R.I.P. Professor Coase

Economist Ronald Coase died today. He was 102 years old. To pin his career down to two articles is to say not nearly enough, but two in particular have been hugely influential, both to the discipline and to my own thinking: “The Problem of Social Cost” and “The Nature of the Firm.”

In “The Problem of Social Cost,” Coase tackled the idea of competing resource uses and showed that when transaction costs are zero, it doesn’t matter who holds the original grant of right, the resource will end up in the hands of the user who values it mostly highly. All that will change is whether money is exchanged. To illustrate he uses an example of a cattle-raiser and a crop farmer operating adjacent to each other, so that without a fence the cattle damage the farmer’s crops, but a more intuitive (and hence more common) example is of an upstream user that pollutes the water and a downstream user that needs clean water. Typically we blame the polluter for the harm done, but as Coase notes, just as the polluter imposes costs on the downstream user, so the downstream user’s needs impose a cost on the upstream user.

The traditional approach has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm.

In the traditional resolution, the “harmer” has to pay the “victim,” but Coase shows that both are harming each other, so ideally we could sort out the problem by letting the higher value user buy out the lower value user. Of course in the real world transaction costs are never zero, so some would sniff at this fluffy theoretical idea. Such sniffing is appropriate when conflicting users are many, resulting in exceptionally high transaction costs, but when we are talking about two users, in proximity to each other, and with awareness of each other, transaction costs can be minimal (although never zero, because at a minimum completing the transaction requires some expenditure of time).

The application to environmental issues is fairly obvious, and one thing I’ve taken from this is to emphasize competing values of uses for particular resources when we consider environmental problems, and to emphasize that it’s often the case that environmentalists are either demanding something that is socially costly (would reduce the net value gained from the resource if a more valuable use is prevented) or, if the environmental benefit is really more valuable, can get that through the market. Case in point: The Nature Conservancy (just today on a field trip for my Environmental Politics class I pointed out a Nature Conservancy site that preserves a prairie wetland that drains into our major local river, whose likely alternative use is either agricultural or for a subdivision).

This article also provided one of the highlights of my graduate school career. A professor (whom I didn’t love much) was giving a talk on his planned new research program in environmental politics, and stated that he was going to base it on a Coasean analysis. He then proceeded to talk about an upstream user and a downstream user, and how the upstream user was harming the downstream user. At the end of the talk I raised my hand and pointed out that this was in contradiction to what Coase actually assumed, which produced the marvelous response of, “Hmm, I guess I should read Coase’s paper.”

“The Nature of the Firm,” considered why firms grew by internalizing operations, rather than contracting with other firms for their needs, through the market. It was written in the 1930s, when “vertical integration” (e.g., a steel-making firm owning not just its mills, but also the ore mines, and even the coal mines for the coal to power their mills) was all the rage, and theorists were trying to understand why businessmen were making that type of decision. In a nutshell, Coase argued that it was–again–about transaction costs. Firms internalized to avoid the transaction costs of contracting through the marker, but only up to the point where marginal internal management costs did not exceed the marginal costs of transacting. It’s wonderfully elegant and explanatory (although, of course, it’s undergone some refinement in details since then).

And as old as it is, I say it’s as-if not more–relevant than ever, given that so many new tech firms are forgoing the vertical integration model to a contract model. Microsoft realized early on that it didn’t need to build hardware, and you can even buy a computer from a company that does almost nothing other than organize the contracting out of the whole process–an order is submitted online, received by a contracted manufacturer who puts the parts together, it’s shipped via UPS, and the billing is done by a billing service. The most amazing part is that I’ve seen business writers asking why, wholly unaware that Coase gave them the answer 3/4 of a century ago.

I think the analysis, with proper refinements and adjustments, is relevant to all social organization, of societies, states (countries), provinces and large metropolitan areas (where it should be a complement to Tiebout sorting as an analytical model). I don’t think it’s been done much, yet. If so, it’s in the public choice lit and I should know about it, but don’t.

The value of Coase’s insights sheds light on the debate about whether the social sciences are, properly, sciences, as challenged recently in the New York Times, and discussed just yesterday at The Monkey Cage.

The NYT has a full obituary.

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About J@m3z Aitch

J@m3z Aitch is a two-bit college professor who'd rather be canoeing.
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20 Responses to R.I.P. Professor Coase

  1. Another application of “The Nature of the Firm:” Coases’s Penguin.

  2. Matty says:

    Interesting, has there been much work on how regulation can actually alter the relative costs of integration vs contracting out? I’m thinking of my own case as a one person business I have a few times come across cases where I needed an extra person for a few days to a week. The actual cost per person would have been pretty much the same if they were contractors or employees but what swung it for me is that the time cost of my complying with tax rules for employers would have been too much.

  3. pierrecorneille says:

    I”ve read “Nature of the Firm” a while ago, although I don’t think I understood it. I’ll probably have to read it again. I didn’t realize (at the time I read it) that Coase was still alive.

  4. I didn’t realize (at the time I read it) that Coase was still alive.

    And still publishing. Sometimes you really do have to shoot them.

  5. ppnl says:

    Yeah, I have been reading about this over at the Volokh Conspiracy. I’m not an economist and I have not had time to look at the arguments in detail but I have to say that I’m very very skeptical.

    For example the upstream polluter dumping smelly chemicals. Yes from a simplistic point of view I am imposing a cost on them by refusing to snort their taint. I’m so sorry. I will try to be more reasonable in the future.

    And it is strange that the example involved only a discomfort. What if the waste was carcinogenic? From an economic perspective I can either risk the cancer or sell my land at the price he has degraded it to.

    What if the waste was causing the extinction of a non commercial species? From an economic perspective there is no individual with a purely economic incentive to protect Uglicus Frogicus from being wiped out. That can only be a decision from society as a whole and may not be based on pure economics.

    Also it seems to be based more on power than economic worth. What if the upstream polluter gets little profit from his pollution but personally values his right to pollute? If he is much richer than the person downstream then he can afford to value his right beyond the down stream persons ability to match. Even if the downstream person’s entire livelihood depends on the river.

    Property rights are important exactly because they carry protection from your neighbors that transcend pure economic value. Reduce that protection and you devalue all property.

    BTW an example of this kind of conflict seems to be playing out over at Greg Laden’s blog:

    http://scienceblogs.com/gregladen/2013/09/02/energy-exodus-rally-to-build-cape-wind/

  6. J@m3z Aitch says:

    Ppnl,

    Keep in mind Coase was using an ideal model to explain this. Nobody seems to care if physicists assume, for purposes of analysis, assume no friction, but let a social scientist assume away, for the purpose of analysis, a single real world characteristic and, boy howdy, everyone chimes in to complain and criticize them for not being real scientists like, ummm, physicists.

    From that ideal case we build up the model by adding in the real world complications. Ideally–that is, in our simplified and not wholly realistic model of the scientific approach!–we examine one complication at a time, so we can understand the effects of each individually. In the long run we hope to put all the pieces back together to understand how they all interact. And that’s what I meant by refining the theory over the past 7+ decades.

  7. J@m3z Aitch says:

    Addendum:
    Also it seems to be based more on power than economic worth. What if the upstream polluter gets little profit from his pollution but personally values his right to pollute?

    Eh, economic worth is purely the sum of personal valuations. You can’t distinguish between the two, because all value is subjective.

    Have I not harped on that regularly here? Maybe not. Maybe I just do it so often at the League that I don’t realize I just assume it as common knowledge over here.

  8. Matty says:

    The example linked at Greg Laden’s blog is interesting to me as wind turbines are an area I’ve worked with in the past, though not offshore ones. It would be over simplistic to see it as environmental values versus others. Even from a purely environmental point of view the reduction in carbon emissions must be measured against seabird collisions, disturbance to fish and their habitat from anchoring the turbines on the sea bed, risks of water pollution during construction and probably other things I can’t think of right now.

    Now I’m not saying a proper analysis wouldn’t find the turbines to be less damaging than the alternative of a coal or gas fired power station producing the same amount of power or that the harms can’t be reduced. I make my living finding ways to do exactly that so I know it can happen.

    What I am saying is that even if we deal only with environmental issues there is still a trade off between different aspects and choices to be made.

  9. James Hanley says:

    Matty,

    Could you and I have an off-blog discussion about your work sometime? You’re in a position to bump up my knowledge base for issues that come up in my environmental politics class.

  10. ppnl says:

    I understand that Coase’s work can simply be seen as a method of analysis. I’m just skeptical that it is very useful.

    Eh, economic worth is purely the sum of personal valuations. You can’t distinguish between the two, because all value is subjective.

    Value may be subjective but money isn’t. I have free speech but if I don’t have the cash to defend against a meritless libel suit then effectively I do not have free speech. It is no longer about subjective value. It is about objective power. Even despite the law.

    The whole point of individual speech and property rights is that they are mine and I should be able to simply refuse to sell them at any price. When I can’t then that is bad.

    Matty,

    I would think that there would be a net positive for fish. Birds are a problem everywhere so if you can’t build it there because of the birds you can’t build it anywhere. The whole point of building offshore is to reduce the impact. I’m not a fan of wind power but if it is going to work I think offshore is the place.

    Now the thing here is that Bill Koch has spent 1.5 million opposing the wind farm. Why? I don’t know. Maybe he thinks it will reduce the value of his summer home. Maybe the sound from the farm really is an intrusion on his property rights. Maybe he just opposes any energy source that is not petroleum based.

  11. Dr X says:

    @James,
    “And as old as it is, I say it’s as-if not more–relevant than ever, given that so many new tech firms are forgoing the vertical integration model to a contract model. Microsoft realized early on that it didn’t need to build hardware, and you can even buy a computer from a company that does almost nothing”

    You lost me there. It doesn’t seem to me that this Microsoft example applies to the question of whether to internalize an operation or contract out. Microsoft did neither with the hardware business because they stayed out of the hardware business. Of course, now they’re going into the hardware business with the Nokia purchase. And there, I’m sure, they’ll be farming out manufacturing, just like all other hardware brands that find it cheaper to do so. So now, with this recent hardware deal, Coase’s analysis would apply. No?

  12. AMW says:

    Economist Ronald Coase died today. He was 102 years old.

    I chose a good profession. Economists live forever

    ppnl,

    Those are some good points, but I think you’re overlooking the notion of “coming to the nuisance.” If the polluter was there first, then he wasn’t harming anybody (at least, nobody human). In that case, the affected downstream land owner who wants the polluter to stop dumping chemicals can be thought of as inflicting a harm – or at least a cost – on the polluter.

  13. James K says:

    Coase was truly a giant of the discipline.

  14. James Hanley says:

    PPNL,
    The whole point of individual speech and property rights is that they are mine and I should be able to simply refuse to sell them at any price. When I can’t then that is bad.

    I agree. I’m unclear how you’re getting from that agreement to a position where we apparently part ways.

  15. James Hanley says:

    Dr. X,

    Microsoft needed desktop computers in order to sell their software. They could have gone Apple’s route insisted on proprietary hardware. Instead they contracted out the delivery system, so to speak, for their hardware. I think it’s easier for us to conceptualize the hardware manufacturers as having contracted out to MS the software/programming for their machines because the hardware is more tangible–it’s what we see and what we touch. But the fundamental product is not the machine but the software.

    Reasonable people can disagree, of course.

  16. James Hanley says:

    AMW,
    I chose a good profession. Economists live forever

    Then why do I have a book titled “New Ideas from Dead Economists”?

    By the way, can either of our economists answer Matty’s question in comment 2?

  17. Matty says:

    James, sure I think you can see my email on the comments so drop me a line and we’ll go from there.

    PPNL,
    I would think that there would be a net positive for fish. Birds are a problem everywhere so if you can’t build it there because of the birds you can’t build it anywhere. The whole point of building offshore is to reduce the impact. I’m not a fan of wind power but if it is going to work I think offshore is the place.

    Ironically I am a fan of wind power, properly done but to pick up your other points. There could well be a net positive for fish but I would hope decision makers looking at this aspire to greater rigour than “I would think”. As for birds, they actually aren’t a problem everywhere or at least not an equal problem. Some locations lead to more collisions (think Altamont pass where the topography funnelled migrating birds into the wind farm) and some species are more vulnerable either because their flight patterns mean they collide more often or because in a small population the same number of deaths has a greater long term effect.

    Offshore probably does reduce a lot of impacts and as I say I’m generally in favour of well placed, well designed wind power. I’m not arguing against the proposal just highlighting some of the complexities of impact assessment.

  18. AMW says:

    By the way, can either of our economists answer Matty’s question in comment 2?

    I do not know of any studies looking at the effect of regulatory red tape in hiring vs. contracting decisions, and a cursory Google Scholar search didn’t turn anything up that seemed to be of interest. However, it’s inconceivable to me that no one has thought about (and published on) this topic. And it is nearly as inconceivable to me that they would fail to find that making it more burdensome to hire an employee encourages employers to contract work out instead.

  19. AMW says:

    P.S. I covered the Coase Theorem with my MBA students today. They were sad to hear that he had passed away so recently. Until I told them how old he was.

    When I mentioned Pigouvian taxation I pointed out that Pigou is another dead economist.

  20. Murali says:

    @James Hanley
    re: PPNL’s concern
    I think I can explain what’s going on because I have the same concern. So, let’s start off with what we or at least I think Coase is saying:

    So long as there is some initial configuration of property rights, given zero transaction costs, people can transact their way to something approaching justice (or at least their own conception of it). i.e. suppose people can dump their shit anywhere, then I can in principle pay my neighbour to keep his shit on his side of the fence. Similarly, if we initially start off with the configuration that my neighbour is legally entitled to my labour, there is some amount I can pay him to relinquish either temporarily or even permanently any claim on my labour. This seems implausible as even with zero transaction costs, someone’s reservation price for something that really ought to be mine may be higher than I can afford.

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