Economists Do It With Models

Warning: “graphic” content…

Bookmark and Share
Happy Birthday, Mr. Coase…

December 29th, 2010 · 7 Comments
Econ 101 · Environmental Econ · Markets

(As before, you have to imagine that in my Marilyn Monroe voice. Also, aren’t my Photoshop skills coming along nicely?) Today is the 100th birthday of economist and Nobel Laureate Ronald Coase. Why is this interesting? Well, for starters, there’s the fact that he’s still alive. Second, there’s the fact that he’s not only still alive but has a new book coming out with Ning Wang of Arizona State University about China and its economic system. (In case you’re wondering, I currently have a feeling not unlike the one that I get when I am running a marathon and get passed by some 75-year-old dude with his running shorts pulled up to his armpits.) Third, he wrote one of his most influential papers in 1937 but, according to my sources, didn’t get his doctorate until 1951. (There is hope for me yet.)

So why is this guy so important? Well, he made two major contributions to the field of economics. First, he initiated a lot of the theorizing on why companies exist. Think about it- when you hear about Adam Smith and the invisible hand of the market as it relates to the breadmaker’s self interest, you’re implicitly led to envision a world where everyone is essentially a self-directed entrepreneur. However, despite the fact that no one says “I want to work in HR at Bank of America when I grow up,” we see a lot of companies and a lot of employees as opposed to independent contractors. Why is this? After all, it’s theoretically possible to produce all of the things that we currently produce by buying the product and service inputs as needed in an open market. Coase’s explanation is that it has to do with transactions costs- can you imagine how annoying it would be if you had to engage in a market transaction every time you wanted your assistant to write an email? Because of these sorts of logistical costs, it is often easier to hire people into an organization and pay them for the right to tell them what to do rather than have them figure out over and over where their services are most needed.

Coase’s second main contribution is, not surprisingly, the Coase theorem. The Coase theorem states that “if 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.” Huh?

Personally, I like to refer to the Coase theorem as the “get off my lawn you damn kids” principle, and it is most easily explained via an example. A little while back, I wrote about how households in Eastern Oregon were being offered cash to not complain about noise from wind turbines. I had meant for the post to be about internalizing externalities, but a number of astute commenters pointed out that it was an interesting illustration of what Coase was talking about. In the example from the article, it is implied that households have a right to a quiet environment- if they didn’t, their complaints would fall on deaf ears and wouldn’t be of concern to the wind power company. However, it also follows that the right to pollute via noise is worth more to the wind power company (at least $5,000 per household) than the right to quiet is worth to households (at most $5,000), since a payout of $5,000 per household induced an agreement to not complain from most households. Therefore, when property rights are allocated to households we end up with turbines and no complaints, and this is an efficient outcome since the turbines are worth more to the company than the quiet is to the people. Now suppose that, rather than households having the right to noise, the company had the right to noise pollution. The households wouldn’t be willing to pay enough to make it worth the company’s while to turn off the turbines, but they also wouldn’t have any grounds for complaint, and we would again have turbines and no complaints. Note, however, that in the first scenario the households got $5,000 each, while in the second scenario they didn’t get squat. This is why Coase merely said that the outcome would be efficient, not that the allocation of value or payouts would be fair.

As such, I will leave you with a suggestion from Twitter user @jbarro:

In celebration of Ron Coase’s 100th birthday, go offer your neighbor money to stop making that annoying noise he makes.

Tags: Econ 101 · Environmental Econ · Markets

7 responses so far ↓

  • 1 Dr. John S. Harvey // Dec 29, 2010 at 10:00 pm

    The Coase Theorem explains reality very well except in the case of extreme preferences. For instance if I am very allergic to a given environmental pollutant (say to the point of death if it is present for extended time periods), than you will end up with different outcome in terms of the amount of the pollutant produced (some versus none) depending on who (me or the polluter) gets the property right in the first instance.

  • 2 Justin Ross // Dec 29, 2010 at 11:49 pm

    I’d like to add that Smith did not seem to intend on people envisioning producers as a bunch of one-man shops or independent entrepreneurs. His WON chapter on the Division of Labour (Book 1, Chapter 1) famously describes the setting of a pin factory, and to some extent he expresses what business schools today label as the “make or buy” decision. I like to think of Coase’s 1937 piece as fleshing out the details and the importance of costly access to market information in Smith’s Pin Factory.

  • 3 econgirl // Dec 30, 2010 at 2:31 pm

    What you say is mostly true, which is why I’m a tad perplexed regarding how these concepts get glossed over a bit in the discussion of the invisible hand:

    “By directing that industry in such a manner as its produce may be of greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”

    The notion of people seeking out the highest-value use for their labor is at odds to some degree with what Coase would consider employment, since Coase basically defines the employment scenario by something along the lines of “a worker no longer moves from task A to task B because his value is higher in task B, he moves from task A to task B because he is told to do so.” In this way, the notions of employment and firms supercede the invisible hand (or supercede the price system, as Coase puts it). I guess you could imagine the invisible hand pushing people to their highest value employment option, but it’s not quite the same.

    Technically speaking, Smith’s pin factory doesn’t require employment contracts, and each person in the pin factory could act as an independent entrepreneur with a very specific product or service.

  • 4 Dan Hirschman // Dec 30, 2010 at 3:10 pm

    Dear Jodi,

    Two things, one about Coase, the other about Smith. First, the Coase theorem (which Coase did not call a theorem) has become wildly influential in law and economics, which is strange, and it’s almost always remembered wrong as “property rights don’t matter for efficient outcomes.” I informally surveyed some first year law students, and was saddened by that result. A way to rephrase the same statement that reinforces the assumptions would be, “If transactions costs exist, then the allocation of property rights may affect the efficiency of an outcome.” Since transactions costs almost always exist… Also, I really like how much you emphasize that Coase is not talking about distribution, only efficiency! The Law and Econ folks seem to have missed that part as well..

    Second, and more critically, be careful with Smith! Do you read historian of economic thought Gavin Kennedy’s blog, Adam Smith’s Lost Legacy? Kennedy devotes most of the blog to trying to fight the abuse of the idea that Adam Smith had some ‘theory of the invisible hand’. Kennedy has an excellent paper on the metaphor and how it became a myth (mostly blaming Samuelson’s influential textbook), Adam Smith and the Invisible Hand: From Metaphor to Myth. Long story short, that metaphor comes in the middle of the Wealth of Nations, and refers specifically to merchants who (because they are risk-averse) put their money in lower-yielding, but less risky, domestic investments and thus unintentionally stimulate local commerce. The “invisible hand” simply refers to an unintended consequence, not to some overarching thesis that self-interest leads to socially beneficial outcomes (a position held by an earlier author, Mandeville, and that Smith and his contemporaries ridiculed). For example, Smith himself lists 60 ways in which the government ought to intervene to produce better outcomes, from providing public education to regulating bank money creation. Smith also distrusted merchants, and thought they would (acting on their self-interest) readily conspire against the public (hence why he especially disliked trusts and large corporations, see Emma Rothschild’s Economic Sentiments: Adam Smith, Condorcet and the Enlightenment).

    Best!
    Dan

  • 5 Fiona Turnbull // Jan 8, 2011 at 7:27 pm

    I stumbled on your blog (like most things in life) through an economist friend of mine. I just want to add that Ronald Coase’s other great contribution was teaching Mick Jagger when he was a student at the London School of Economics. He tells the tale of Mick being quite talented as a student but his success as a musician caused him to drop out. It has been theorized that Mick’s business savvy explains the longevity of the Stones. My dad is Ronald’s cousin although they haven’t seen each other in several years now.

  • 6 offre emploi cdd // Jul 27, 2014 at 12:33 am

    Thanks for sharing your info. I really appreciate your efforts and I am waiting for your next post
    thanks once again.

  • 7 gagner a la bourse // May 24, 2015 at 5:17 am

    Eux nenni vis par hasard archimilliardaire et l’contraire lol

Leave a Comment