm
“There are still exchanges (through time), rights, and property.”
Rights (in my mind) are contractual obligations. If there is only one person in the world, there can be no contracts and thus no rights, including property rights. Assuming rights or inferring property rights assumes/infers the existence of other people, which violates the given presumptions of the scenario.
Exchange (at least in my head) is a change/alteration in property rights. Even if you assume informal property rights to the single person living there, that person moving objects on the island around would not qualify as an exchange using that definition, because, to the extent there are any informal or assumed property rights, they haven’t been altered–no change in ownership has occurred. To make it false would require broadening the definition of exchange to include any change in space, time, etc. unmooring “exchange” from its relationship to property rights. Which is reasonable and logical in a universe without property rights, but different from the point I was making.
I guess property still exists on the island. So you’re right about that. I was mistaken on that point.
Jon Murphy
Jun 4 2020 at 12:35pm
Ok, but that’s not how you defined it earlier: “‘Property rights’ define who has the authority to ration particular resources.”
SaveyourSelf
Jun 4 2020 at 1:20pm
This is true…
Well done, Jon. Thanks for pointing that out. Now I have to try and reconcile these two definitions so they are both true simultaneously. Hmm…
Rights are contractual obligations. Property rights define who has the authority to ration particular resources. So property rights must be contractual obligations that define who has the authority to ration particular resources. Yes, that works. A deed, for example, is one simple concrete example of a contract delegating the right to ration property. The other party to the contract is everyone else in the society with government acting as their representative.
Jon Murphy
Jun 4 2020 at 1:39pm
What about non-contractual property rights a la Demsetz or Anderson and Hill? Informal property rights exist all the time and in many dimensions. Indeed, as Coase pointed out, sometimes the informality increases transaction costs.
SaveyourSelf
Jun 4 2020 at 1:55pm
The model I’ve described does not require formal, written contracts to define property rights. Informal contracts are common. In fact, they are far more numerous than written contracts. So I take issue with your phrase, “non-contractual property rights”. Informal agreements are still contracts. There is no such thing as “non-contractual property rights”. All rights are contractual by definition.
Jon Murphy
Jun 4 2020 at 2:19pm
Are all agreements between individuals contracts?
Mark Z
Jun 4 2020 at 2:28pm
It sounds like what you’re getting at is social contracts, perhaps. Property assignment by (more or less) universally agreed upon standards that don’t require explicit statement.
SaveyourSelf
Jun 4 2020 at 5:46pm
Jon Murphy, yes, the noun forms of the word agreement are all contracts. I can’t find anything in Webster’s dictionary that would contradict that statement.
Mark Z, social contracts, as I understand them, are simply multiparty contracts. So, yes, our conversation here includes them under the broad umbrella of contracts in general. That said, I believe there is a special, unique Social Contract [indicated here and hereafter using capital letters] that is the foundation of any society. That Social Contract is a multiparty contract involving all citizens. In fact, that particular Social Contract defines what it means to be a Citizen– ie. citizens’ contractual duties and rights — within their society. The most important overlooked aspect of said Social Contract (or Citizens’ Agreement) is that it is exclusively between citizens. It is not between citizens and their government. Government is the group of individuals that citizens hire to specialize in enforcement of the obligations of the Social Contract. Citizens’ contract with a government is separate from their Social Contract. Thus the US Constitution is not the Social Contract. That said, the US Constitution contains much of the language and meaning of the actual Social Contract underneath it. That makes sense since, typically, government employees are also Citizens–though not always–and because the primary purpose of a government is satisfaction of the terms of the Social Contract, so much so that much of the language and meaning of the Social Contract would necessarily be spelled out in a Constitution. The items in the US Constitution that relate to the function and payment of government employees are unique to the Constitution and not part of the Social Contract.
The Citizenship Agreement is one of my favorite topics, one of the most important if not the most important concept in all of economics and politics, and one of the least well acknowledged or understood. Thanks for bringing it up.
Jon Murphy
Jun 5 2020 at 9:47am
The very first definition seems otherwise:
A contract can be an agreement, but an agreement need not be a contract (at least, not without stretching the definition of “contract”).
If I agree to drive my roommate to the airport, not for money or anything but just out of friendship, then can we reasonably say that is a contract? It’s not legally binding, which is the definition of a contract.
Furthermore, contracts are explicit (which is an issue I have with social contract theory, but that’s a discussion for another time). Many agreements, such as the division of labor within a household, are not.
I think you’re making a mistake flattening everything down to contract; it’s something a lot of libertarians like to do and I think it is incorrect.
SaveyourSelf
Jun 5 2020 at 9:57pm
Jon, thanks for the reply. I very much enjoy working with you. English is not my strong suit (I’m not being modest. It’s not), but I believe that when the word agreement is used to mean “harmony or accordance in opinion or feeling” that it is an adjective. When”We have an agreement.” Agreement is a noun. Similar to, “that is a line” where line is the noun. But when “Our feelings are in agreement.” Agreement describing some feelings. Feelings is the noun. Agreement is an adjective. Same structure as, “those lines are in parallel.” Parallel is not a noun, it is describing some lines. Lines are the noun. Parallel is an adjective.
This matters because an agreement is a contract only if it is a noun. So I repeat, the noun forms of the word ‘agreement’ are all contracts.
You wrote, “A contract can be an agreement, but an agreement need not be a contract (at least, not without stretching the definition of “contract”).”
I don’t think it’s a stretch. Look up the definition of contract and agreement. Each contains the other in their definition. I don’t know of two words that are closer in meaning. In fact, they have the same meaning. Similes.
“If I agree to drive my roommate to the airport, not for money or anything but just out of friendship, then can we reasonably say that is a contract? It’s not legally binding, which is the definition of a contract.”
First ‘legally binding’ is not the definition of a contract. ‘Legal’ is a second order concept. What is “legal” is defined by underlying first order contracts, chiefly the Social Contract with case law built up from it over time. Contracts can exist before the premise of legality develops.
Second if you agree to drive your roommate to the airport but fail to define what you get from the exchange, that does not mean you got nothing and that no exchange occurred. You may be paying back a past debt to your friend or building reputation with your roommate for the future. In either case, offsetting payment into the past or future does not change the fact that there is an exchange. Or perhaps you just enjoy your roommates company in the present. Or else you feel good giving service to other people. It doesn’t matter if what you get out of the exchange is unmeasurable or undefinable. “Contract law deals with, among other things, the formation and keeping of promises (in Latin, pacta sunt servanda—‘agreements shall be kept’)” (West’s Business Law 6th edition. ©1995. p214.)
“Many agreements, such as the division of labor within a household, are not [explicit].”
Contracts with people who are incompetent—like children—are more challenging for sure, but they still exist and still follow the forms. ‘You do what I say and I will feed and protect you,’ is one side. ‘I will do as you say in exchange for food and protection,’ is the other. A perfectly valid contract. It need not be written. It need not even be understood by both parties. But so long as its terms are reliably upheld, the contract exists. (My first clue to the fact that contracts existed inside families was just before I got married when I noticed my marriage vows seemed remarkably like contractual commitments. And when I studied them closely, I realized they were!)
“I think you’re making a mistake flattening everything down to contract; it’s something a lot of libertarians like to do and I think it is incorrect.”
Jon, you are one of the smart people who haunt Econtalk. You will come around or else you or someone like you will show me something better and I will change my position. But, to date, this is the best, most predictive, most elegant, explanatory tool that I have ever come across or produced. If you know of something better, I honestly can’t wait to hear it. Until then, I think you’ll love this model once you get to know it better. But regardless of the outcome, I look forward to the discussion and I think we will all be better off for it.
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