Wednesday, September 4, 2013

Thinking like RH Coase

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. 

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 the 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 be 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, many 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. He joked recently that he made his career stating the obvious.


  1. Too true. It is what has held me back from academic pathways: teaching to bright youth that which will see em unemployed.

    BTW applying for a PhD right now

    Wish me luck :-)