Direction of Analysis

Men in Bread Line

A year ago, I took a class titled “Law and Economics” — one of the most thought provoking (and difficult) classes I’ve ever taken —, and the first few lectures were a review of intermediate microeconomics, including Pigovian welfare economics. The professor asked the class what the implications of welfare theory were. Raising my hand, I answered that if some of the crucial assumptions don’t hold then the implications are that the market cannot maximize societal welfare. The professor’s response was that one’s answer to that question says a lot about how they approach economic problems. The implication is that free market economists may focus on salvaging the assumptions, while others on how to solve the resulting market failures. I disagreed, and still do, but I’m not one to disrupt classroom time. What reminds me of this story is Ronald H. Coase’s The Firm, the Market, and the Law.

This 1988 book by Coase is a collection of some of his most well-known journal articles, but it includes two new chapters that serve to critically inspect the profession’s assimilation of the lessons of his work on transaction costs. He notes that the market largely develops to deal with these transaction costs. For example, traditionally fairs allow sellers to congregate, assuaging some of the costs associated with finding buyers. They also could offer protection during the course of the fair, and even legal services. In other words, markets evolve to help increase the volume of exchange by reducing some of the costs associated with trade. In the first chapter, he provides a response to the professor’s conclusions cited above. He argues that those who advocate interventions to some market failures, specifically externalities, oftentimes don’t consider that governments too suffer transaction costs. In fact, if markets are prohibited from maximizing welfare, then most likely so are governments.

This isn’t the response I would have chosen, but his work on transaction costs and market evolution leads us to what I have in mind — which I borrow from Hayek. Actually, Coase hints at my own thoughts, but he ultimately takes the turn outlined above, because he seems to believe that future research will unearth the answers to our institutional problems, how they work, and how law can be altered to maximize social welfare. (Just to clarify, the difference between Coase’s position here and that of Pigou, and others, is that rather than intervene within the framework of existing institutions, the real solution is to change the institutions themselves — which, despite the preceding sentence, shouldn’t be dismissed out of hand.) The Hayekian challenge to Pigovian intervention is similar to Coase’s in that the market evolves to reduce transaction costs (and possibly to create them), but that intervention is fatally handicapped by man’s inability to understand institutions and their development well enough to design solutions. To put it another way,  we are choosing between non-ideal solutions, and that the spontaneous, piecemeal, heterogeneous, and flexible market is preferable.

While not exactly the same as “mine,” Coase’s objection to what may be referred to as Pigovian interventions belongs to the same classification: the difference is not between a denial and acceptance of imperfections, rather what the best method of tackling these problems are (and whether we can, or should, even plan solutions to market failures). It’s a difference in direction of analysis. It’s probably true that many of these differences are ideologically induced; someone not keen of interventionism is more likely to search for alternatives. But, the Hayekian and Coasian difficulties outlined above pose two, in my opinion, insurmountable obstacles to the “Pigovian interventionist.” Hayek’s is that planners can never hope to understand society well enough, due to its sheer (and growing) complexity, to engineer its betterment. Coase’s lessons are two-fold: (i) government suffers the same (or even greater) handicaps as do markets, and (ii) given existing institutions government intervention can also reduce social welfare much more than the market imperfections they seek to solve, as it often does.

The direction of analysis that economists like Coase and Hayek, and others, took is one, I think, that the bulk of the profession will need to turn to if our understanding of the social world is to progress at a much more significant rate. But, this will only occur if the bulk of the profession acknowledges the importance of these contributions. Fortunately, despite frequent signs to the contrary, there is evidence that it is: the growing Austrian school, new institutional economics, theories of complex systems, et cetera. Maybe in future classes, instead of suggesting that the point of divergence is in accepting the omnipresence of “failure” — I much prefer the term “imperfections” —, the divergence will be taught as beginning in theories of why imperfections exist and alternative means of institutional change to solve them.

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