Who was Ronald Coase? - with Cento Veljanovski

From the IEA comes this video in which Syed Kamall interviews Cento Veljanovski about the work of Ronald Coase.

 

A conversation with Ronald H. Coase

From Newmedia at UFM.edu comes this 2001 video of  A Conversation with Ronald Coase.

A point worth making about the Coase theorem

Economist George Stigler dubbed Coase’s insight the “Coase theorem.” Unfortunately, because Coase called attention to what would happen in a world of zero transaction costs, many have interpreted him to mean that ours was a world of zero transaction costs. In Coase’s words, “Nothing could be further from the truth.”  Instead, he highlighted transaction costs because he believed that in many cases they were significant and he thought it important to understand why.

This is from an interesting new book "Applied Mainline Economics: Bridging the Gap between Theory and Public Policy" by Matthew D. Mitchell and Peter J. Boettke.

It is amazing to me just how many people still don't get this point. Many still think Coase's thinking was about a zero transaction cost world when in fact his whole approach to economics was driven by wanting to understand the implications of positive transactions costs. Firms exist because of positive transaction costs (Coase 1932) and the law matters (the allocation of property rights matters) when there are positive transaction costs (Coase 1960).

Part of this confusion is, I think, due to Stigler's statement of the "Coase Theorem" in terms of a zero transaction cost world:

The Coase Theorem thus asserts that under perfect competition private and social costs will be equal (Stigler 1966: 113).

Perfect competition requires zero transaction costs. This seems to have lead many people to believe Coase thought the real world was a zero transaction cost world. Not so.

Refs.:

• Coase, Ronald Harry (1937). ‘The Nature of the Firm’, Economica, n.s. 4(16) November:386–405.
• Coase, Ronald Harry (1960). ‘The Problem of Social Cost’, Journal of Law and Economics, 3 October: 1–44.
• Stigler, George (1966). The Theory of Price 3rd ed., New York: The Macmillan Company.

Forever Contemporary - The Economics of Ronald Coase

is the title of a new book edited by Cento Veljanovksi from the IEA in London. It provides an introduction to the ideas of Ronald Coase.

A quick summary of the book is

• R. H. Coase (1910–2013), a leading modern figure in the classical liberal tradition, was awarded the Nobel Prize in Economics in 1991 for his analysis of the significance of transaction costs and property rights for the functioning of the economy.
• Before Coase’s work in the 1930s, there was no real understanding of the relation between the theory of the firm and the theory of markets. Coase showed that the size and structure of firms, and the location of the border between internal exchange within the firm and external exchange through markets, are systematically related to the costs of transactions.
• These transaction costs, which Coase termed ‘costs of using the price mechanism’, include search and information costs (those involved in finding business partners, rather than having to produce your own inputs), bargaining costs (which rise sharply with the number of contractual partners) and enforcement costs (which, in the absence of a strong and effective legal framework, depend largely on trust in partners). When these costs alter dramatically, for example, as a result of introducing innovative technology, we can expect substantial alterations in firm and market structures.
• Coase was a pioneer in the modern analysis of environmental issues. He showed that, with clear property rights and low transactions costs, private solutions to many environmental problems can be achieved without government regulation. Such solutions were logically independent of the initial distribution of property rights. This is highly relevant to a number of modern economic problems which the government currently handles badly, such as land-use planning.
• His work has had a profound effect on later generations of economists, several of whom themselves won Nobel Prizes. His work on environmental issues, for example, influenced another Nobel Prizewinner in Elinor Ostrom, whose work focused on how common pool resources could be used effectively with minimal government intervention. This is especially relevant to debates about environmental and ecological degradation in forestry, fishing and game animal resources – perhaps particularly in developing economies.
• Similarly his work on the firm led to the development of the ‘New Industrial Economics’, now associated with Oliver Williamson, which has changed our understanding of issues of economic governance. This is relevant to current concerns over corporate social responsibility.
• Coase’s editorship of the Journal of Law and Economics over many years did much to stimulate economic analysis of legal institutions, an innovation which has had a major influence on public policy, particularly in the US. It has fed, for instance, into recommendations for accident compensation.
• Coase’s insights have challenged economists’ assumptions about the nature of public goods, which he demonstrated could often be provided more effectively by various forms of private initiative. He also illuminated such varied topics as the allocation of spectrum bandwith, the regulation of financial institutions and water resource management.
• Methodologically, Coase was opposed to ‘blackboard economics’ which relied on theory or econometric analysis at the expense of more practical investigation. He favoured careful examination of case studies and the history of industries when analysing economic policy issues.
• His work retains considerable significance in the twenty-first century. Coase’s analysis of China’s economic advance, published shortly before his death, sheds light on its future prospects, while his transaction cost approach can be argued to explain the new phenomenon of the ‘sharing’ economy which is reshaping businesses and employment. Furthermore his work should continue to be at the forefront of debates surrounding regulation, broadcasting and the environment. If policymakers and the economists who advise them ignore Coase, they are in danger of perpetuating policies which may work ‘in theory’ but do not work effectively in practice.

The table of contents reads:

1 Introduction   1
     Cento Veljanovski
     A short biography    1
     Coase’s approach    3
     What of the future?    6
     Contributions   8
2 The economics of Ronald Coase    14
     Cento Veljanovski
     What Coase did    14
     Coase’s impact    23
     New Institutional Economics (NIE)    24
     Economic analysis of law    28
     Economics   31
     Regulation   37
     Antitrust   39
     Spectrum: from wireless to mobile phones    42
     Coase’s legacy    44
3 Ownership, governance and the Coasian firm   46
      Martin Ricketts
      The nature of the frm    46
      ‘ownership’ in the Coasian theory of the frm    49
      The hazards of transacting    52
      Competition and the selection of governance structures   57
      Public policy towards the governance of enterprise    64
      Conclusion   68
4 Coase’s contributions to the theory of industrial organisation and regulation    70
      Alex Robson
      Introduction   70
      The nature of the firm: implications for the theory of industrial organisation    73
      Regulating utilities: the Coasean critique of marginal cost pricing    77
      The hold-up problem: implications for regulation    80
      Regulation and industrial organisation of the communications industry    83
      The development of the radio broadcasting industry in Britain    85
      The allocation of radio frequency spectrum in the United States    86
      Conclusion   89
5 Coase on property rights and the political economy of environmental protection    92
       Mark Pennington
       Introduction   92
       Coase on the problem of social cost    94
       Coasian analysis and the scope for environmental markets   100
       Ethical objections to the extension of environmental markets   108
       Conclusion   116
6 Coase and water    118
       Nicola Tynan
       Introduction   118
       Clearly defned property rights    120
       Integrated water resources management    124
       Conclusion   136
7 The Coase research agenda: public goods, transaction costs and the role of collective action   137
       Stephen Davies
       Introduction   137
       Was the lighthouse a public good?    138
       Conditions for private provision    140
       Coase’s research agenda    141
       Bundling private with public goods    147
       Coase’s way    159
8 Stock exchanges as lighthouses    160
        Philip Booth
        Lighthouses – what does not work ‘in theory’ works in practice   162
        Financial regulation – what does not work ‘in theory’ works in practice    163
        Private regulation and stock exchanges    166
       ‘Big bang’ and ‘deregulation’    172
        The further development of statutory regulation    175
        Could bank regulation be provided by market institutions?   178
        Conclusion   182
        Coda   185
9 Coase and the ‘sharing economy’    187
        Michael Munger
        Introduction   187
        Tomorrow 3.0: rent or own?    189
        The power drill trope: it’s about time    191
        Entrepreneurs can sell reductions in transactions costs   195
        Middlemen as brokers and sellers of connections    197
        Why sell products when you can sell reductions in transactions costs?    200
        Coase’s insight    204
Publications by Ronald H. Coase in chronological order    209

Interestingly in the book Coase is seen as "a leading modern figure in the classical liberal tradition", but this is not how everybody sees him. Bylund (2014), for example, sees Coase's paper "The Nature of the Firm" as a defense of socialist economic planning!!!

And not many people have ever called Ronald Coase a socialist!

For me the "The Nature of the Firm" is one of the - if not the - greatest papers in economics in the 20th century. It is this paper that introduced the idea of transaction costs and lead to the modern theory of the firm. Coase asked the big three questions about the firm: questions about the existence of the firm, the boundaries of the firm and the internal organisation of the firm. It is these questions that have largely driven the contemporary theory of the firm.

Ref.:
Bylund, Per (2014). 'Ronald Coase's "Nature of The Firm" and the Argument for Economic Planning', Journal of the History of Economic Thought, 36(3) September: 305-29.

How to misunderstand the Coase theorem 5

Someone else get it! James Johnson at the Monkey Cage gets the point that the Coase Theorem doesn't apply to the reclining seats in airplanes issue. He writes,

In a recent post Josh Barro provides an example by misinterpreting one theoretical argument commonly known as “the Coase Theorem.”

Barro is commenting on a fracas aboard United Airlines flight 1462 last week. One passenger attached an apparatus to the seat in front of him preventing the woman occupying that seat from activating its recline function. When asked by a flight attendant to remove the apparatus the man refused. This caused mayhem that resulted in the pilot diverting the flight so that both passengers could be removed from the plane and reported to the authorities.

Barro declares himself a frequent flier and unrepentant recliner. He seems genuinely perplexed by the animus toward people like himself, reflected in media commentary, this fracas reveals. In his defense Barro invokes the “Coase Theorem” which, he believes, provides useful advice for how to avoid situations like the one that erupted on United 1462. He poses this question: “If sitting behind my reclined seat was such misery, if recliners like me are ‘monsters,’ as Mark Hemingway of The Weekly Standard puts it, why is nobody willing to pay me to stop?” Unfortunately for Barro, the Coase Theorem does not support the conclusion he draws. If we consider what the Coase Theorem actually says, we won’t be surprised either by the events on United 1462 or by the fact that no one offers Barro money to change his reclining ways.

and

Coase’s argument appears to generalize the virtues of decentralized market exchange, namely voluntary action generating efficient outcomes, to situations of strategic interdependence where markets tend to function poorly, if at all. For it to work, however, two conditions must hold. First, the initial distribution of property rights must be well defined. Second, transaction costs must be zero. This is where Barro goes astray. In the dispute between recliners and reclined upon, neither condition obtains.

Barro recognizes the first condition. He insists that, having purchased a seat with a recline option, passengers “own the right to recline.” Consequently, by installing an apparatus on the seatback in front of him, the man on United 1462, “usurped his fellow passenger’s property rights.” This claim is contestable. What is at issue is increasingly limited space and access to it. And if crew member instructions provide any indication, passengers “own the right” to the space under the seat in front of them where they are told to place their carry-on items. Recliners limit the reclined-upon passenger’s access to that space and any belongings stowed there. Moreover, passengers purchase a seat with a tray table and arguably “own the right” to use it for a variety of purposes. Reclining often interferes with that right as well. The airlines and the government treat recline function and tray tables as equivalent in their safety instructions: “In preparation for landing please make sure your tray table is stowed and your seat back is in the upright and locked position.” Despite his confident assertion, Barro is mistaken to assert that property rights to space for airline passengers are well-defined.

Even if you accept Barro’s view of property rights, what about transaction costs? Here Barro is sloppy. He depicts the dispute between recliners and reclined upon as one where “transaction costs are low.” Coase, however, insists that for his argument to work, transaction costs must be zero. Not low. Zero. Yet the reclined upon face substantial transaction costs. Most obviously, information problems abound, even beyond the ambiguous distribution of property rights. It would be costly to discern which type of person they might be bargaining with. Are they sitting behind an inveterate recliner and who might turn belligerent if asked not to recline, even for a price? Is the passenger in front of them a moralist who will take offense at the very suggestion of treating one another as bargaining partners rather than relying on norms of decency and respect? Other such possibilities are plentiful. Barro simply dismisses such problems because it suits his claim that, if only they would try, the reclined upon could easily buy off recliners like himself.

That property rights to the space around a seat are not well defined is the point I made in my first post on this issue. I am not so sure about Johnson's second point. I would say that transactions are low in that you know who you are bargaining with and its simple to bargaining with them, they are just in front of you. This doesn't mean that bargaining will not be hard. I don't see anything in the Coase Theorem that says bargaining must be easy, it just says whoever values the property right most will end up with it. May be only after some tough negotiations.

How to misunderstand the Coase theorem 4

Continuing with the application of the Coase Theorem to reclining seats in aircraft, Jodi Beggs writes at the Economists do it with Models blog,

Assignment of property rights: To me, it seems pretty clear that the property rights belong to the recliner, for two reasons. First, there is a functional recline button on the chair- when airlines don’t allow you to recline (in front of emergency exit rows, for example), they disable the functionality as opposed to just asking you to not recline. Second, the device used to prevent the seat from reclining is banned, and it’s only a small logical jump from “preventing an activity is banned” to “said activity is allowed.”

My problem here is that just because I have a product that will do X, doesn't mean I have the right to do X. If I buy a gun, which has the ability to shoot people, doesn't mean I have the right to shoot people. As to the second point, the fact that I can't do Y to stop you doing X doesn't mean you have the right to do X. Just because I can't shoot you to stop you peeing on my foot doesn't mean you have the right to pee on my foot.

Beggs goes on to say,

That said, this scenario highlights the fact that it’s not only the assignment of property rights that is important, but also the recognition and respect for said property rights. (When multiple parties believe that they have the property rights, you get coexisting news headlines such as “Don’t Want Me to Recline My Airline Seat? You Can Pay Me” and “Don’t Want Me to Spit on You When You Recline Your Airline Seat? Pay Me.” as opposed to effective bargaining.)

This I think is the real point. If people don't know what the rights are or if different people think the rights have been defined differently, then its as if the rights have not been defined. Without clearly defined, well known  and respected property rights the Coase Theorem doesn't apply.

Of course this just raises the question of why don't airlines delineate rights more clearly?

How to misunderstand the Coase theorem 3 (updated)

From the comments on one of my previous posts comes this from Economists Do It With Models

Actually, one of the articles on the subject mentioned that the SeatDefender device that was used was not allowed, which would imply that the property rights are at least implicitly assigned to the recliner.

I have not seen that. But if true then the airline just has to make clear what the property right is and let bargaining take place or while the SeatDefender may be illegal it still doesn't necessarily mean that property rights have been defined. Use of the device may just be an attempt at "homesteading" legroom.

Update: Economists Do It With Models has kindly provided the source that mentions the device being banned: http://consumerist.com/2014/08/26/united-flight-diverted-after-passenger-uses-banned-seat-recline-jammer-starts-scuffle/

Also from the Environmental and Urban Economics blog comes an Update:

Yes, I am well aware that the Coase Theorem assumes that property rights are well defined and agreed upon (so some have said that the Coase theorem does not apply here) but what is interesting about this case is that the airline has not established these rules. It is also interesting that transaction costs precluded the ability of others on the plane to offer their seat to the woman who wanted to recline because this simple solution would have resolved this "crisis". Nobody gained by landing the plane in Chicago. People lost time, they had to land and takeoff one more time. The Coase theorem assumes a smooth redistribution of resources but instead resources were destroyed in this multi-player interaction. This should interest economists.

How to misunderstand the Coase theorem 2

Following on from my posting yesterday I see that someone does get the Coase Theorem. Writing at the Wall Street Pit Donald Marron says

Somewhere Ronald Coase is smiling. He identified that answer in 1960 in his famous paper, The Problem of Social Cost.

If the little girl has the property right to recline, then you can pay her not to do so. If you have the property right, you can install a Knee Defender.

Yes, but as I noted yesterday the problem here is that property rights are not defined.

Marron goes on the say,

But who should have the property right? Coase would say it depends–some people don’t like negotiating with other passengers. Given those “transaction costs” the right ought to be given to whichever person is most likely to want it most.

I’d bet on the “reclinee” not the recliner. Which might explain why more airlines now offer the ability to pay extra for more legroom. After all, United would rather you pay them than the little girl.

This answer, extra legroom, may not be about the airline collecting the payment which would otherwise go to the recliner since a seat with more legroom is not the same thing as a seat with less legroom. The amount of the externality is not reduce by having more legroom, the recliner may still recline just as much, its just that the reclinee is no longer affected by the reclining. So seats with more or less legroom are two different goods and thus the airline may simply be selling different types of goods to different types of customers.

How to misunderstand the Coase theorem

This comes from Matthew E. Kahn's Environmental and Urban Economics blog:

My fellow University of Chicago economists, stop reading Krugman's latest and explain this puzzle to me. A United Flight to Denver was diverted to Chicago because of a fight between two 48 year olds over whether the person sitting in front in Economy Plus has the right to recline her chair. For details read this.

As we get ready to start the new academic year, here is an excellent example of the Coase Theorem not working! Who has property rights on an airplane when the person in front of you wants to recline while you care about your knees? Why was this United flight diverted to Chicago? Wasn't that a destruction of resources for everyone involved? My fellow Becker students, what is the answer? You have 10 minutes to answer this 6 point question. The Coase Theorem predicts that the recliner should have paid the person behind her? True, false, uncertain. Explain.

Kahn states "here is an excellent example of the Coase Theorem not working" and then asks "Who has property rights on an airplane when the person in front of you wants to recline while you care about your knees?" And he does not seem to notice the importance of the second point to his first point.

The Coase Theorem assumes that property rights are well defined, it doesn't matter who has those rights, but someone must have them allocated to them. The problem with the seat example, as the second point makes clear, it that property rights are not well defined and thus the theorem does not apply here. Not, at least, until the airline clearly defines seating rights.

Drug deals gone bad

Or are they?

Donal Curtin writes at the Economic New Zealand blog that

I was shocked - shocked! - to read in the Economist last week that drug companies, faced with the prospect of superprofits on patented drugs evaporating when the patents expire and the off-patent drugs can be substituted by much cheaper 'generics', have been paying generics producers not to enter the market.

Is this so bad? Looks like it could just be the Coase Theorem in action. Transaction costs are low for the companies involved and so they bargain to a mutually profitable outcome. Whats not to like?

Well maybe the problem is that not all affected parties are at the bargaining table. Under the Coase Theorem it is (implicitly) assumed that all parties affected by the externality, or whatever, are able to bargain with each other. In the drugs case clearly consumers are not at the bargaining table. Transaction costs prevent consumers of the drug, who would gain most from a price reduction, from bargaining with the companies involved, so their voice is not heard. The outcome therefore may not be the socially efficient one.