Russ Roberts

Boudreaux on Coase

EconTalk Episode with Don Boudreaux
Hosted by Russ Roberts
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Don Boudreaux of George Mason University and Cafe Hayek talks with EconTalk host Russ Roberts about the intellectual legacy of Ronald Coase. The conversation centers on Coase's four most important academic articles. Most of the discussion is on two of those articles, "The Nature of the Firm," which continues to influence how economists think of firms and transaction costs, and "The Problem of Social Cost," Coase's pathbreaking work on externalities.

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0:33Intro. [Recording date: October 23, 2013.] Russ: Our topic for today is the intellectual legacy of Ronald Coase, the Nobel Laureate who passed away in September at the age of 102. And Coase was a guest on EconTalk in May of 2012. Don, today's guest, is a long-time teacher of law and economics and contributor to the literature; and I thought it would be nice to talk about Coase's legacy. So we are going to talk about his most important papers today, of which there are relatively few but incredibly influential. Guest: Coase wrote more than people realize he wrote, but when you compare his total corpus to that of most Nobel Prize winning economists, it is relatively small. Russ: Shockingly small. In terms of number. Guest: Yeah. In terms of insight per word. [probably meant words per insight--Econlib Ed.] Russ: And influence on the profession as well. We're going to focus, just to give people a heads' up, on four of his papers. The two most important are "The Nature of the Firm," which was published in 1937 in Economica, and "The Problem of Social Cost," which was published in 1960 in the Journal of Law and Economics. I'm hoping we'll have time at the end to give significant time for "The Marginal Cost Controversy," which is 1946 in Economica and "The Lighthouse in Economics," Journal of Law and Economics, 1974. We'll put links to those; there are also books that have collected those essays. But those are the big four. He did, as you point out, other things as well, and they are all interesting. But those are the four we are going to focus on today, I think that had the most lasting impact.
2:34Russ: Let's start with "The Nature of the Firm", published in 1937--a long time ago--and yet a paper that still gets a lot of attention. Guest: "The Nature of the Firm" and "The Problem of Social Cost", these are the two that were understandably singled out by the Nobel Prize Committee in 1991 when he was awarded--justifiably--the Nobel Prize. That paper grew out of a trip that Coase had made, with a fellow student I believe, to the United States, a research trip. He was a student at the London School of Economics (LSE), where he encountered Friedrich Hayek; Hayek was one of his professors. His main professor was Arnold Plant. Arnold Plant was very interested in accounting and did some work in the economics of accounting. As did Coase. Coase got a fellowship in the early 1930s to the United States, and he studied actual business organization. At some point it dawned on him that the way economists talk about the firm, the firm is a black box. To this day we don't really talk about what goes on inside the firm. Russ: Things go in--labor, materials--things come out--products, services. Guest: Firms are, as we economists say, production functions. They have certain technologies for transforming inputs and they take the input prices given, or if they are monopsonists somehow, and then they produce things up. And Coase said, well, that may be okay for certain theoretical purposes but let's investigate more: Why are there firms? A straightforward question. Asked what are firms, but Why are there firms. And very few economists until that time--I say very few but maybe none, but certainly very few economists asked the question: Why are there firms? We've asked what are firms, but why are there firms? And Coase's answer in a nutshell are there are firms because there are transaction costs. Firms, for Coase are institutional devices for dealing with transaction costs, for minimizing the consequences of transactions costs. And we can talk in more detail about exactly what his theory about the firm was. But it's interesting that Coase wrote that paper, "The Nature of the Firm", in 1931. So he was 21 years old when he wrote a paper for which he won the Nobel Prize 70 years later. Russ: I should say, it's Wednesday, October 23, 2013, so Coase was kind of the Xander Bogaerts of economics. That's an inside-baseball reference for Red Sox fans. Go ahead, Don; I'm sorry about that. Guest: Well, it's okay. I was going to get a good sports reference in. Because the fall classic starts tonight with the Red Sox and the Cardinals. And so Coase wrote the paper when he was 21; you think, well, what did I do when I was 21? I was struggling with calculus. And it wasn't published until 6 years later. I'm sure he polished it a bit. But to this day, "The Nature of the Firm", which is a very straightforward article, remains the foundation of all the best theoretical work that economists do on the theory of the firm. Much has been built upon that foundation. But Coase's original insight remains. Russ: It's more than a foundation in the way that, say, Adam Smith's work on The Wealth of Nations is a foundation. Which it is. But Coase's article is worth reading today not just for--of course, The Wealth of Nations is, too; you can still learn something today from The Wealth of Nations--I don't know if there are many articles written in 1937 that a modern economist can read profitably, understand, and be stimulated by. And when you said it's straightforward, I think what you meant was: It's not theoretical. It's not technical. It's not mathematical. Guest: It's theoretical; it's not mathematical. Russ: It's not mathematical. It's bristling with insight and interesting observations. Guest: Yes. And the fundamental insight is this: Coase asked, look, we economists have this theory that resources are allocated according to prices. Sellers sell to willing buyers and there is this process, and goods and services get moved around the economy from where they are valued less to where they are valued more. So why do we need firms? Why doesn't all production take place across what I call 'ownership boundaries'? Why does General Motors, for example, own the Fisher Body Co., to take a famous example later used? Why did it buy the Fisher Body Co.? Why does it make bodies for its own automobiles? Russ: And by doing so lose the power of the price system to induce competition, excellence, innovation? All the things that we like as economists about the market process, when they are put inside a firm, have become a top-down, to be blunt, socialist, command-and-control system that seemingly gives up all the advantages of price and competition. Guest: It is, a firm is what Hayek called--and remember, Coase was a student of Hayek--an 'organization'--it is administered from the top and it's conducted according to some conscious direction. And Coase said, so why do we have this? If the market is so great, why do we have these, I think it was Dennis Robertson who called them 'islands of conscious power' in a sea of markets? Why do we have these things? And Coase said, well, it's because, look, markets, as wonderful as they are, contrary to what basic economic theory might imply, markets have transactions costs. Contracting in a market is not costless. People have to worry about the honesty of the people with whom they are contracting; they have to worry about: will the quality of the thing that I'm contracting to buy be what I expect? Russ: Sometimes it won't be; I have to then deal with the implications of that. I have to have a contractual or legal way to cope with the surprises. Guest: Yes. There are a variety of different sources of transaction costs. And Coase said, when the transaction costs of using the market are sufficiently high, it's worthwhile to take those transactions out of markets and put them into the firm. Now, the firm itself is not a costless thing to operate. There are costs of operating a firm. I call these 'administrative costs.' So you have a cost of using the markets on one hand versus administrative costs on the other hand. Russ: And those costs are? Guest: Well the manager of the firm has to consciously direct workers: You guys, when you finish doing that, move those intermediate products from there to here; and you people, do it this way; paint them green or paint them red, make sure you ship them to Toledo or make sure you ship them to Tijuana. So it has to be-- Russ: But that's the smallest. The bigger challenge is you have to figure out what technology to use. Guest: Yes. Russ: What skills to use. What mix of people and machinery. Normally you just say: Let's go find the cheapest one that meets--when you go out in the marketplace you are not thinking about this at all. You are just thinking, I want to find the cheapest one that meets my quality expectations. All of a sudden you have to wonder: Am I doing this the best way? And you may not be. So there are the costs of discovering mistakes, etc. You've got loafing--which again, in the competitive external market, you just say, Well, you're late; we're done. I'll find somebody else. But here you are saying, the guys, well we had this bottleneck, how do you know it's real? Seems to me the monitoring and quality control of product and decision-making process within the firm is by far the biggest cost. Guest: Yeah, yeah, of course, of course. You are right. The general lesson here is: Coase is a realist. So, look, markets aren't perfect; administrative direction isn't perfect. They both have their costs. And in a competitive economy when people are allowed to experiment with different operational forms and markets aren't constrained by excessively by regulation to fit some model, then what will happen is over time firms will emerge, depending on the industry, depending on existing technologies, that minimize the entire costs of transforming raw materials into final products for delivery to consumers. You still have costs of using markets; you have administrative costs. But if firms get too large then the administrative costs at the margin outweigh the costs in the markets, so firms will shrink. If the costs of using the market are too high at the margin then firms will emerge to reduce those costs and substitute the lower administrative cost with the cost of using the market, all the while lowering the total costs of transforming raw materials into final outputs. It's an astonishingly simple insight, but no one had it until Coase discovered it.
12:06Guest: And this is a theme that runs throughout all of Ronald Coase's work. He recognized when economists overlooked obvious questions and he asked questions that, once they are asked seem important to ask but no one thought to ask them before Ronald Coase asked them. And that's a really important role to play. And "The Nature of the Firm" is an example of that. Why are there firms? I've often said about that, that it's easy to understand the nature of the firm if you've think of it first as really a theory of vertical integration. It works for horizontal integration as well, or even conglomerates. Russ: Explain what you mean by 'vertical integration.' Guest: 'Vertical integration' is the economists' term for the integration within one firm of different stages of production. So, I used earlier the example of General Motors and Fisher Body. General Motors makes the bodies, then it attaches the bodies to the chassis, then it puts the motor--so you have these different stages of production extending back from the raw material, extractive, stages where you get iron ore out of the ground all the way to the final stage where you run a dealership that delivers the final product to the consumer. Russ: And of course any of those stages you could either outsource--meaning get it from outside the firm-- Guest: use the market-- Russ: or you could produce them in-house. And they do a mix of both. Guest: Yes. And you could imagine, theoretically, one firm, Giant Corp., having its own iron ore exploration division, extracting ore from the ground, smelting ore, turning it into steel, turning that steel into auto bodies-- Russ: having its own rubber plantation-- Guest: rubber plantation; for a while I think Henry Ford did indeed have that. All the way to actually owning the dealership. We don't see that. We see General Motors doing some of it but not all of it. It contracts out parts of it both in early stages of production and in latter stages of production. And Coase's theory remains the starting point for economists' understanding why in particular circumstances certain processes are integrated within a firm and why in other circumstances the processes occur across ownership boundaries in markets. Russ: I never thought about it until just now--a similar set of factors come into play when I decide what to do on my own inside my house versus what I hire someone to do. Guest: Yep. Russ: So, we talk in economics about comparative advantage, which, one way I like to think about comparative advantage is self-sufficiency is the road to poverty. If you try to do everything for yourself, you are going to be very poor because you have a limited set of both time and skills. But if you think about it, there are a lot of things inside your house that you end up doing for yourself because of transaction costs. I'll just speak for myself; most of us, I think, are in this situation. I take out my own garbage. I change my own lightbulbs. There are a thousand things I do around my house that I could hire someone to do. And in fact, the previous owner of our house hired someone to change all the lightbulbs in a whole set of lights in our house because they were up high, and he didn't want to get the ladder, and he didn't want to climb the ladder, he didn't have the ladder, he didn't want to climb the ladder. So he paid someone actually to change the lightbulbs, at least for some of the lightbulbs. But the point is that if I could instantaneously say, oh, I'll give you $.75 to change a bunch of lightbulbs, I might decide not to do that myself. I might pay someone. But the costs of finding that person, getting him to my house, waiting for him, letting him in, all those "transaction costs"-- Guest: Dealing with the risk that that person may be dishonest or incompetent. Russ: Correct. So there are a lot of things that I do inside my house that I don't have a comparative advantage; and you'd think in a way I would contract out for them. But I don't. And that's because of this factor, which is a beautiful application. Guest: Just really quickly, I heard yesterday that Jerry Jones, the owner of the Dallas Cowboys, when he's sitting in the owner's box watching a game, he has someone beside him to clean his glasses, so when his glasses get dirty--I don't know if it's true but I heard someone say it and it sounded like they were telling the truth. So that's really contracting out to another party. Russ: Yeah. But for him, evidently--I clean my own glasses. Guest: So do I. Russ: So, for me, the cost of having someone next to me to do that isn't worth it. But for him, evidently in his situation--maybe he's not very good at cleaning them, as well. He may be inferior. May be a case of absolute advantage, in that case.
17:02Russ: So, as you said--I want to spend a few more moments on this paper. You said it's a simple insight. One view is that it's like many insights as you say by Coase-- Guest: No one had it before Coase. Russ: Correct. So it's one of these things, oh, that's obvious. But it wasn't obvious at the time. But it wasn't just that it was obvious and now we know it. It has implications and has had implications for research in industrial organization; and of course, we are going to apply it in a minute to the case of externalities and public policy. Which is what Coase came to do in the next paper we are going to talk about. But talking to James Buchanan--besides the fact that it "explains" why firms socialism within the firm--and of course some firms use market competition do things in house but they still try to leverage the price system. They might have competing divisions. I know there are retailers that their stores, they have an in-house arm that creates clothing for their retail stores but the retail store is allowed to buy from anyone. So they are not forced to buy from the in-house supplier. They can buy from anyone. So there is competition forcing that inside supplier to compete with the outside suppliers. There are all kinds of creative ways that firms try to leverage and get the power of competition of markets. But is there anything else you want to say about the influence this paper had on how economists think about firms and organization? Guest: Oh, sure. And we'll talk about this in an even broader context in a moment, I'm sure. But the underlying insight here is the importance of transaction costs. Until "The Nature of the Firm" was published, economists paid little attention to transaction costs. In fact, I don't know that they paid any attention to them at all. I confess I haven't read Alfred Marshall's book on industry. Maybe it's in there. But certainly "The Nature of the Firm" brought to the fore the importance of transaction costs. Oliver Williamson, one of the co-winners of the 2009 Nobel Prize, much of his work is built on and is inspired by Ronald Coase's work. And the generalization that has occurred--which Coase noted and was proud of--is that it became a theory of commercial contracting. We have all sorts of--we initially think of as firm versus not-firm. Well, you have different kinds of contracts. A franchise contract, for example. The McDonald's down the street may be owned by McDonald's; probably not. It's probably owned by a separate individual or a separate company. Russ: It's an innovation, that structure. Guest: And so where Coase's insight has been taken since 1937, by Oliver Williamson, by Armen Alchian, by Harold Demsetz, by many others, is in a direction of explaining the contours of contracts and the details of contracts that otherwise would remain mysterious absent Coase's insight into transaction costs. Why have franchise contracts, for example-- Russ: And what is their nature? What do they contract on? What are they worried about? Guest: Exactly right. What explains how they change over time? All of these explanations into the nature of commercial contracts find one way or another roots in Coase's 1937 article. Which is an astonishing thing, considering that a 21-year-old youngster wrote that. Russ: In a field where--that is not the nature in our field. There are fields where 21-year-olds make important contributions but not often in economics. Guest: There is in mathematics; but there is no mathematics. This is a straightforward insight. Just a quick footnote: the importance of that article--I think I'm correct in saying this--really took off in 1951, I believe, so some 14 years after it was published, when it was reprinted in the AEA (American Economic Association) Readings in Price Theory that was edited by George Stigler and Kenneth Boulding. I think the article was not given the attention that it subsequently got until it was reprinted in that famous reader. And when that famous reader came out, that's when we really see an explosion of work done on the theory of the firm. Russ: I want to say one more thing about it and get your reaction. A paper we've talked about many times on this program is "The Use of Knowledge in Society," by Friedrich Hayek, which is 1945, American Economic Review. So, that paper, the theme of that paper is that prices convey knowledge and aggregate knowledge. There's a lot to be said about that paper; maybe we'll do a podcast on just that paper some time. That would be fun. But, that paper was about the power of prices to solve what came to be called the 'knowledge problem'--the fact that a lot of the most valuable knowledge isn't stuff you can look up. It's not stuff you can compile in a report. It's stuck in the heads of people. And how do you leverage that knowledge--how do you get that knowledge to come into play when it's scattered among individual brains, scattered across time and space? And what Coase is saying really is that there are times when you forgo--the timing of these articles is kind of ironic; Coase is writing in 1937, perhaps influenced by conversations with Hayek as you suggest, but Hayek writes in 1945 and what Coase is saying before the fact is: sometimes you are going to give up that aggregation of knowledge, that ability of prices to convey knowledge, and you are going to solve that problem--because you've got to solve it, and there's a whole modern management literature about the culture and history and knowledge of an organization, sort of a obsession for a while and then in the 1990s, I don't follow this literature any more but how does an organization preserve the knowledge embedded in its employees given that 1. They are scattered around the organization, and 2. They die; 3. They transfer, they quit, they get fired, they leave. And they take with them embedded in their brain a bunch of stuff. How do you get that knowledge out of them into some sort of accessible way? Of course you can't. There's no easy way to do it. But especially in this context we are talking about, when you give up the competitive market-driven outcomes that come from competition and price-equality [?] competition, how does the firm solve that problem? They have to find a way to solve--not solve it, but deal with those issues. Guest: Coase was all about tradeoffs. Quoting Tom Sowell now, but it's a very Coasean notion: there are no solutions; there are tradeoffs. You can reduce this cost only by increasing this cost. What you hope is that the reduction in this first cost is greater than the increase in the subsequent resulting higher cost on this other front. You want to make sure the economy is competitive--we were already clear: Coase was a very, very free-market guy. So that this balance is made as best is possible and when external factors change, that the balance itself can change to reflect changes in external reality. Russ: And, to take a modern day application, the ability of the Internet to allow firms to find out--one of the most simple transaction costs that arise when you use the outside market, which is: What is the price? It takes time. When you want to go buy a car, you can't look up: What's the price point now? Well, now we almost can. A lot of people have access to the information. And I'm really thinking about the supply chain. You're a firm and you want to buy something from the outside; you can at a very low cost, very quickly find out two very important things: the price itself--not a lot of legwork any more--and secondly whether people are happy with the quality. You get a lot of information that before had to be gained with a lot more uncertainty. So you'd expect that to change how firms organize, what they produce versus outside. Guest: These things are happening all the time, and so you don't want a rigid template for what the world "should" look like except to say it should be competitive; entrepreneurs should be free to experiment with different methods of organization. Coase published that paper, "The Nature of the Firm"--you mentioned Hayek. An even deeper paper, maybe his most profound paper, is his "Economics and Knowledge" paper published in 1937, the same year. And this is when Coase and Hayek are close together in London. And what those papers share is an appreciation of the--let me use a modern--the pixelization of knowledge. That knowledge is not a whole. It's spread out, it has to be captured, it has to be utilized; different people utilize it differently, have different subjective reactions to it. You can see in Coase's work a lot of Hayekian influences. Which themselves maybe just go from Hayek and Coase was respecting the results of the intellectual climate of the LSE in the 1930s. Russ: London School of Economics. We're going to move on now to another paper but I want to mention that long-time listeners will recognize that we've talked about the nature of the firm in lots of other podcasts. We'll put up links to it. I did a podcast with Mike Munger on it and it may have come up in other places--I think it did--along obviously with the actual interview with Ronald Coase in 2012.
28:01Russ: Let's move on. Let's move on to "The Problem of Social Cost", which was, really--is it the single most-cited paper in economics? Guest: It was for a very long time. It would not surprise me if it still is the single most-cited paper in any economics journal. It was published in the Journal of Law and Economics. There's a great story behind that paper. George Stigler has a story in his 1988 autobiography, "Memoirs of an Unregulated Economist". And the story, at the time that he wrote it he was on the economics faculty at the U. of Virginia with Jim Buchanan and Gordon Tullock and Leland Yeager. And he presented it in a seminar at Chicago; and of course he sent it on ahead of time. And there was a dinner party the night before the presentation. I've heard different stories. I can't remember which one is Stigler's. It was either at the apartment of Aaron Director or the apartment of Milton Friedman, but anyway, you had many future Nobel Prize winners there--Coase himself, Milton Friedman, George Stigler. Aaron Director was there--many other luminaries. Allan Wallis, in the economics profession. And Stigler says that when Coase arrived, when Ronald arrived at the dinner party, there was only one person in this room of 20-odd people who thought that Coase was correct. All these people were astonished that a person as careful as Coase would get something so fundamentally wrong. Russ: That one person of course being Ronald Coase. Guest: Right, the only person who believed that Coase was correct was Coase. And Stigler said by the end of the evening, everyone in the room understood that Coase was correct. So here you have an insight that today when you talk about it, it's going to sound almost trivial. And yet some of the greatest economic thinkers in history when they first encountered it, it was so unbelievable to them, so unfamiliar, that they rejected it out of hand. Ronald Coase cannot possibly be correct. By the end of the evening they all knew that he was correct. Stigler called it the most exciting intellectual evening of his life, this discussion of Coase's "Problem of Social Cost" paper. There's a prelude to that paper, and that's the work that Coase did--Coase, by the way, was British, although he spent much of his, his most productive years of his professional career at either the U. of Virginia or the U. of Chicago--so in the United States. He did a 1959 paper on the Federal Communications Commission (FCC), and one part of that paper involved the allocation of the electromagnetic spectrum--how do we allocate it? Russ: For radio. Guest: For radio or, I can't remember, television. For broadcast purposes. And, you know, Coase realized: regulators don't have to worry too much about getting it right. Just create property rights in it, make sure those property rights are secure, and then we can trust the forces of the market to ensure that each piece of the electromagnetic spectrum, if it's not initially possessed by its most valued owner, will eventually wind up with it's most valued owner. This is simply an application of things we recognize about the economy in a routine way. If you value my watch more than I value it, you'll offer me a price for it, and I'll sell it to you. No one thinks that's astonishing. This happens all the time. It's very routine. And Coase said, look, those same market forces operate for nontangible property rights in the same way that they operate for tangible things. And that's one of the fundamental insights of the 1960 paper, "The Problem of Social Cost." The proposition--or I assume it's the proposition that Stigler referred to. By the way, Stigler is the person who named it the 'Coase Theorem'. Russ: Unfortunately. To some extent. Guest: Yes. The proposition was that if transactions costs are sufficiently low--some people would say if they are 0; they have to be sufficiently low, people can transact--then the legal authority, maybe a court, a bureaucracy, an all-powerful monarch, it doesn't matter. If that legal authority's goal is economic efficiency--that's a big if and we can come back to that--and transactions costs are sufficiently low, the legal authority needn't worry himself, herself, itself terribly much about how to initially allocate the thing--who do I give it to? do I give it to these people over here? Just create property rights in it, give them out--it doesn't matter really who you give them out to. Those property rights will eventually wind up in the hands of the people who value them most, who can put them to the best economic use. If I'm given a part of the electromagnetic spectrum and I'm a terrible broadcaster, if I think that the best thing to broadcast is cricket noises, and then you think that the best thing to broadcast is population music, then eventually you'll purchase from me my part of the electromagnetic spectrum because you can put it to better use than I can. Now if transactions costs are sufficiently high, then it does matter how property rights are initially allocated. Russ: Expensive to negotiate, we can't find each other.
33:54Russ: So, up to here, on the surface, this looked like the flip side of "The Nature of the Firm." Because it basically said, if costs are low, use the market. Let the invisible hand work. Let competition and other things work. But of course to me, that's the--and I learned this from Deirdre McCloskey when I was a first year grad student at Chicago--the transaction costs aren't zero, and they are often not sufficiently low. So to me, the insight of the Coase Theorem is not that one. It's not-- Guest: Well, that is the Coase Theorem. The insight of Coase's paper is not that. And Coase said many times over the years-- Russ: And he did on EconTalk as well-- Guest: that he very much regretted that that's what is regarded as the Coase Theorem, as the main takeaway from that paper. Russ: Because it became a straw man. It became a way for people to dismiss the paper by saying, Well, since transactions costs, they are not zero; they are never zero; this whole paper is just a curiosity. So before we do the second half of what Coase really thought is the deep insight--which I agree is the deep insight--it's worth noting that at that dinner party where people didn't accept it, they didn't accept that first one. Guest: They didn't accept that first one. And it's a curious thing to reflect on. Once it's stated it becomes obvious. Why would people be any less willing and able to exchange disembodied property rights than they are willing to exchange physical things? If the transaction costs in both cases are sufficiently low, they'll do it. Now, in both cases the transaction costs might not be sufficiently low. But there's nothing fundamental about property rights per se that makes them a different thing to exchange than physical things. So that's the first part. It's really the simplest part of Coase's argument. Let me say, I think Coase in a way overreacted to the popularity of the Coase Theorem. I do think it is an important insight. Russ: It shouldn't be neglected. Guest: It is important. Transactions costs are sufficiently low in many, many instances. I think in the case of the electromagnetic spectrum, they probably are sufficiently low. There's a pretty well organized market, I think, in those sorts of things; and if CBS owns more of the electromagnetic spectrum than NBC and NBC can put it to better use, they both have incentives to transfer that part of the electromagnetic spectrum that can be better used by NBC from CBS. We see transactions taking place every day. So transactions costs often are sufficiently low. In many cases. Russ: I never really thought about it, but Coase is, in a way, saying economics, markets work, when transactions costs are low. Again, it just sounds trivial and simple. But to take another example, Julian Simon, who we both have a great deal of respect for, his solution to the fact that airlines have an incentive to overbook, but that imposes a cost on them because sometimes somebody gets bumped and is angry, so they have to be very careful with how they do that--they came up, Julian Simon came up with the idea of, well, let's just--they should overbook, because there are advantages of not having empty seats; and it turns out that too many people show up then you can auction off the--and they don't literally auction them off. They say, the first three people who come forward are going to get a free ticket. And now all three parties are better off: the airline, the person who was bumped who still gets to stay on the flight who didn't have a seat. And in a way, that's the Coase Theorem in action. Because before this innovation, you are sitting there thinking: I really want to go to Chicago, but it's sold out. I need to find somebody who is on that flight who is willing to get off the flight. And of course that's really hard to do. You knock on doors to people to travel to Chicago? Do you call up people and say, Who is going to Chicago who I can outbid? And what this does is it's a way to allow this to happen in a low-transaction cost way. Guest: I hadn't thought of this; that's a good point. That desirable action, that useful action, is integrated into the firm. The airlines take it over. Again, it doesn't work perfectly. Nothing works perfectly. But it works pretty smoothly.
38:54Guest: So, as with the firm, Coase wanted to explain things we observe in reality that seem at odds with basic theory. The firm seemed at odds with basic theory: if markets work so well, why do we have firms? The law, as it exists--Anglo-American law, at least, the one that Coase was looking at--why is its structure as it is? What explains the details of nuisance law and property law and contract law? What Coase is driving at in "The Problem of Social Cost", one of the things he was driving at--it's a really deep, multi-layered paper--was that because we are living in a world where transactions costs are often sufficiently high to block what would otherwise be mutually advantageous exchanges, the law itself takes on a character. The law itself takes on details. It takes on contours, it takes on substance, that is best explained, just like the firm, as institutions to deal with these transactions costs, to minimize the ill consequences of transaction costs. Russ: And in particular, he was interested in what economists call 'externalities', where my actions harm you-- Guest: Social cost-- Russ: or help you. And why is it in those situations some legal structures make more sense than others? So let's talk about some of those examples and what comes into play with transactions costs and what he was trying to explain. Guest: Well, of course, the most famous example was the railroads and the farmer. So you have railroads going through a field--that's a socially useful activity. But railroads throw off sparks and sparks always run a risk of igniting crops growing nearby. So the railroad imposes a cost on the farmer. That's how it's normally said, how we normally think about it. So, we need a way to deal with this. Russ: We need a way to protect the farmer from the harm of the railroad is the way it's usually said. So we've got to punish the railroad for its actions. Guest: Yes. So, the first pass at this: If the transaction costs between the railroad the farmer are sufficiently low, then the law doesn't matter that much. Russ: Explain what the law would be. The different choices that the law would make. Guest: All the law would have to do is simply declare one or the other as owning the right. Okay, Mr. Railroad, you have the right to run your train. Or, Mr. Farmer, you have the right to be free of sparks. If they can bargain--let's say the farmer is given the right. This is the Coase Theorem: the railroad will buy from the farmer the right to run trains across or near his land up to the point where the value to the railroad of running that train is equal to the value of the risk to the farmer of having his crops burn. The farmer will be willing to sell to the farmer to run the risk of burning his crops. And the same thing would work if the railroad had been given the right. If the farmer thought it was more valuable to keep the railroad away, the farmer would pay the railroad to stop. Russ: Or to put up some barriers to keep the harm from happening. That's another way to think about this. Guest: The lowest-cost ways of dealing with these things would emerge. Russ: And that's really important, though, because we don't know what's the lowest-cost way. The regulator might not know. So for me, one of the insights of the Coase Theorem is: do you impose a regulatory solution from the top down or do you let it emerge from the bottom up? And what Coase was suggesting was that if--and again, if--transactions costs are relatively low, the low-cost solution will emerge through the natural interplay of these negotiations. And then the parties will have the incentive to improve that going forward. Guest: Yes. This part of Coase's paper is a powerful explanation of the nature of secure property rights. People who are secure in their property rights and can exchange those property rights, they have incentives to either exchange them if they can or to take steps to minimize the damage to them. Or to put it another way, to maximize their value. You don't need a top-down regulator saying doing this or do that, don't do this or don't do that. People will do that on their own. It's a really powerful insight. But a deeper insight--and this is one that Coase also emphasized, but it's so deep I think it still is not sufficiently appreciated, is the mutuality of harm. When we talk about externalities, when we economists talk about externalities, we typically, for whatever reason--it seems easy to identify the harmer and the harmee. Russ: [?] and the perpetrator. Guest: The tortfeasor and the tort victim. But Coase said: Look, it's not that easy. Take the railroad and the farmer example. It looks like the railroad is imposing costs on the farmer. But let's face it: Suppose the railroad had been there first, and then the farmer came by and started growing crops. Then why don't we say the farmer is responsible for his own risks? It's true the sparks physically come from a passing train, locomotive. But the farmer himself has some responsibility for where he sets up where he grows his crops. It's not clear that all the causality runs from railroad to farmer in terms of the harm. We have to look at it both ways. When we recognize that all the harm is mutual, then it's easy to recognize that the appropriate adjustment--the appropriate adjustment is not obvious. It's not necessarily the case that the railroad should stop running as many trains, that the railroad should take steps. Russ: Maybe it should be that the farmer shouldn't grow close to the railroad. That may be the cheapest way to cope with this problem. Guest: Yes. That's exactly right. And so one insight, one of the many particular insights, from this is that Coase would predict--did predict--that the manner in which the law actually classifies a perpetrator as distinct from a victim is that the perpetrator is the party that the law determines somehow is the lowest-cost avoider of the harm. If the railroad can avoid the cost at a lower cost than the farmer, then when the railroad runs its trains by, we say the railroad 'causes' the harm. And so the railroad should be the party taking steps to minimize the harm. If, on the other hand, the determination is made that the farmer is the lowest-cost avoider, then we say the farmer is the perpetrator and the farmer should take the steps.
46:43Russ: When I teach this, I summarize it by saying, 'It takes two to tango.' And the idea that externalities are mutual, this mutuality you are talking about, is disturbing. It's jarring. Because we often want to, and sometimes should impose a moral judgment on harm. So, if I came and I hit you in the face with my fist and that annoys you, if you are not careful you could say, in a Coasean way: Well, it's your problem; you should enjoy it; or you should just say it's no big deal; it's just as much your problem as mine. We all are repulsed by that logic, correctly. And so I think one of the most powerful aspects of Coase is, taken to an extreme, I think it's dangerous to say, well, all we care about is minimizing the cost. That's not true. We do care about, many times, something more than minimizing the cost. We care about morality; we care about justice. But at the same time, what Coase forces you to acknowledge is that sometimes the morality you impose on an economic situation is false. It's not just a different metric. It's wrong. It opens your mind to the possibility that you haven't imagined, that there's a different way to handle this social problem. Guest: That's right. Russ: An example I've used--I may have used it on the program in the past, I apologize--is that if you are hiking in Montana, you will encounter horse manure. And it's your job to avoid it. No one expects the horse owner to clean up after his horse. Although in Manhattan, the horse wears a diaper, in Central Park. Because it has culturally emerged--or it may be legal, but I think it's cultural-- that there it's unpleasant; it's unexpected. But in Montana there is no moral blame placed on the horse owner. If you step in the output of his horse, that's your problem. Why weren't you more careful? In the city streets of Chicago, when I was there in the winters and springs of and falls of the late 1970s, dog owners did not clean up after their dogs. Everybody understood--it was culturally totally acceptable--to leave that on the street; and only a fool would step in it. Keep your eye out. Keep a lookout. And today that's not true. That has culturally changed for a bunch of reasons. Some of it is technology: I think the cheapest thing is plastic bags. And a hundred other reasons. Guest: Better understanding of the transmission of disease. All sorts of things. And a similar point--it's the same point, again, these are examples--and you start seeing the Coase Theorem everywhere after you think about it. When I spend the summer in California, in California it's the driver's responsibility not to hit pedestrians. Pedestrians in California are extremely aggressive. They are much more likely to cross the street carelessly. Because they are aware of the culture there. You come back to the East Coast, and it's Walker Beware. And drivers are less careful. And so if you've been out walking in California for a summer, if you grew up in California and you move to New York or Manhattan or Washington, D.C., you better be careful. Because there is a different set of expected norms about whose responsibility it is. Who owns property rights in the street. And the cultural norm in Washington, D.C. and New York is the driver owns the road. And in California, it's much more the pedestrian owns the road. And there's nothing moral about that. Your first thought is, well, of course it's the driver's responsibility not to hit people. And it is. True. But there's a continuum of care. Which is another insight you get from Coase. It's an entirely[?] rich paper. Guest: There's a flip side to the important point you made. And that is our moral assessments are surprisingly determined by these economic factors. If you hit me in the face, unprovokedly you punch me in the face, it's true in a very technical sense that we both caused it. My face, if my face weren't here, it wouldn't hit; if I had moved it, then your punch wouldn't have landed on that. Russ: Yeah, I'm just swinging my arm. Side to side. Guest: But morally, we reckon the code--if you want to reduce it to the economics, you are clearly the low-cost avoider. I'm not expecting you to hit me in the face. You swing. You are the low-cost avoider. Therefore the blame falls there. Our very moral senses are determined in large part by transactions costs. Russ: Correct. Guest: A lot of people don't[?] like that because we like to separate morality-- Russ: It's unsettling. So on this issue of morality and how the costs play a role reminds me of this issue that arose when legislation introduced tradable emissions coupons for sulfur dioxide. And a lot of environmentalists were offended by this, because of the morality of it. They said: A firm shouldn't be able to buy the right to pollute; polluting is harmful, and I don't care, we don't care about the efficiency or other things; it's just wrong; that's just immoral. Economists' reaction was very different. Guest: Yep. That particular issue arises in different related circumstances. Economists say, well, yeah, but pollution is not without benefits; it's the by-product of a beneficial process. And so if you think that--pollution is not amoral because it has, the thing that produces it has beneficial consequences. Why would you assume, as a matter of morality, that the harm is necessarily at the margin, necessarily greater than the benefit? Do you want to live in a society without any pollution? You can do that, without any industrial pollution. But we'd have no pharmaceuticals, we'd have no petroleum fuel. We'd have a very different lifestyle. Our lives would be much more miserable. And so the economist points to the benefits of at least the process that pollution causes. Economists--and Coase was very good at this, by the way--dismiss that kind of talk of morality more easily than do other people because we recognize that there are costs and benefits to almost any action. Russ: And, in this case where the firm "buys the right to pollute", it's going to ultimately almost always end up passing those costs on to the consumer of the product. Who I would argue morally is the person who should pay for it. So, if there is pollution, that's the way it should be. Guest: Excellent. Russ: And people say, yeah, they should pay for it, not the firm. Well, the firm, don't worry. They do pay for it. Not the firm. I wish we could talk some more about this; I've been meaning for a long time to write an essay on it, on the Coase paper and the insights, the things I've learned from Coase. I have a preliminary version of it up on the Library of Economics and Liberty website, a related paper at least, and we'll put a link up to that, on the Napster issue that arose, which to me is an application of Coase's insights.
54:36Russ: But we're going to move on. It's late in the day. I want to talk briefly about the other two papers, "The Marginal Cost Controversy" and "The Lighthouse in Economics." Let's take 5 or so minutes for each one to summarize why they were important. Guest: The "Marginal Cost Controversy," the 1946 paper, and it has a very--like all Coase's papers--it has a very simple insight. Economists will argue, efficiency requires output up to the point where marginal cost equals price. Russ: And define 'marginal cost.' Guest: Marginal cost is the cost to producing one additional-- Russ: A little bit more. Guest: A little bit more. One additional unit of output. So, it was this famous example back in the 1940s; it's still famous. The uncongested bridge. And so what could be the price of crossing an uncongested bridge, say, a motorist crossing an uncongested bridge? What should be the toll? Well, says the naive economist, it should be zero, because the cost of--putting aside the small wear and tear, ex de minimus [?]--the cost of crossing an uncongested bridge is 0. And so that person shouldn't be charged a price. Russ: Shouldn't be discouraged from crossing. We want them to cross. Guest: That's right. If you charge a toll, you'll have fewer people crossing the bridge. You'll have a social inefficiency. People who would get more value from crossing the bridge will be dissuaded from doing it even though they know the social cost to them of crossing the bridge is less than the value they would get. So we can't have positive pricing of such things. And Coase--we don't have enough time so we won't get into it--this article, too, is a multi-layered article with many deep insights. But the one I like best--and other people have made it. Coase made it in a particularly clear way. He said, Look, one purpose of pricing--remember Coase was a student of Hayek--is not simply to--remember, prices convey information. Not simply to allocate goods and services. They convey information. And so if we allow bridge owners to charge what the market will bear, then yes, if the bridge is uncongested and you have a positive price of, say, $2 to cross, if you look only at the individual drivers[?] some of them who shouldn't quote-unquote who should cross won't cross, social efficiency. However, if we force the price down to zero--some economists advocate that that's the socially efficient price--we lose the informational content of the price. We lose the informational content of how valuable is it to build new bridges. How valuable is to expand bridges. And so Coase, a year after "The Use of Knowledge in Society," Coase is pointing out in "The Marginal Cost Controversy" the important informational role of pricing and how that information would be sacrificed, destroyed, if some of the more naive economists' solutions for efficiency were implemented. If uncongested bridges, as an example that apply, if the price were forced down to marginal cost where marginal cost here is zero. Coase said, No; price should be what the market bears. Russ: How do you do that in the case of a bridge, where the government built the bridge, the government is setting the toll? Where are you going to get this informational value in that setting? Guest: Well, the insight--I can't remember exactly--imagine a private bridges. A private bridge owner. It's not inefficient for the private bridge owner to charge what the market will bear even in an uncongested times, because the efficiency of the information made by prices-- Russ: to other poetential bridge-goers-- Guest: Yeah. It has to be weighed against the inefficiency of dissuading the margins and people who shouldcross the bridge. Coase went on in the paper--he discussed mutli-part pricing schemes and explained the value of those and how they are superior to top-down regulation or outright subsidies.
59:00Russ: And what about the lighthouse? Which I have to say, when I read it in graduate school--I think that was probably my favorite paper in many ways, because it's so simple; it's a little historical episode and it's eye-opening. It's a fabulous paper. And I thought, this is the greatest. Guest: It's very careful economic history done by--most people don't think of Coase as an economic historian. But he did do--and this certainly was an economic history paper. And he was taking aim at standard textbook economics. As he did so often. Russ: And by the way, I forgot, it has to be mentioned: the Problem of Social Cost was in many ways a reaction to Arthur Pigou--which we forgot to mention. Guest: Oh, Coase really disliked Pigou's work. Russ: Yeah. So, the so-called Pigovian tax, which is that when you have a negative externality you should impose a tax on the so-called 'perpetrator'--the apparent perpetrator--was what Coase was reacting to in saying that sometimes that's not always the right policy. I mention it only because the Pigovian tax, a carbon tax, is often mentioned as a way to "solve" global warming. And I think what Coase would have said, and maybe he said it; I think I mentioned on this program, is that that's one way to solve it; it may not be the best way. The best way might be to let global warming occur, if indeed it's happening, and to let human beings respond to it; and that might be cheaper than forgoing current output which the tax will produce. Guest: Coase said, basically: The world is a lot more complicated than your simple theory, Mr. Pigou. I think it's not too much of an exaggeration to say that much of Coase's work, certainly in after 1937, was a reaction to naive Pigovian blackboard theory. It looks very nice, very scientific, but Coase understood that the real world has complexities in it that most economists overlook when they do their theories. Russ: So, going back to the lighthouse-- Guest: A lighthouse is a very standard public good. A lighthouse is erected on the shore. It casts its beam. And any boat that needs guidance in storms or darkness to a harbor can look at the beam. So the reasoning goes in the standard textbook--Paul Samuelson's textbook that Coase singled out, or one of the ones that he singled out in his article--reasoned, well, so no private owner has an incentive to build a lighthouse because you can't charge for the benefits. You can't exclude. Russ: Everybody can free-ride. Everybody can say, I won't pay because then I can still get the light. Guest: And Coase said: let's look at the actual history of lighthouses in Great Britain. And he did that. He looked at the actual history of lighthouses in Great Britain. It's too simple to say that what he found was that, oh, yes, they were all built by private enterprise in Great Britain. Russ: Correct. Sometimes it gets parodied that way, either by its proponents who love that conclusion; people who tend to be market-oriented, like us; or by the antagonists who want to challenge Coase's thing and say that's what he said. Guest: That's not what he said. Russ: As always. Guest: But he showed that in the history of lighthouses in Great Britain, it was in many cases driven by private enterprise. The contractual arrangements that harbor-builders and dock- or harbor-owners, people who manage[?] harbors, would arrange with boats coming in were ingeniously designed to enable lighthouses to collect fees, allow the suppliers of lighthouse services to collect fees for the provision of those services. The naive view that a lighthouse is a straightforward public good, unless it's provided outright by government and funded exclusively through taxation--and lighthouses in early on in Great Britain were not funded in this way. They were funded by--I forget the term--harbor fees. They were funded in large part by fees that boat owners did pay. And this is an example of Coase saying, well, let's look at the history. And the history of lighthouses is far more complex than the notion you get by reading the standard textbook story about a lighthouse.
1:03:41Russ: And I want to bring that insight back to a related problem, which is common property, common resource property, which of course the ocean is. One of the challenges of the lighthouse is you can't, if you wanted a purely private, profit-making entity to provide it, I can't say, well, my lane, this shipping lane will be illuminated by a lighthouse; the other one's won't. Or only people who pay for it, as you say, I can't exclude the non-payers from the value of the beam from the lighthouse, so the implication is it can't be provided privately. Similarly people would say with common resource property there's an over-raise the sheep, over-fish the ocean; so common resource property has to be government regulated. And what Elinor Ostrom argued--and Pete Boettke did a nice episode of EconTalk on this topic, on Ostrom's insights and others who have worked on this--is that there's something in between this government solution--and my view is that's the wrong dichotomy; we should really be thinking about bottom up versus top down. Guest: Yes. Russ: Or, a distinction I learned from Dan Klein--coercive versus voluntary. There are a lot of voluntary solutions to a lot of problems that are not profit-maximizing or what we would normally think of as private enterprise, but they are privately-agreed to. To, essentially in these two cases, the lighthouse and the fishing of private property, norms emerge about what's acceptable behavior by the participants that aren't government-run. They are not what we would think of as private enterprise. But they are voluntary and they are bottom. So in the case of, say, lobster traps in New England, where yes, there is an incentive to fish all the lobsters; and then you've killed the goose that lays the golden eggs--to mix animal metaphors, sorry. But obviously the lobster people understood that. They are not idiots. So there is a natural incentive for them to find ways to work together. And in that case norms emerge about property rights that are enforced in traditional ways but not through government, not through police, not through the state. There were certain norms that emerge about who is allowed to take what, when; what you keep; what you throw back. And those norms are enforced by social interactions. The fact that the lobster people hang out together; and somebody who cheats on the deal is then pushed out and is a pariah. So, similarly, yes, once a set of agreements is reached about paying for a lighthouse, a person can come along and free-ride on it. And if you do, you are not going to have any friends. The people at the dock are going to sabotage your boat; there are a thousand things that are going to happen. You don't have to do it through the state. And again, to make it as Coasean as possible: you want the solution, whether it's the government-run solution or the emergent solution that's voluntary, or some hybrid, to be the one that minimizes costs. Not necessarily the totally theoretically thing that emerges out of the blackboard. Guest: A couple of closing thoughts. I know we are getting near the end. I think it's appropriate to summarize Coase's life work, or a theme, sort of [?] Hayek, a theme, as saying, look: If you try a social engineering solution--you could have the most elegant--Coase called it 'blackboard economics', and that was a derisive term for him. You could have the most elegant model, and put aside public choice sorts of problems with bad incentives: You have knowledge problems. Your elegant model imposed in the best possible way on reality will always be too simple for reality. Reality, if bottom up forces are allowed to percolate and operate, they will always devise more nuanced ways of dealing with the problem that outperform your elegant engineering models. Your Pigovian tax looks nice on paper. Your Pigovian tax won't work as well as letting bottom up methods of dealing with these externalities operate. Shifting gears just a little bit: You are right. The market versus government dichotomy is a mistake. Russ: Or in the worst way to think about it, I think: profit versus social good. Guest: Even better. And I think the last podcast we did was on Jim Buchanan, and there's a connection here with Jim Buchanan. Jim Buchanan's Presidential Address to the Southern Economics Association--it was 1963--called "What Should Economists Do?"--and Buchanan wrote this when he was still a colleague with Coase, I believe, at UVA, University of Virginia. Buchanan makes the point very clearly. People miss it; I don't know why. Buchanan is very clear that good economic theory is not just about profits. Good economic theory is explaining what we observe people doing. And of course Buchanan is most famous by observing what people do in the political sphere. But in this article he talks about private yet non-profit ways of dealing with social problems, things that Elinor Ostrom researched and won a Nobel Prize for. By the way, she shared the Nobel Prize with Oliver Williamson, who of course was inspired, probably most [?] by the work of Ronald Coase. People get away too frequently with saying, oh, well, yes, markets are fine if the y are perfectly competitive, if all private property rights are well defined, if transactions costs are zero or very low. But this is not the world we live in--therefore. And Ronald Coase more than any [?], his work is an assault on that simplistic way of looking at the world. Unfortunately, that way of looking at the world remains. It is still the dominant way of looking at the world. Joe Stiglitz looks at the world, Paul Krugman looks at the world very much that way. Russ: Most modern economists. But most economists that Pete Boettke calls mainstream. Guest: Main-line. Russ: I think you are right. Guest: You know, look. We pass everybody in modern America today, daily encounters, institutions that no economist using standard, say, Joe Stigletzian economics, should be able to explain. Churches. Churches in America--yes, they could tax [?]. Russ: It's not decisive. Guest: No. These things shouldn't exist; and yet they flourish. Many of them have lots of money. People voluntarily contribute to these things. They contribute money; they contribute time and effort. And whether you are religious or not, you can't deny the existence of them; you can't deny the thriving of them; you can't deny the influence of these things. Russ: You can't deny the dynamism that results relative to a top-down solution from a government-run state religion. Guest: Larry Iannaccone, our former colleague at GMU, worked on this. And so we see these things every day. This is the kind of thing that Ronald Coase--they are directly at odds with basic economic theory, with simplistic main-line economic theory. And we should be--I think the Coasean lesson is we should be more critical of the simplistic theory that--the simple theory of course is important. But we have to exercise far better judgment about its application. And what distresses me is the astonishingly poor judgment that even many prominent economists have about using their theory to analyze the real world. Coase had a judgment on that front by anyone imaginable, by very few.

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COMMENTS (47 to date)
Brandon writes:

It was Jerry Jones son-in-law who was caught on camera cleaning his glasses during a game.

R.I.G. writes:

Hmmm... may just be me, but this episode won't download. Has anyone else had better luck?

Russ Roberts writes:

We're working on it. Stay tuned.

The new server is up and running again. You may have to clear your browser cache if you are listening directly from this webpage. Files are downloading properly on iTunes. If you still cannot access the mp3 files, please email me at webmaster@econlib.org.

Thanks, everyone, for your alerts and email. I've removed from public view all but the first of the can't-access-the-audio comments above so as not to deter newcomers to this page. We apologize for the inconvenience and thank you for your patience.

--Econlib Ed.
This comment was revised at 6:30 a.m., Oct. 29 to reflect the new status.

P.S. No, this server failure was not related to the government's more substantial problems. We were back up and running last night as predicted, and we're pleased to announce that there are no changes to price or coverage. :)

Jason Scheppers writes:

I may have had to wait until tonight to listen, but outstanding as always. Thank you, Gentlemen.

Ken from Ohio writes:

Another great podcast.

I was wondering if one of the commenters could give an explanation for the Tobacco Settlement.

It seems to me that:
1) Cigarette manufacturing is a productive economic activity

2) Smoking cigarettes results in an externality, a social cost, to the smoker.

3) The Tobacco Settlement provides a means of compensation for the externality, without putting the cigarette makers out of business.

I'm sure ther is a deeper explanation than that...
and I am interested

Thanks

Greg G writes:

I thought the first 95% of this podcast was brilliant. This was the part where the ideas of Coase were explained. In my opinion, the wheels really came off at the very end when the topic shifted to a parody of "mainline economics."

As a non-specialist in this material I was familiar with Coase mainly from the excellent interview Russ had done with him on a previous EconTalk. Russ and Don did a virtuoso job of making Coase's ideas come alive today.

I thought the analogy Russ made between a firm doing things in-house and a homeowners doing a lot of his own home repairs was extremely lucid and effective.

The explanation of how Coase's ideas show why airline overbooking can be the solution that makes the most people happy was clear and effective.

The analysis of why horse manure is dealt with differently in Montana than in NYC, and how that is an example of the larger theory, was powerful in the same way.

All that left me feeling that this podcast is not just a great tool for learning about Coase. It is also a great tool for learning about how the best teachers practice their craft. Thank you for all that. I can't see how that part could have been improved on.


In the last three minutes I thought the podcast suddenly veered off the track in an orgy of straw man bashing. First it was simply asserted that "mainline economics" of the type practiced by Krugman and Stiglitz means means that things like churches should not exist.

Then it was noted that they do exist. And just that easily the case was triumphantly considered to be proved. As a final flourish, Don did a little dancing in the end zone by chiding "mainline economists" for their lack of connection to "the real world."

Now this is an intensely ironic charge, coming as it does from a voluntarist who advocates an approach to the problem of government that the world has never seen.

There may be any number of good criticisms of mainline economics but this was not one of them. Their work was grotesquely caricatured and then dismissed. I think Don is at his very best when he points out how the things that he argues for are often unfairly caricatured and parodied in various ways. So it is ironic that he so easily indulges in the same thing.

When you get two people with the same ideology cheering each other on against straw men it is not nearly as interesting as when people are challenging each other and keeping each other honest.

This was a disappointing end to an otherwise superb podcast.

Greg G writes:

So then, transaction costs can explain why it often makes sense for firms to exist that operate in a top down, socialist manner. That is a great insight.

But it is an insight that can just as easily be used to explain why it makes sense for governments to exist that operate in a top down socialist manner. Not every problem should be tackled by the firm and not every problem should be tackled by government. But some should be.

The transaction costs of us each contracting separately for our own police protection and military defense would be extraordinarily high. The same applies to urban water and sewer systems, roads, fire protection and any number of other government functions.

I would have enjoyed hearing some discussion of that point that did not simply parody opposing viewpoints.

Walter Clark writes:

Russ, Rich,
Are you aware that the text stops before the end of the interview. I've seen that before. It often ends with the phrase "[more to come, 54:50] "
Walt

[Yes, Walt, we are all aware. I type up the Highlights myself in my occasional, rare spare time. We are happy if you find these optional materials useful. Sometimes a backlog builds up or something happens and I may not have time to finish them right away. For example, yesterday, as you may be aware, we had a little technical problem before I had a chance to complete them. And this episode is on the long side so I still won't have time to finish them today. Email me at webmaster@econlib.org if you have further questions.
--Econlib Ed.]

BZ writes:

@GregG -- interesting comments.
RE: "it makes sense for governments to exist that operate in a top down socialist manner". If it weren't for public choice analysis, there might be something to this.

Greg G writes:

@BZ

I agree that the problems identified by public choice analysis are very real. But they reappear when non-governmental groups need to make collective decisions. Whether it is a corporation, a non-profit, a club or even a family you still often see principal agent conflicts and decisions that don't accurately reflect the collective sentiments of the group.

Another problem is that simply referencing public choice analysis is so often used as a substitute for any further argument.

Michael writes:

Greg G,

Part of the issue is that with private companies, the market ultimately decides whether what a company is doing is worthwhile. A government will never fail or be forced to change processes because people stop buying its product, but a private company would be.

However, I think you are right to point out that central planning is involved in both. And even though there is a line (profits), it can be a somewhat blurry line. Consider:

1. "The market" passes its judgment on the products/services offered by the company to the public. But a customer can only directly evaluate the cost and quality of the product for sale, not the underlying business processes that lead to the product (at least not directly). If a company does a lot of things very well and a few things poorly, market forces may not help the company identify and improve on its weaknesses. It's often said that it is easier to learn from failure than from success.

2. What if a company's main customer *is* the government, as is true for many companies today?

3. What if companies choose to "compete" on K street instead of competing in the marketplace?

Don Boudreaux writes:

Thanks for the comments. I don't have time now to respond substantively, as I am preparing to teach a three-hour-long class tonight.

I do, though, apologize for mixing up my words in at least one case: I said "mainline" when I meant "mainstream."

One other quick note now: For better or worse, the end of the podcast to which Greg G objects - and perhaps with good reason - nevertheless reflects Coase's own attitude. Coase was HIGHLY critical of mainstream neoclassical economics (as practiced in his day by scholars such as A.C. Pigou, Paul Samuelson, Joe Bain, and Francis Bator). Perhaps I did "dance in the end zone" inappropriately, but I did so in an unambiguously Coasean spirit. Coase himself, while undoubtedly more low-key than I sometimes tend to be when criticizing mainstream economists who take their textbook theories too seriously, seldom lost an opportunity to criticize mainstream theory for its naive obeisance to "blackboard theories."

Nils writes:

What happened to Cafe Hayek?

Greg G writes:

@Don Boudreaux

I was not criticizing your portrayal of Coase. I thought that part of the podcast was excellent and went into some detail trying to make that clear.

It is the way that you caricatured mainstream economics that I want to challenge. Especially the part where you claim that the existence of churches somehow refutes the work of Krugman or Stiglitz. What exactly is it they said that leads you to make this claim?

I don't see how the existence of churches has much to do with economics at all. Many people (not me) believe in a life after death where we are judged and given eternal reward or punishment based on how pleasing our action have been to God in this life. That is plenty of motivation for them to donate time and money to their churches and the charities supported by their churches. How in the world does that disprove the work of any economist?


@ Michael

I certainly agree that bad government programs are a lot harder to kill than bad businesses. No argument there.

It is not true though that "A government will never fail or be forced be forced to change processes..." Politicians do sometimes lose elections and governments do fall and get replaced. When that happens voters are rejecting the product they are offering.

It is also worth noting that politicians are removed from office a lot more often and easily than corporate directors.

Mort Dubois writes:

I think that one thing to remember about non-governmental, bottoms-up norms for building/allocating common resources is that the actors involved might make decisions based on attitudes that include harmful prejudice irrelevant to the matter at hand - it's not inconceivable that membership in the right race or tribe might be an important consideration as to whether a newcomer is allowed to participate. And that consensus decisions might be to designed primarily to suppress competition and exclude outsiders, not just to maintain the resource. So this type of decision making isn't necessarily any better than government intervention. Nor any worse. The quality of these decisions depends mostly on the nature of the group of stakeholders and/or the government involved.

Walter Clark writes:

Is gasoline tax (collected by private companies) an example of what was presented in the paper "The Lighthouse in Economics"?
Walt

Jim Feehely writes:

Hi Russ,

Thanks again for another very lucid discussion.

When I read Coase's articles collected in a book, some time ago it struck me that his view of markets was the most realistic of any economic theory I have read.

Yet mainstream neo-classic market economics still emphasises nonsense like the efficient market hypothesis.

I disagree with Don's refutation of those who challenge the hegemony of market theory on the basis of social and natural complexity. I suggest that it is not an 'easy cop out' to point out that no economic theory or model goes even close to truly representing the realities of the great complexities that confront humanity.

In contrast, it is conventional economics that is most guilty of the 'easy cop out', although I do not count you as one of those economists. What conventional economics does when faced with disproof of the universality of any conventional theory or model is simply note the disproof as an exception, rather than thoroughly re-examine the relevant theory or model. That long-established practice of conventional economics, in my view, destroys its credibility.

Coase is rightly lauded for pointing out the obvious (not apparently recognised by any other economist until 1937) that transactions incur cost. But it must also be recognised that that all such costs are not quantifiable. It is economics' obsession with 'price' that most constrains its relevance. Social cost cannot be quantified because it is on-going and inter-generational. So what is economics' response?: We will go with the efficient market hypothesis because 'its the best we have'.

And all resources and nature itself cannot be reduced to the concept of property. Russ' comment that oceans are 'common property' reveals the limitation of economics, which, it seems can only think of the world in terms of property and price. That governments are so besotted with economic theory that suits their respective political ideology, it is no wonder that humanity is being debased by the delusion that economy is life.

Regards,
Jim Feehely.


lloydfour writes:

What I learned today:
Managers have been considering transaction costs all along and may not be aware that is what they were doing. So, when a company mentions synergies of a merger, I suspect what they really mean to say is that the purchaser sees the market driven low transition cost of the purchasee, how those low transaction costs translates into profits, and wants to import that into their structure. The risk to all that enthusiasm is that purchaser's already existing non-market driven internal transactions costs will overwhelms the purchasee's advantage leading to less than desired improvement.

lloydfour writes:

I have not yet read the Lighthouse article but it seems from the podcast that Lighthouse furnishes a format for businesses to take over the public transportation systems as discussed in the Dr. Winston's transportation podcast.

Russ Roberts writes:

Jim Feehely (and Greg G)

I understand your point but you take it too far. It is an understanding of economics that helps me understand why common property is misused. No one owns the ocean so the natural incentive is to overfish and overuse the resource. Why throw back a fish to grow larger if the odds are close to zero that you will be the one to catch it in the future?

So economic theory predicts that the oceans will be overfished to the point of possible extinction.

That's not a bad place to start. It is generally true that people take better care of their own property than the property of others or unowned property. That's what Don and I might call blackboard economics. It's useful. But in this case, it's not the end of the story. The rest of the story is that cultural forces emerge to prevent the destruction of common property in many cases. Norms develop and informal systems of property rights emerge that are enforced via culture rather than through legislation. Sometimes these are successful. Sometimes they are not. When they are not, legislation can potentially help, depending on how the political forces come into play.

In the case of the oceans, there is a wide array of responses. Lobster fishermen develop territories (and so do ticket scalpers by the way even though the sidewalk is unowned). Tuna get raised in enormous pens, converting public property into private property. And then there are legal interventions--minimum sizes for a catch along with limits on how many fish you can take.

The same idea applies with wikipedia. In some sense, economics suggests that it won't and can't exist. Why would anyone do something carefully for no pay? But wikipedia does exist and it's incredibly useful. That doesn't mean economics is wrong or useless. It means you have to apply it with a bit of art understanding non-monetary factors and the richness of culture and other forces that are part of economics properly applied.

Greg G writes:

Russ,

Thanks for taking the time to respond and thanks for the interviews. I listen to a lot of podcasts and EconTalk is my favorite. I don't always agree but you always make me think and I always learn something.

I agree with almost everything you wrote in the comment above. What I continue to challenge is the idea that Krugman or Stiglitz don't believe that "anyone" would "do something carefully for no pay." And that that they have advanced economic theories that the existence of churches would refute. I believe it is you guys who "take it too far" on this one.

I could be wrong but I am very skeptical that you guys can come up with the goods here. Let's see some quotes from those guys where they say what you claim they are saying.

Chambana writes:

Several observations:

Most of us change our lightbulbs and take out our trash not because of the high transaction costs, but because of the comparatively high “production” cost. The cost of finding a “supplier”, and then writing, specifying, monitoring and enforcing a contract is comparatively insignificant for a simple production process such as lightbulb replacement. (Conversely, the relative production cost of fixing an electrical system is high for most folks, suggesting that most of us will call electricians to economize on the production, not transaction costs.)

Second, I would argue that Coase’s paper was resurrected in the post 1975 period (not after the 1951 as suggested) with introduction of Williamson’s “Markets and Hierarchies”. The reason is simple: Williamson was the first to propose operationalization of the make vs buy dilemma (question originally posed in Coase’s 1937 piece), which then led to formation of the organizational economics empirical literature (including much of the work in the corporate strategy literature.)

Third, I urge Russ to bring in Williamson for a chitchat. From the current conversation an important issue remains unanswered. Namely, the difference between the two competing views of the firm: Jensen and Meckling’s (1976) “Nexus of contracts” view, which suggests that firm boundaries are irrelevant (also, view favored by most corporate finance people) versus the Coase/Williamson’s view that there is an important difference between an employment and a commercial contract.

Daniel Barkalow writes:

I think it's worth noting that government regulation is, in general, critical in creating the property rights that can then be negotiated on. If you have the farmer and the railroad, and the government doesn't get involved at all, there's no basis for a contract between the railroad and the farmer. Once the government steps in and assigns one of them a right, then the party with the right can sell it at some price like a tangible good. I suspect that the reason that economists came to the dinner party not believing Coase was that they hadn't considered the fact that you can make intangible property rights be fungible legal assets, rather than either unregulated behavior or non-transferable rights.

It's also worth noting that, in many of the cases you consider, the loss is not evenly distributed. If you punch me in the face, even if I accept that we're both to blame, I'm the one with the bloody nose. Even in places where pedestrians are supposed to avoid traffic, drivers are still penalized for collisions, because pedestrians get nearly all of the damage while they only have most of the responsibility, and matching the cost distribution of avoidance still means transferring some cost to the drivers. You have to do something of this sort, or people will go into business setting up useless, hard-to-stop spark-generators next to fields and getting paid to stop them.

Mike S. writes:

This podcast sets a new standard of excellence. Thanks to Russ and Don for the intelligent and entertaining discussion of some of the great works of economics.
Keep up the good work!

Don Boudreaux writes:

A clarification: I never said that Stiglitz or Krugman - or anyone else, for that matter - ever expressed mystification at the existence of unsubsidized churches and religion. Of course they never said such a thing.

My point is what I take to be the Coasean one that our world is full of phenomena that, according to the tenets of much mainstream economic theory, ought not exist (or ought not exist in the forms in which these phenomena are observed to exist). But because so many of these phenomena - such as unsubsidized churches - are so very common, we (including famous economists) typically take them for granted. We don't think about these phenomena as deeply as we should; we don't draw from them the lessons - for economic theory and for public policy - that we should.

It is I - Don Boudreaux - who says that unsubsidized churches such as we have in America are a challenge to the explanatory power of mainstream welfare economics. Many other such phenomena exists, too, if we only would take notice of them. (Note: please do not come back at me with the observation that contributions to religions are tax-deductible unless you are prepared to argue that in the absence of such tax-deductibility churches and religion as we know it in America either would not exist at all or would be very much fewer in number and membership.

Greg G writes:

@Don Boudreaux

It is quite true that you never said that anyone "expressed mystification at the existence of unsubsidized churches or religion." This why I never claimed that is what you said. We agree that you did not say that.

Which tenants of mainstream economics are the ones you think are refuted by the existence of churches which "ought not to exist" if mainstream economics is correct?

That question remains as unanswered now as when this conversation started.

I agree entirely that tax deductibility is not the issue here. America was full of churches long before there were taxes to deduct contributions to them from.

I do not claim an exhaustive knowledge of mainstream economics. If they really do claim, as Russ seems to suggest, that we shouldn't expect people to do things carefully for no pay then please show us where they say that.

If I am misinterpreting what you guys are saying please show us a few quotes from mainstream economists where they express these "tenants of mainstream economic theory" that should preclude the kind of churches we see.

Jim Glass writes:

our world is full of phenomena that, according to the tenets of much mainstream economic theory, ought not exist (or ought not exist in the forms in which these phenomena are observed to exist). But because so many of these phenomena - such as unsubsidized churches - are so very common...

What in mainstream economic theory says unsubsidized churches ought not exist?

I'm not trying to start an argument, but am curious about this claim. Coase has been my hero for decades, since he was only in his 70s, and following him I have a lot of reservations about mainstream 'blackboard economics' ("Utility is to mathematical economics what the aether was to 19th Century physics") but this issue never occurred to me.

People who are religious value the services of a priest or minister and thus voluntarily pay for them. The priest or minister takes the payments and organizes facilities to better serve the people, who become a congregation. The better service attracts more people to it.

What tenets in mainstream economics says this ought not to happen?

Russ Roberts writes:

The article on lighthouses that Coase wrote and that Don discussed in this episode is a response to the arguments of Paul Samuelson. Samuelson argued that a private person could not make a profit from a lighthouse because he would be unable to charge each user. Therefore, lighthouses need to be provided by government. The implication is that ships would "free-ride" allowing others to pay for the lighthouse. But if everyone free-rides, then there is no lighthouse. The point of Coase's article is that there are different arrangements short of government provision that could still result in lighthouses.


The free-riding issue is probably why Don brought up churches. It's why I brought up wikipedia in my comment earlier. In all of these cases, many economists would have argued that these institutions or organizations would struggle to exist or to thrive because of the incentive to enjoy the benefits of the contributions of others without making one's own contribution.

Obviously churches exist. No one is out there literally arguing they shouldn't or that they don't. But the standard view of economics (and in my youth I held this view) is that charities and churches are "too small" because of the free-riding problem.

I don't think Don wasn't saying that Stiglitz or Krugman think everyone will free ride--he was arguing that their style of economics often leads to simplistic policy conclusions such as government needs to do x or y because there is asymmetric information or something is a public good or there is free-riding. Or that a case for protectionism exists because of some special circumstance that may or may not exist in reality.

Such an approach ignores the creativity of voluntary actions that might work to overcome these problems and the challenges government has in implementing the policies that economists' theories suggest will improve matters. That's the Ostrom point that I raised in the podcast. Economics predicts that oceans will be ruined because of overfishing. That's an interesting start. But it's an incomplete story. It ignores what goes on to happen in the real world to cope with the blackboard incentives.

This is a very interesting set of issues. I hope to write more on it. If I do, I will try to alert EconTalk listeners on Facebook and Twitter on how to find it.

Greg G writes:

People join churches primarily because they believe they will be judged by an all knowing God. I gotta say I am still totally baffled at how there is, in that, any kind of incentive to free ride for believers. That doesn't seem like something God would like. Using a simplistic conclusion is not an effective way to argue against simplistic conclusions.

It would really help if Don could come up with some quotes from Krugman or Stiglitz to illustrate his point. This should be easy because the very thing that makes something "mainstream" is that it is very common.

The health of the oceans is a more interesting example of the principle and it will be interesting to see how that one turns out. I don't know how to fix it but most of what I read says the health of the oceans is continuing to deteriorate at an alarming rate.

Greg G writes:

So then, there are a number of ways to look at what is happening with the oceans. One way is to see in it primarily the failure of mainstream economists to realize that some people would do something about the problem even in the absence of government action. Maybe that is the most important issue here. Or maybe not.

Here is another way to view it using the same principles we see advanced here so often:

Life in the oceans evolved in a bottom up, decentralized way for many hundreds of millions of year through natural selection. The result was an astonishing volume and variety of marine life. Then suddenly, in what is the blink of an eye in evolutionary time, one single species began to exert an unprecedented degree of top down control over what happened in the oceans.

Due to an inability to plan competently for the results of such top down control, this species experienced a lot of pernicious unintended consequences from this top down control of the oceans. The "prosperity"of the oceans declined and with it the utility of the oceans for the dominant species also declined dramatically.

Then within that dominant species, an argument broke out about whether or not the transaction costs involved justified a more top down or bottom up approach to the problem.

So what should we conclude from all this? For me the main lesson is the point made by Oliver Wendall Holmes that general principles do not decide specific cases.

There are two reasons for this. The first is that there is almost always more than one general principle involved and these general principles often conflict with one another.

The second is that even the same general principle can look different at different scales.

Ralph writes:

@ Greg G: If man is just another species then his impact on ocean life is just as natural as everything that came before. It is just a successful species invasion. The Lion fish is having a similar impact as an invading species new to the waters of North America.

Great Podcast Russ and Don!

The church issue has to do with the mainstream economics assumption of maximizing utiltiy. If you are a proponent of Pascal's Wager, then churches meet that maximizing behavior assumption; but that is not why most people attend church or volunteer their time, treasure and talents to helping others. Mainstream Economics doesn't capture that distinction.

Why do people spend time on hobbies that don't pay? Why do they treat all their children as equals when they obviously will end up with different earning potentials?

Greg G writes:

Ralph,

Of course you are right that man is just as much a part of nature as any other species.

My point was that talk of top down or bottom up arrangements is always relative. Having one species dominate so throughly is relatively much more top down than not having one species dominate that way.

There is a very real sense in which government solutions are bottom up. Millions of voters elect thousands of political representatives who then hire thousands more bureaucrats. All of them have their own self interests at play. So the results of that are bottom up emergent in a very real sense. They result in unpredictable and unintended consequences.

Even so, viewed from a different scale that is relatively more top down than having non-governmental solutions determine the result.

Ralph writes:

How the officials gained office is not the point. The POLICY they produce determines their status as 'top-down' or not. Hitler was elected; was fascism 'bottom-up' emergeant?

Greg G writes:

Yes, Fascism was emergent. It was evil but it was emergent. Emergence refers to a process, not a policy.

Unless you just want to use the term, as many people do, as little more than a compliment for policies you like.

Ralph writes:

The concept of emergence is not the same as saying "Stuff Happens." Fascism wasn't emergent in the sense of a spontaneously rising complex order. If that were so, Hitler wouldn't have had to become a dictator. The movement may have arisen spontaneously from conditions in post-WWI Germany, but its control of the country was not "emergent."

You said earlier: "talk of top down or bottom up arrangements is always relative"

Explanations or excuses for 'arrangements' may claim spontaneous emergence, but everything about government is proposed, passed and enforced by someone. The legal system can be emergent based on a series of isolated precedents, but politics is not. You can say that the social and economic conditions favoring independence in America were emergent, but the Declaration, Revolution, and the Constitution certainly were not.

The issue was how our behavior, including the existence and functions of churches, often contradicts the insular utility maximizing assumptions of mainstream economics. I think Don simply threw out the names Krugman and Stiglitz as representatives of the current economic trends rather than as having discussed the 'economics' of churches. He could have mentioned any number of other economists, but they would be unfamiliar to us. These two often appear in the newspapers, hailed as leaders in the field.

Greg G writes:

Ralph

We do agree that emergence is not the same as saying that "stuff happens."

The definition of emergence is a matter of some controversy but I have never seen a definition that turns, as yours does, on the difference between conditions and the results caused by those conditions. Surely the conditions that cause the process of emergence to operate should be viewed as producing results that are, well, "emergent."

I prefer the definition of John H. Holland who says that emergence results from complex adaptive systems which he defines as follows:

"Cas [complex adaptive systems] are systems that have a large numbers of components, often called agents, that interact and adapt or learn."

Holland is a scientist who studies many different types of emergent systems in an attempt to determine what principles they have in common. One reason I think his definition is more reliable than most is that he is not an advocate for any particular economic or political policy.

Millions of different people played a role in Hitler's rise and fall. Some within his own government plotted to kill him and nearly succeeded.

You say that politics can not be emergent because "everything about government" depends on action "by someone."

Well then everything that happens in markets depends on action by someone too.

Actually your lapse into the singular there ("someone") betrays the error of talking as if one person can control a government with out relying on the actions of many, many other individuals, each with their own set of motives. Indeed, isn't that self interest of each individual and unpredictability of results one of the main insights that proponents of Public Choice Theory insist on when it suits them?


"Mainstream economists" are indeed less confident than Austrian economists in the reliability of markets to solve some problems. That in no way implies that they think that churches or private charities should not exist. And despite the fact that we are 36 comments in here, no one has yet been able to produce a single quote from a mainstream economist that implies such a thing. That suggests to me that even if there are a few such yet undiscovered crackpots out there, they are far from mainstream.

Ralph writes:

It seems according to your understanding, that everything that exists is 'emergent' because the conditions were there, and the fact that an order was imposed by an individual or party doesn't matter. Obviously you're not a proponent of the 'great man' theory of history. Things are because they are and because they are they are necessarily emergent? Mao's Cultural Revolution was emergent? Obamacare is an example of emergence?

Ralph writes:

There's some element of de facto and de jure involved. A spontaneous order can exist in contradiction to, or even as a response to, written laws.
Sometimes enforcement of the written laws disrupts the spontaneous order, and sometimes it reinforces the spontaneous order, particularly if the laws were written with knowledge of and appreciation for the spontaneous order.

Greg G writes:

Now that is exactly what I mean by simply using these terms as compliments for policies you like.

Russ Roberts writes:

Ralph and Greg G,

Many things are emergent. Not everything, but many things. And many of those things are things that look like they're not, so people are easily fooled into thinking that someone is in charge or controlling the process.

Some emergent phenomena have very nice outcomes because the feedback loops that hold them together encourage good outcomes. Some do not.

Here is a talk I gave on emergent order.

Here's my book on it.

Ralph writes:

Thanks Russ !

You know, when I wrote "Obamacare" in the post above, I didn't make it a link. Looking back, it now pops up an ad. That's odd.

Greg G writes:

I just finished listening to the talk and enjoyed it very much. Thanks for that Russ.

Unless I am misunderstanding you, we mostly agree on how to use the term emergent. There are far more emergent orders than most people realize but the word becomes meaningless if applied to everything. I think I remember an excellent EconTalk on ant colonies as emergent orders.

Classical physics emerges from quantum physics. Chemistry emerges from classical physics. Then biochemistry, life and consciousness form further emergent orders.

I particularly enjoyed your discussion of word meanings as emergent conventions. That is especially relevant here since the precise technical meaning of "emergence is still a matter of some debate, even among specialists. A couple of widely agreed on principles are: 1) More is different in many cases. You need a certain critical mass of components to see the phenomenon. And 2) The exact results are unpredictable, even in principle, due to a sensitive dependence on initial conditions.

So the convention on this one is still kind of up for grabs. The concept is important but very hard to define precisely. It is hard to find its exact borders. It has that in common with any number of important, but hard to define words like, "life," "love" and "consciousness to name a few.

I agree that markets do an astonishing job of efficiently using decentralized information. That is conventional wisdom now but it wasn't when Hayek explained it better than anyone had before.

I think Hayek did get a little sloppy in talking about emergence. He actually tended to use the word "evolution" which was problematic after Darwin. I think he should be forgiven for this since he was one of the first to explore the concept in a deep way and understand the unpredictability problem.

I think we agree that the political process often operates as an emergent order but not always in the good way.

I am trying to muster the will to read your book. I have heard good things about it. Unfortunately I am being blocked by a fierce and probably unfair prejudice against using novels to teach economics. That came from reading too much Ayn Rand.


John from Reno writes:

One thing that I did not hear discussed was the externalities of parties that are not in direct contact. If a power plant in Missouri pollutes the Mississippi River and it affects the Louisiana Coast, there is no feedback mechanism for the Louisiana residents to address their concern with the Missouri plant. Isn't that what government regulation is? A chance for citizens to collectively negotiate externalities with firms?

Owen Barron writes:

I'm getting to this podcast late, but I had to comment here because I, like Greg and others, was disappointed by the one-sided approach taken here. The two of you were clearly big fans of Coase and while, in other Econtalks, Russ usually plays a questioning or devil's advocate role, here he and Don seemed of one mind. That doesn't help us, the listeners, understand the controversy posed by Coase's theories. (Yes, you discussed how controversial Coase is, but mostly by discussing how "naive" conventional economists can be and how Coase boldly upended their ideas).

I'll start with the topic of the commons and overfishing of the oceans. In the podcast, this was discussed mostly in theory. Russ brought up the fact that in olden days, lobster trappers had managed to avoid the problem of the commons through voluntary restraint and social recriminations against those who over-trapped. Well, fine. I have no doubt that in small communities, where social cohesion is high and fishermen are not just competitors but also neighbours and constituents of the same churches, groups can restrain the naked self-interest of the market.

But people who are concerned with over-fishing aren't looking at markets that small. They're looking at the oceans at a macro-level, where the participants aren't New England fishermen but Malaysia and Spanish and Japanese and Canadian megacompanies trying to extract the highest possible catch. And they're seeing fish populations plummet. I'm neither an economist nor a fisheries expert, but a quick Google brought up this article (http://www.washingtonpost.com/blogs/wonkblog/wp/2013/10/29/just-how-badly-are-we-overfishing-the-ocean/) , which summarizes various attempts to describe the extent of overfishing. Note that more mature markets like the US, Canada, Norway, etc, have healthier populations... *precisely* because they have more stringent regulations. In the Wild West that is less regulated markets, overfishing is proceeding just as predicted by the tragedy of the commons.

So how exactly are private solutions expected to address this issue? There's not enough commonality or interaction between parties to enforce social recriminations. Could the major fishing companies establish an effective cartel, if unconstrained by regulation? No, since there would be little incentive to join the cartel and voluntarily limit one's own production. Could the cartel prohibit non-members from fishing? No, because that would violate their rights. And if we did allow the cartel to freeze out non-compliers, we'd have a legally sanctioned monopoly, the kind Hayek thought wouldn't arise naturally.

You also keep returning to the Wikipedia model, as if its existence disproves the validity of conventional economics or shows that Coase had a better understanding of how people and markets interact. I'm not a specialist, but I don't understand what point you're making. Wikipedia is nothing but a technological example of volunteerism. Why do people help out at soup kitchens, or pick up trash outside their home towns? They obviously derive some non-monetary value from their labor. We can't really predict or model it, but I'm not hearing many "mainline" economists angrily shouting "People shouldn't volunteer! It doesn't make sense!" And why is Wikipedia free? Well, being free helps keep labour free too (psychologists have shown that when you introduce token amounts of money to a transaction that had previously been voluntary, people get offended and are less likely to work than they were when they were working for free). So of course people "free ride" on Wikipedia-- that's what it's there for.

I've gone on too long already, but as I said above, I wasn't especially impressed by the critical discourse in this episode. Polemicists on both sides of the ideological aisle frequently deride their opponents as naive, unable to understand the complexity of issues. I was hoping better than that sort of straw men from you folks.

(But keep up the podcasting, it's great! Thanks so much).

Andrew Wagner writes:

Russ,
I'd like to contribute a few thoughts on Theory of the Firm, and the Use of Knowledge in Society, from the perspective of somebody who has spent his career within large industrial firms.

The ongoing debate in the business community between manufacturing cost accounting methods illustrates transaction costs and the knowledge problem in firms, and provides another lens to look at the outsourcing debate in American manufacturing today. Since the 1920s, most American firms, led by General Motors have used an internal method known as "standard cost accounting" to determine the cost of components or products made within the firm. How much should a GM transmission plant “charge” a GM assembly plant for its component? And how does GM minimize the transaction cost of calculating this number?
The standard cost method has often been used to determine the price at which to sell to other firms as well. Basic economics tells us that price is determined by what the customer is willing to pay, not by cost, yet many firms still use standard cost methods to set prices because it’s easier to calculate costs and add margins than it is to determine what a customer is willing to pay—knowledge problem in action.
Now, those of us familiar with standard cost and familiar with manufacturing operations--knuckle-dragging neanderthals with machining oil soaked into the soles of our shoes--know well that standard cost accounting, as conceived in the 1920s, does not reflect the modern workplace in the slightest. Standard cost assumes that all costs of the firm are directly proportional to the number of labor hours it takes to make a product. In the manual labor days of the early auto industry, this was a safe approximation, however, with the widespread automation that has taken place in the intervening 90 years, direct labor cost pales in comparison to the costs of facilities, tooling, maintenance, equipment, and support staff. Standard cost accounting buries these costs in its obscure allocations. As a result, the standard cost number obscures the knowledge about the manufacturing process that engineers and managers need to make decisions. Outsourcing decisions are usually based on this kind of incomplete information.
A number of alternatives have been proposed and embraced across industry: Activity-Based Accounting, Throughput Accounting, Velocity Accounting, and Lean Accounting to name a few. The debate about which to use, and the entrenched interests around standard cost methods are vigorous. Each of these is an attempt by firms to answer that simplest of questions begged by Coase' essay: how much does it cost me to make this widget within my firm instead of outside?
An interesting practical example of how the knowledge problem manifests itself in industry is given by the strategies that Toyota is known to use around supplied parts for its automobiles (Liker). In contrast to most American automakers, Toyota is known to engage in few long-term partnerships for its supply of components. Further, Toyota, as a matter of philosophy, retains the ability, internal to the company or its subsidiaries, to make any given family of car parts. For example, when developing hybrid technology, Toyota bought an interest in a battery manufacturer so that they would have access to the tacit knowledge involved in making batteries, rather than relying on an external firm and explicit contract relationships. As a result of this deeper understanding, Toyota's contracts with external companies can be more explicit on the dimensions they have discovered to be critical to the performance of their product. Producing a small percentage of a given component type gives them the information they need to reduce transaction costs across the entire part family. Many consider this one of Toyota’s main strategic advantages for cost and quality.

Russ Roberts writes:

Owen Barron,

The funny thing is that I agree with you. Voluntary emergent solutions work poorly with large groups of strangers. Coase would agree with you, too.

In one hour, it's impossible to cover every nuance of any serious idea.

The wikipedia point isn't about Coase. It's about the naive application of an otherwise good idea (incentives matter) and to remind ourselves that the world is a complex place.

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