Misunderstanding Coase

There exists those figures in the history of economic thoughts whose lessons are often lost on certain people. Particularly bad are those whose legacies don’t even correspond to their contributions. One such figure is Ronald Coase. I had two run ins with such injustice this weekend, one in a conversation on Facebook and the other while reading. First, when I mentioned Coase’s critique of government intervention in “The Problem of Social Cost,” someone argued that, essentially, the Coase theorem legitimizes court cases which “[destroy] any concept of private property protection” and that Coase’s work applies only in an unrealistic world. Second, here is a footnote in Hülsmann’s biography of Mises that discusses Coase,

Mises (Hülsmann)The postulate of a dichotomy between individualism and collectivism led Keynes to anticipate the now-famous Coasean view on the problem of optimal social organization. Thus Keynes surmised that the “ideal size for the unit of control and organization lies somewhere between the individual and the modern State.”

— Jörg Guido Hülsmann, Mises: The Last Knight of Liberalism (Auburn: Ludwig von Mises Institute, 2007), p. 533, ftn. #19.

I can’t speak for Keynes (the in-text quote is from The End of Laissez Faire), but I’m certainly sure of the fact that the “Coasean view” doesn’t begin to approximate what Hülsmann implies it does. Hülsmann’s and the first errors of interpretation that I note are in reference to two separate pieces: “The Nature of the Firm” (1937) and “The Problem of Social Cost” (1960). Both are recommended reads, and neither support any of the claims outlined above. I’ll first address the misinterpretations of his 1960 essay, and then offer some comments on Hülsmann.

The Coase Theorem was developed — formalized — by George Stigler, based on “The Problem of Social Cost.” Stigler’s model shows us how, in a world without transaction costs (costs to using the pricing process), the existing organization of property rights is irrelevant as individual agents will exchange with each other to bring about a Pareto optimal distribution. When you learn about the Coase Theorem (nostalgia: this was my textbook) the transaction costs point is usually trivialized. You accept it as a condition for the problem set you’re given, but even if you recognize the lack of realism you usually don’t explore the other side of the issue: a world with transaction costs. It’s no wonder that many people consider Coase’s work unrealistic.

The truth of the matter is actually much different. While I disagree with the hardcore stance that none of Stigler’s formalization fits Coase’s piece — it does —, what amounts to the “Coase Theorem” makes up only a fraction of the original article. In fact, the purpose of the essay is to illustrate the relevance of transaction costs in the real world. If property rights would be distributed Pareto optimally through the pricing process in our model, why doesn’t it do so in the real world? Thus, Coase introduced the role of the legal system: to solve disputes when the alternative, the pricing process, isn’t available as an option. Rather than damning Coase, his use of the equilibrium condition represents an excellent method: what does and what doesn’t it explain.

True, Coase argued that the legal system should rule in ways that correspond to increasing “efficiency.” Murray Rothbard described efficiency as a chimera, but I don’t think Coase meant to imply that the legal system can resolve property disputes perfectly. Rather, his point is that since the legal system has said responsibility, it makes sense that its opinions ought to be as well informed as possible. Otherwise, you may have rulings that make the situation worse, and that can’t be easily remedied through the market. Neither is it Coase’s argument that all these property disputes should be dealt with, or that they should be dealt with through whatever means necessary. Throughout the paper — and much of his other work — Coase adamantly argues against government interventionism, arguing that this is likely to make the problem worse. So no, Coase’s work on externalities and transaction costs is in favor of neither interventionism nor the notion that the world is frictionless.

What of the footnote in Hülsmann’s book? There is one passage in “The Nature of the Firm” that comes to mind that seems to give credence to Hülsmann’s [mis]interpretation,

The Firm, the Market, & the Law (Coase)There is … point in [Evan F.M.] Durbin’s answer to those who emphasize the problems involved in economic planning that the same problems involved in economic planning have to be solved by business men in the competitive system. The important difference between these two cases is that economic planning is imposed on industry, while firms arise voluntarily because they represent a more efficient method of organizing production. In a competitive system, there is an “optimum” amount of planning!

— R.H. Coase, “The Nature of the Firm,” in The Firm, the Market, and the Law (Chicago: University of Chicago Press, 1988), p. 37, ftn. # 14.

Coase’s response to Durbin is somewhat ambiguous, but to read this passage as advocating that there’s an optimal amount of planning somewhere “between the individual and the modern State” is disingenuous (and it requires one to take the excerpt out of the context of the rest of the article). I claim it’s ambiguous, because the word “planning” as used by Coase is used in a way that takes a lot of meaning out of the word. Coase means planning without the pricing process, rather than planning more generally. Individuals plan through the pricing process as well, and this kind of planning suffers from the same problems as all kinds of planning. No less, that firms supersede the planning process doesn’t mean that they work independent of the pricing process (profit and loss). But, if you approach the above excerpt more charitably Coase’s argument is actually quite agreeable. The market will decide to what extent planning is profitable.

We should also note the context of the piece. Coase was interested in knowing why the firm exists at all. He came to the conclusion that firms make sense when the pricing process can’t accomplish the same ends. Actually, I’d put it another way: the firm comes into existence to more easily reduce transaction costs so that it may use the pricing process. It also replaces the pricing process, such as through vertical integration. But, for whatever the pricing process isn’t used for, the costs of this form of organization has to be less than that of using straightforward exchange. Remember that almost two decades earlier Mises had developed his theory of the pricing process as a sort of proxy for value imputation, helping to allocate the means of production, and that this proved the impossibility of socialism. In this context, it makes sense that Coase briefly address the fact that his theory of the firm seems to, superficially, fly against this case against socialism (“planning”).

Further, when Coase writes “optimal amount of planning” he doesn’t mean on an aggregate level. He means that the market will help decide to what extent individuals can supersede the price system through different forms of organization on a case-by-case basis. This should be obvious: Coase didn’t argue that we should all form part of firms, because the firm is the “optimal” system of organization. Rather, he simply argued that sometimes it pays to go over the pricing process, but note that he’s explicit that it’s prices themselves which decide the size of the firm (because only through the pricing process can you decide what pays and what doesn’t).

Ronald Coase was [ed. is, since, as Lorenzo below notes, Coase is still alive] one of the most steadfast defenders of free markets. Readers should be skeptical of narratives that interpret Coase’s work as advocating something else. None of this argues, however, that Coase was never wrong, or that there aren’t aspects of Coase’s work that deserve less attention (I interpret him as a logical positivist, I disagree with his theory of the opportunity cost of the factors of production, there’s more to resource allocation than prices and the legal system, et cetera). But, the above examples unfairly criticize some of Coase’s most important contributions to economic science.

7 thoughts on “Misunderstanding Coase

  1. JCatalan

    Sorry, I had mistyped the excerpt from Coase’s “The Nature of the Firm,” and it actually comes from footnote #14 on page 37. The post should reflect these changes now.

  2. JCatalan

    @TancredHastings:disqus : Some of Block’s work on Coase I can agree with, like his comments on Coase’s lighthouse piece. I’ve also skimmed his argument in an article on the Kelo case, but I think his connection with Coase is weak. I’ll have to take a look at his other stuff. But, sometimes I really think he misses the point. (It doesn’t help that I disagree with an ethical discussion of an economic concept, especially when there exists a plurality of ethics.)

    @Lorenzofromdownunder:disqus : Oops, thanks! I was writing in past tense in reference to his older writing, and I guess it transferred over.

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