Atanu Dey On India's Development

Ronald Coase and his Theorem

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Ronald Coase, the author of “The Nature of the Firm” (1937), turns 100 on December 29th, reports The Economist. Wow! If you have not heard about Coase — which is likely if you are not an economist — you have a treat waiting for you.

I briefly mentioned Ronald Coase in a March 2008 post, reproduced here.

I clearly remember the moment when a light went off in my head [around 1996]. Brian Wright was teaching and we were talking about EV and CV. Equivalent variation and compensating variation, and the related concepts of “willingness to pay” and “willingness to accept.” As I had come to economics rather late in life, I had had the opportunity to figure out some of the basic concepts in my head. But I did not have the vocabulary to fully express the ideas. So when I got the vocabulary, it was an “aha” moment.

I remember Brian posing the question: so PG&E (the local gas and electricity utility company) is going to string up high-tension cables above your backyard, which you know increases health risks. In other words, PG&E’s action would impose an externality on you. How much are you willing to pay to stop PG&E from doing so? And how much are you willing to accept to allow PG&E to do so? Note that in the former case, the assumption is that PG&E have the right to string high-tension cables over your backyard and you wish to stop them; in the latter case, you have the right and can disallow PG&E from stringing wires across your backyard. It’s a matter of who owns the rights.

The willingness to pay is bounded by how deep your pocket is but the willingness to accept is open-ended. If PG&E owns the rights, then most likely you are out of luck because you may not be able to pay them enough to deter them from going ahead. If you own the rights, then you can make a pretty neat pile of cash by holding out.

Ronald Coase showed that regardless of who owns the property rights, if there are no transaction costs, then bargaining among the parties is sufficient for the discovery of the economically efficient amount of pollution.

Sometimes I wonder. I wonder if we would continue to have the kind of problems such as Nandigram if basic economics principles were better appreciated by a large percentage of the population. I think a lot of coercion and violence could be avoided. But perhaps I place too much faith in rationality.

Here’s a bit from that article in The Economist mentioned at the start of this post.

His central insight was that firms exist because going to the market all the time can impose heavy transaction costs. You need to hire workers, negotiate prices and enforce contracts, to name but three time-consuming activities. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. But if markets are so inefficient, why don’t firms go on getting bigger for ever? Mr Coase also pointed out that these little planned societies impose transaction costs of their own, which tend to rise as they grow bigger. The proper balance between hierarchies and markets is constantly recalibrated by the forces of competition: entrepreneurs may choose to lower transaction costs by forming firms but giant firms eventually become sluggish and uncompetitive.

. . .

Mr Coase’s theory continues to explain some of the most puzzling problems in modern business. Take the rise of vast and highly diversified business groups in the emerging world, such as India’s Tata group and Turkey’s Koc Holding. Many Western observers dismiss these as relics of a primitive form of capitalism. But they make perfect sense when you consider the transaction costs of going to the market. Where trust in established institutions is scarce, it makes sense for companies to stretch their brands over many industries. And where capital and labour markets are inefficient, it makes equal sense for companies to allocate their own capital and train their own loyalists.

That article goes into what the limitations of Coase’s work are. Worth a read, for sure. And now, here’s a bit on the Coase theorem from the Wiki.

In law and economics, the Coase theorem, attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that when trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasian bargaining.

This theorem, along with his 1937 paper on the nature of the firm (which also emphasizes the role of transaction costs), earned Coase the 1991 Nobel Prize in Economics. The Coase theorem is an important basis for most modern economic analyses of government regulation, especially in the case of externalities. George Stigler summarized the resolution of the externality problem in the absence of transaction costs in a 1966 economics textbook in terms of private and social cost, and for the first time called it a “theorem.” Since the 1960s, a voluminous literature on the Coase theorem and its various interpretations, proofs, and criticism has developed and continues to grow.

. . .

Coase’s main point, clarified in his article ‘The Problem of Social Cost’, published in 1960 and cited when he was awarded the Nobel Prize in 1991, was that transaction costs, however, could not be neglected, and therefore, the initial allocation of property rights often mattered. As a result, one normative conclusion sometimes drawn from the Coase theorem is that property rights should initially be assigned to the actors gaining the most utility from them. The problem in real life is that nobody knows ex ante the most valued use of a resource and also, that there exist costs involving the reallocation of resources by government. Another, more refined normative conclusion also often discussed in law and economics is that government should create institutions which minimize transaction costs, so as to allow misallocations of resources to be corrected as cheaply as possible.

Transaction costs matter. See my posts on “It’s Transaction Costs All the Way” (Part 1 and Part 2) from July 2004.

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    Coase is alive! Wow! And he’s publishing a new book! Incredible…
    How come I didn’t know that? I guess the prejudices one forms in one’s youth actively prevent one from noticing information that doesn’t ‘fit’ even after one has discarded the theory one then subscribed to.
    I recall being taught Coase’s theorem at the LSE back in 81- but in the context of Public Finance not Theory of the Firm- and quite naturally thought it wasn’t relevant as it arose against a background of Substantive Rationality and bred complacency amongst the Right Wing Nut Jobs who were on the rise back then.
    Thus Coase’s theorem, in my mind ranked with the Laffer Curve or Laffer’s notion that a monopolist competes with his potential competitors (who are infinite) and so Monopoly must always be atleast as allocatively efficient as Perfect Competition. Indeed, back in those days when it ‘was Morning in America’- I still vividly recall that the Sun shone at Night, because it had to compete with that other potential Sun Laffer had predicted.
    Back then, my memory is, the Myerson-Satterthwaite theorem seemed way more fundamental and that type of approach did indeed seem to have more practical applications.
    The problem, for me, was my own penchant for a mimetic approach- i.e. most preferences and transactions are mimetic, not in some grand Hegelian or Girardian phenomenological or metabletic sense but because networks work that way- complexity economics based on cellular automata were starting to generate that sort of stuff back then- BUT this approach pretty much puts paid to Economics of the Pareto/Walras type.
    Indeed, Pareto’s own trajectory illustrates this. I see Henry Adams as a parallel, or foil, to Pareto (except he didn’t know any Math) and what is interesting is that this type of Liberalism ended up seeking scapegoats (as Renee Girard’s theory would require) like the Jews and so on.
    For Indian origin Religious and Cultural traditions, a Mimetic Field approach is quite natural (Boscovitch’s notion of a Field may as plausibly derive from the Vimalakirti Sutra just as Leibniz’s monadology from the Buddha Avatamasataka) but does not need the scapegoat, the ritual violence, the coercion.
    In this sense, it might be socially useful for Economists to speculate as to what exactly constituted that Game Theory which Yuddhishtra had to learn to overcome his Vishada (Depression, parallel to Arjuna’s accidie in the Gita)
    Perhaps some thread or discussion topic could be started on this.