Political Entrepreneurs

The Economic Engine of Political Change

Ronald Coase (1910-2013): He kept his hands dirty

September 3rd, 2013 by Edward Lopez

The news has spread quickly that Ronald Coase has passed away at the age of 102. The list of his fundamental contributions to human understanding runs long, as did his career. Just last year he published a book on capitalism in China (discussion here and here).

He is most famous for the “Coase Theorem,” which is fairly easy to grasp at a superficial level but is quite rich and nuanced at deeper levels. For this reason, the idea is often misunderstood. In my view, Deirdre McCloskey’s short article, “The So-Called Coase Theorem” is required reading for getting into that depth and nuance. It is also quite polarizing, in characteristic McCloskey form.

His deeper legacy, in my view, will be his method. He always encouraged economists (actually, social scientists more broadly) to “get their hands dirty.” By this he meant that true understanding of human affairs requires getting into the nitty-gritty of human affairs. Put in a different way, Coase understood that people find ways of getting along with each other when it’s worthwhile to do so (which is more often the case than not), and when it’s not worthwhile then a messy, imperfect world is the understandable state of things. It’s those ways of getting along that should be the social scientist’s primary focus–not the elegant solutions of mathematical models that are too often several steps removed from reality. Nirvana is not an option.

In Chapter 4 of Madmen, we discuss Coase’s body of work as a counter argument to the economics of market failure, alongside those of Hayek and Buchanan:

Coase’s Dirty Hands

Ronald Coase (born 1910, Nobel Prize 1991) was raised in suburban London among a family of athletes, but he had weak legs as a boy and preferred bookish pursuits instead. He excelled academically and at age eighteen began studies toward a Bachelors of Commerce degree at the London School of Economics. Coase arrived at LSE in the fall of 1929.  While he wasn’t pursuing a degree in economics, some of his professors were economists.  And, in his second year, he was introduced to Adam Smith’s theory of competition. Coase became fascinated by the invisible hand and the body of work it spawned. He mastered economics by reading all the neoclassicals and more. He abandoned plans for a career in law, and LSE instead sent him to the United States for a semester to tour businesses, plants, laboratories, and other production facilities. Coase studied the process of production and exchange, read scores of legal cases, and conducted interviews with men of practice, not theory. It was a very different approach.

Coase’s most famous works are “The Nature of the Firm” (1937) and “The Problem of Social Cost” (1960), two wordy, detailed, and extremely fertile papers. These papers created entirely new lines of research and fundamentally changed the path of scholarship in business, the environment, economics, and law. Not even Milton Friedman or Paul Samuelson had a publication that has been cited even half as many times as either “The Nature of the Firm” or “The Problem of Social Cost”[i]

Coase’s method of studying economics was an unconventional one. He investigated the real world first and used the patterns he observed to form theories. He says to truly analyze the effectiveness of market and government institutions requires getting one’s hands dirty with real world details. When asked how he developed his theory of the firm, for example, Coase said he went out and asked businesses what they do. There were no mathematical models in Coase’s work. There was just gritty evidence and detailed explanations. He was never indoctrinated into the orthodox economics of allocation, and he used that to his advantage. “Not being trained to think in a certain way, I hadn’t been trained not to think in a certain way, and therefore I was free to tackle the problems… At that time, the only place you could find discussions of real problems were in the law cases, because they weren’t in the economics literature.”[ii]

Contrasted with the Pigou-Keynes-Samuelson paradigm, Coase’s study of legal and historical detail portrays a very different picture of market failure and government intervention. Coase studied a variety of obscure but important stories in the area of nuisance law. His papers are riddled with characters from different periods and walks of life. There are railroads and farmers, doctors and confectioners, beekeepers and orchardists, smokestacks, hog farms, cattle ranches, and fallow fields. There are even rabbits.

First, Coase says, every externality is reciprocal by nature. Suppose you’re stuck in traffic and so am I. We both want to be in a lane where only one car can fit. Who creates this externality, and who is the victim? We both do, and we both are. In Pigou’s system an externality is viewed as one party harming another. On the contrary, in Coase’s stories an externality is of mutual responsibility. The sparks from a passing train would do no damage to crops if the farmer would set his growing area back a few more feet. A confectioner’s grinding machinery wouldn’t disturb the doctor’s consultations if the doctor’s office were not located next door. The hog farm’s stench and drainage wouldn’t matter much if the neighboring property didn’t have a house on it. In each case, curtailing the activity in order to avoid harm to the “victim” necessarily means harming the perpetrator.

The problem is reciprocal in nature. As a consequence, not all externalities are undesirable. That 30 minutes in traffic is a cost, for sure, because it could be time well spent relative to the alternatives (unfortunately, an empty freeway during rush hour isn’t a relevant alternative). Even if the externality is undesirable, reciprocity means that either side can avoid the externality. The doctor’s office could postpone visiting with clients and therefore be undisturbed by the confectioner’s grinding noises. An obvious question is, if either side could avoid the externality, then which side should avoid it? Coase points out that economic efficiency is served only when the avoider is the person who can avoid at lower cost. Thus, a general rule comes into view: if an externality is undesirable then liability should be assigned to the party who is the least cost avoider. If it costs the railroad less to install a spark arrester than the costs of paying for crop damages, then the railroad has a clear choice.

In separate work, Coase also challenged the theory and facts supporting Samuelson’s public good argument. The Seventeenth-Century lighthouses along coastal England is a favorite example of economists from John Stuart Mill to Paul Samuelson. Before the marine-chronometer enabled precise on-ship calculations of longitude in 1759, rocky coastlines were a deadly and costly menace.[iii] In Samuelson’s framework, a lighthouse beacon is of immense value but unfortunately it is also collective in consumption. One ship can follow the beacon to safe passage and not limit another ship’s ability also to pass safely. With vessels free riding, no purveyor of lighthouses could make ends meet. Therefore, taxation and government expenditure are necessary to create the value that lighthouses provide.

On the contrary, Coase argued that lighthouses were in fact provided through voluntary exchange. Coase uncovered documents detailing the finance, construction, and operation of lighthouses during the period. People who financed lighthouses looked for and found ways to charge their customers. By contracting with nearby ports the purveyors of lighthouses could collect fees from docking ships.

Coase’s revisionist history of lighthouses itself was revised somewhat, as subsequent scholars showed that purely private lighthouses did not survive very long, and successful ones acquired rights from the Crown to collect fees from ships.[iv] Even so, these facts don’t undermine Coase’s argument against Samuelson: that market failure is not sufficient justification for government intervention. Many externalities are desirable in the sense that they are byproducts of valuable economic activity. And even undesirable externalities often go away through voluntary cooperation. There is neither an automatic nor general necessity for government to correct market failures. And there is no guarantee that government intervention will improve efficiency. “Furthermore,” Coase writes, “there is no reason to suppose that the … regulations, made by a fallible administration subject to political pressures and operating without any competitive check, will necessarily always be those which increase the efficiency with which the economic system operates.” Coase’s “fallible administrators” echo Hayek’s knowledge problem, and his “political pressures” directly anticipate public choice theory. Perhaps this is no small coincidence. In the late 1950s while researching all those nuisance cases, Coase worked down the hall from James Buchanan and Gordon Tullock at the University of Virginia.

[i] Citation counts are from Google Scholar. Comparisons to Friedman and Samuelson are from Avinash Dixit and Mancur Olson, “Does Voluntary Participation Undermine the Coase Theorem?” Journal of Public Economics 76, no. 3 (2000): 309-35.

[ii] Ronald Coase, “Intellectual Portrait Series: A Conversation with Ronald Coase.” Interviewed by Richard Epstein at 42:00. Online Library of Liberty, 2002. Liberty Fund, Inc. http://oll.libertyfund.org.

[iii] Dava Sobel, Longitude: The Story of a Lone Genius Who Solved the Greatest Scientific Problem of His Time (New York: Walker, 1995).

[iv] David E. Van Zandt, “The Lessons of the Lighthouse,” Journal of Legal Studies 22, no. 1 (1993): 77-2; Elodie Bertrand, (2006), “The Coasean Analysis of Lighthouse Financing: Myths and Realities,” Cambridge Journal of Economics 30, no. 3 (2006): 389–402.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.189, ch.7)

The most successful entrepreneurs know what they do well, they know the market and the opportunities within it, and they choose those activities that create the most value. This is true in economic as well as political markets.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.178, ch.7)

[W]hen the right elements come together at the right time and place and overwhelm the status quo, it is because special people make it happen. We call them political entrepreneurs.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.176. ch.7)

While we started this book with Danny Biasone saving basketball, we end it with Norman Borlaug saving a billion lives. These stories are not that different. Both faced vested interests, which were reinforced by popular beliefs that things should be a certain way—that is, until a better idea came along.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.174, ch.6)

Because there was a general belief that homeownership was a good thing, politicians found the public with open arms.... Everybody was winning—except Alfred Marshall, whose supply and demand curves were difficult to see through the haze of excitement at the time, and except Friedrich Hayek, whose competition as a discovery procedure was befuddled... In short, once politicians started getting credit for homeownership rates, the housing market was doomed.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.166, ch.6)

Everyone responded rationally to the incentives before them. In short, the rules that guided homeownership changed over time, which in turn changed the incentives of these actors. And bad things happened.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.153, ch.6)

They understood the economics. The ideas had already won in ... the regulatory agency itself. All that remained to be overcome were some vested interests and a handful of madmen in authority.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.146, ch.6)

If the idea for auctions of spectrum use rights had been part of the public debate since at least 1959, why didn’t the relevant institutions change sooner? What interests stood in the way?

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.121, ch.5)

When an academic scribbler comes up with a new idea, it has to resonate well with widely shared beliefs, which in turn must overcome the vested interests at the table. Many forces come together to explain political change, even though it may seem like coincidence of time and place.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.120, ch.5)

It’s the rules of the political game that deserve our focus, not politicians’ personalities or party affiliations.

From the Pages of Madmen, Intellectuals, and Academic Scribblers (p.119, ch.5)

In short, ideas are a type of higher-order capital in society. Like a society that is poor in capital and therefore produces little consumer value, a society that is poor in ideas and institutions will have bad incentives and therefore few of the desirable outcomes that people want.

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