RONALD COASE 

George Stigler on Coase

The Coase Theorem:
An Alternative to the Widely Accepted Pigouvian Viewpoint
by Nicole Gable, April 2002

 

George Stigler on Coase

The disharmonies between private and social interests produced by external economies and diseconomies became gospel to the economics profession. Economists accepted this gospel the way they accept supply and demand as the forces determining prices--instinctively and without misgivings. When, in 1960, Ronald Coase criticized Pigou’s theory rather casually, in the course of a masterly analysis of the regulatory philosophy underlying the Federal Communications Commission’s work, Chicago economists could not understand how so fine an economist as Coase could make so obvious a mistake. Since he persisted, we invited Coase (he was then at the University of Virginia) to come and give a talk on it. Some twenty economists from the University of Chicago and Ronald Coase assembled one evening at the home of Aaron Director. Ronald asked us to assume, for a time, a world without transaction costs.

That seemed reasonable because economic theorists, like all theorists, are accustomed (nay, compelled) to deal with simplified and therefore unrealistic "models" and problems. Still, zero transaction costs are a bold theoretical construct. It implies, for example, that in buying an automobile one knows the prices all dealers charge (with no cost to anyone in time or money), that one is completely certain what all warranties for replacement of defective parts or provision of services mean and has complete confidence that they will be fulfilled (without controversy), and so on. Zero transaction costs mean that the economic world has no friction or ambiguity.

 

Coase then asked us to infer that in his abstract world there would be no external economies or diseconomies, and I guess rather then remember that we accepted this implication without much argument. The thirty coal mine operators would arrange a contract to have each do the amount of pumping (for suitable compensation) that made industry profits the largest possible, since meetings to arrange a contract and the enforcement of the contract would be free. Indeed such meetings would still be costless if there were 3000 mine owners. In a regime of zero transaction costs, lawyers would perish.
But Ronald asked us also to believe a second proposition about this world without transaction costs: Whatever the assignment of legal liability for damages, or whatever the assignment of legal rights of ownership, the assignments would have no effect upon the way economic resources would be used! We strongly objected to this heresy. Milton Friedman did most of the talking, as usual. He also did much of the thinking, as usual. In the course of two hours of argument the vote went from twenty against and one for Coase to twentyone for Coase. What an exhilarating event! I lamented afterward that we had not had the clairvoyance to tape it.
The argument turned on a picturesque example Coase had used. A cattle rancher lives next to a grain farmer, and occasionally the cattle of the rancher invade the fields and damage the grain of the farmer. Does it make any difference in the number of cattle maintained and the amount of grain grown, whether the cattle rancher is responsible for the damage to the grain or the grain farmer is responsible? The Coase answer is: No! One way of making Coase’s answer plausible is to ask what will happen if both the grain farm and the cattle ranch are owned by the same person. That single owner should combine the two operations to achieve the largest profit. If, for example, adding another head of cattle raises cattle profits by $100 but lowers grain profits by $120, he won’t add that head of cattle. Similarly, he will decide on building a fence only if the savings over the years fully compensate for the cost of the fence. But separate owners of the grain farm and the cattle ranch can achieve exactly this best solution by contract, and they will be led to do so because then they will have a larger pie to divide. The assignment of legal liability for the grain damage will determine who pays whom, but it will not affect the best way to conduct grain farming or cattle ranching.
This proposition, that when there are no transaction costs the assignments of legal rights have no effect upon the allocation of resources among economic enterprises, will, I hope, be reasonable and possibly even obvious once it is explained. Nevertheless, there were a fair number of "refutations" published in professional economic journals. I christened the proposition the "Coase Theorem" and that is how it is known today. Scientific theories are hardly ever named after their first discoverers (more on this later), so this is a rare example of correct attribution of a priority.

 

The "reserve" clause in professional baseball for a long time gave the right to control a player’s services so long as he remained in baseball to the team with which a player first signed. (The clause has been eliminated in recent times.) Hence if a team succeeded in first signing a future star, a new Ted Williams for example, it used to be said that the team could keep him permanently-even though he might be much more valuable (in terms of gate receipts) to another team. The Coase Theorem tells us that is wrong: The player would be sold to the team where he was most valuable. That isn’t much of a trick in contract negotiation; both teams and the player would gain by the transfer. The reserve clause could affect how much of his contribution to the gate receipts this player received, but it would not lead to his use on the wrong team. Examples of the Coase Theorem could be multiplied, but the baseball player’s contract should suggest the source of the excitement. The way one looks at many problems is now changed; we look to see whether solutions that benefit both parties can be achieved by negotiation. That approach to problems has wide-ranging effects. Consider the suits at law to settle controversies: Why shouldn’t the two parties to a contract dispute agree on a compromise, and save the money both would have spent on a lawsuit? Generally, indeed, they will, and only a tiny fraction of legal disputes reaches the courtroom. Most courtroom litigation is now attributed to large differences between the parties in their estimates of the probability of winning the suit. Where the facts and the law are clear, the suits will be settled before trial. It is not surprising, therefore, that the Coase Theorem has filtered into the leading law schools and receives much attention in courses and law-journal articles on torts, property, and contracts. Coase himself became a professor of economics in the Law School at the University of Chicago, a proper home for his genius.

 

Creativity often, and perhaps usually, consists of looking at familiar things or ideas in a new way. My most important contribution to economic theory is probably the treatment of information as a valuable commodity that is produced and purchased. I was led to the problem of information by noticing as every shopper in history has noticed that one can often find a lower price by canvassing more sellers. Yet the standard theorem in economic theory was that under competition there will be only one price for a homogeneous good in a market. The theorem simply said that both sellers and buyers would seek out and eliminate all differences in prices. For example, as long as a single seller will accept a lower price than the one the buyer was about to pay, the buyer will seek him out. In seeking to reconcile with the theorem the observed array of prices for even identical goods say, a specific tool priced in thirty hardware stores), I sought an obstacle to complete search for better prices, and found it in information costs. There is a cost in time and travel in discovering how much each seller is asking and how well he provides other services such as a good inventory and quick replacement of defective products. The result is complementary to Coase’s work because I had been examining a major component of transaction costs and, in fact, my article appeared at about the same time as his.
From Memoirs of an Unregulated Economist by George J. Stigler (Basic Books Inc. 1988) page 75 - 80

 

 

 

The Coase Theorem:

An Alternative to the Widely Accepted Pigouvian Viewpoint

By Nicole Gable, April 2002

 

 

Ronald Coase, winner of the 1991 Nobel Prize for economics, has made great contributions to the evolution of theories regarding externalities, market efficiency, and legal rights.  His alternative views on the established beliefs of the economic community have caused many to rethink the Pigouvian ideas of market efficiency in a world with externalities.

 

Background
Born in Willesden, a suburb of London, England, in 1910, Coase attended the London School of economics where he received a Bachelor of Commerce degree in 1932 and a Doctor of Science degree in economics in 1951.  While he received proper education during his university years, his early years of schooling were much less positive.  As a child, Coase was told by doctors he had to wear irons on his legs, due weaknesses found in them; as a direct result, he was forced to attend a school in England for “physical defectives.” This school was run, in turn, by the same organization that ran the school for “mental defectives,” and as Coase states, “there was some overlapping in the curriculum.”  Literally enrolled in courses such as Basket Weaving, Coase did not begin proper education until about the age of 10.
After attending the London School of economics, he was hired as a faculty member at the university from 1935 to 1951.  In 1951 he moved to the United States, where he began his American career at the Center for Advanced Study in the Behavioral Sciences, and after a year moved to the University of Buffalo. Then, in 1959, he moved to the economics department of the University of Virginia, and in 1969 moved again to the University of Chicago, where he became the editor of the Journal of Law and economics until 1982.  The journal promoted the writings of economists and lawyers about how actual markets operated and about how governments go about regulating or undertaking economic activities.  The Journal of Law and economics was the first step in the creation of a new subject at the University of Chicago, “Law and economics,” which was primarily developed through Coase’s research and studies.
His major publications include The Problem of Social Cost (1960), The Firm, the Market, and the Law (1988), and Essays on economics and Economists (1994).  Of these, Coase is best known for his contribution to economic theory known as the “Coase Theorem” (1960).  It was in direct contradiction to the mainstream theories of the time, particularly Pigou’s theory that only governments (or other forms of a visible hand) have the ability to internalize externalities that adversely affect the efficiency of the market.  Below I will outline the conventional thinking of the time, and contrast it with the new thinking of Coase, which caused a reevaluation of judgements across the economic world. 

 

The Coase Theory versus the Conventional Pigouvian Views
Under the Pigouvian theory, externalities can only be internalized through a tax or subsidy.  In a “perfect market,” goods are only produced if costs are less than revenues or the benefits of the goods, thus resulting in a “profit” for the individual.  Those goods whose costs are greater than the price that they can be sold for are therefore not produced, since this would obviously result in a net loss.  Under this system, individuals pay for the costs associated with production, which includes rent to land owners, costs of equipment, wages to workers, etc. 
However, when externalities are apparent, these same individuals no longer pay for all the costs they incur. The externality concept is when one person’s (or firm’s) actions impose costs or benefits on others.  So, in the case of production of goods, where externalities are present, a person no longer pays for all of the costs of production, leading to market inefficiency.  For example, consider the effect of pollution on market efficiency.  If a steel producer has direct costs of a ton of steel of $100, and can sell the steel on the market for $150, the firm will choose to produce and make a profit. 
Now consider if the steel producer emits sulfur dioxide into the air.  The result might be a $100 of cost to those living around the factory.  However, even with the increased cost of production, now greater than the benefit ($250 in cost versus $150 in benefit), the firm will still choose to produce; thus, market is in a state of inefficiency.  Plus, another inefficiency results.  Under the theory of perfect markets, it is worth eliminating the steel producer’s pollution if the cost is less than the benefit.  But, even if it costs $75 to eliminate the pollution, the result will remain – the steel producer will still continue to emit the sulfur dioxide.  As long as the steel producer does not bear the cost of pollution, the emission of sulfur dioxide will continue at the expense of the public.

 

In order to eliminate these inefficiencies, the externalities must be internalized for the steel producer.  There are two methods that obtain this result: direct regulation and emission fees.  Under direct regulation, the government orders restrictions on how much pollution the firm can emit.  With emission fees (or Pigouvian taxes), the government taxes the company for the pollution it produces – the pollution cost actually becomes internalized for the company, and the company, in turn, includes pollution as one of the costs of production.  However, under each of the options, the government is in control of the outcome instead of the market.
Before Coase, this way of thinking was nearly undisputed, and was taught in universities and textbooks worldwide.  Coase’s contribution stemmed from his “thinking through questions more carefully and correctly than anyone else, and in the process demonstrating that answers accepted by virtually the entire profession were false.”[1]  He essentially rewrote the theory of externalities, finding that in a world without transaction costs, market efficiency will result even with externalities.
First, legal rights as previously defined needed to be adjusted.  Coase established that once property was well-defined and easily tradable, the efficient solution would follow.[2]  In the case of the steel producer above, the individual who is being polluted against could pay the firm to reduce emissions of sulfur dioxide if the steel producer had the rights to pollution.  If the benefit of reducing pollution for the individual were greater than the cost, the individual would pay this benefit less the cost to the firm, resulting in social efficiency.  Basically, the government device of Pigouvian taxes is unnecessary; socially speaking, the two sides of the transaction (the “winners” and the “losers”) can internalize the costs of these externalities privately through negotiation, resulting in the same outcome.  So, no matter where the property rights are assigned, the efficiency of resource allocation will not be affected. 

 

Coase’s most famous example is of the railroad and the farmer.  In this example, the railroad passes through the farmer’s wheat field, and the sparks from the train ignite the wheat – an externality for the railroad.  If the railroad has the legal rights to emit the sparks, the farmer will assess the damage done to his wheat and either pay the railroad to put on spark catchers or deal with the damage done to the field (whichever is a more economically sound decision).  On the other hand, if the farmer owns these legal rights, the farmers can require the railroad to put on these spark catchers.  Now the railroad must assess the costs and benefits of their choices: if it is more expensive to install the catchers than the cost from the loss of wheat to the farmers, then the railroad would simply pay the farmers; otherwise, the railroad would install the spark catchers.  No matter who owns these rights, the outcome is the same – the market moves towards efficiency.
So, the Coase Theorem deals with the question of ownership.  No matter who is deemed owner, under private enterprise, even with externalities, the result is the same (again, with zero transaction costs).  Robert Coase gives another example, which uses the discovery of a cave.  Under his theory, it is irrelevant who the law says owns the cave.  It could be owned by either the one who discovered it or the official owner of the land on which the cave sits.  Either way, if the cave could be used for any number of things (storing food, growing mushrooms, etc), but in the end, the cave will be used for which use produces the most value.  “The law of property determines who owns something, but the market determines how it will be used…people will use the resources in the way that produces the most value.”[3] 
Coarse also sees the issue of pollution in a very different light than most.  For him, pollution is both negative and positive.  On the one hand, pollution has obvious negative effects on the environment and human race.  However, pollution is created because it is simply a cheaper method of production for the firm.  This “less expensive” production is the positive side of the seemingly purely negative effect of pollution.
Also, it is not only one party that brings about the cost of pollution; instead, the cost is a result of both parties making decisions which maximize their own utilities.  In the railroad example, the railroad has found it less expensive to spray sparks than to fix the problem, while the farmer also made the decision to use that particular site for his crops.  The farmer in this situation has choices in the matter; he can move his farm, pay the railroad to eliminate the sparks, or simply deal with the cost of lost wheat.  He will chose whichever solution is optimum in terms of net value.  Underlying the Coase Theorem, the basic idea is that with no transaction costs, the market’s resources will be used efficiently, and each party, working to maximize their personal value, will privately solve the problems created from externalities.

 

Conclusion
Since the publication of “The Problem of Social Cost,” economists, students, and the like have questioned and negated the Coase Theory.  Coase states that he now receives letters from around the world (since being awarded the Nobel Prize) in an attempt to break down the Theorem.  In particular, skeptical economists argue that the Coase Theorem is merely a theoretical curiosity, of little or no practical importance in a world where transaction costs are rarely zero.[4]  However, this theorem is young, and its evolution and development is surely to continue.  As a base, though, it has provided the economic community with a plausible and sound alternative to the historically-accepted Pigouvian thought process.

[1] “The Swedes Get It Right,” Reason Magazine and the University of Chicago Law School Record

[2] “Looking for Results,” Interview of Ronald Coase in rights, resources, and regulation by Thomas Hazlett, www.reasononline.com

[3] “Looking for Results,” Interview of Ronald Coase in rights, resources, and regulation by Thomas Hazlett, www.reasononline.com

[4] “The Swedes Get It Right,” Reason Magazine and the University of Chicago Law School Record

Works Cited

 

http://www.encarta.com

http://www.nobel.se/Economics/laureates/1991/coase-autobio.html

http://www.daviddfriedman.com/Academic/Coase_World.html

http://www.law.uchicago.edu/faculty/coase/

http://law.gsu.edu/wedmundson/Syllabi/Coase.htm

http://cepa.newschool.edu/~het/profiles/coase.htm

http://www.econ.ucla.edu/hubbard/ec174/Lectures/3COASE.htm

http://www.fortunecity.com/meltingpot/barclay/212/subjecti/workpape/coasmeth.htm

http://www.maths.tcd.ie/local/JUNK/econrev/ser/html/coase.html

http://www.faculty.econ.northwestern.edu/faculty/witte/pf/handouts/coase.html

http://www.econ.ucla.edu/hubbard/ec174/LectureS/2coafwt.htm

http://www.aliveness.com/kangaroo/L-chicoase.htm

 

 

LINKS

http://en.wikipedia.org/wiki/Ronald_Coase
http://nobelprize.org/nobel_prizes/economics/laureates/1991/coase-autobio.html
http://www.econlib.org/library/Enc/bios/Coase.html
http://www.coase.org/aboutronaldcoase.htm
http://www.law.uchicago.edu/faculty/coase
http://cepa.newschool.edu/het/profiles/coase.htm
http://almaz.com/nobel/economics/1991a.html
http://www.huppi.com/kangaroo/L-chicoase.htm
http://www.sfu.ca/~allen/CoaseJLE1960.pdf
 
 
 
 
 
 
 
 
 

 

 

 

 

 

 

 

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