The Coase Theorem and the Lost Frontier
Background
“… And how admirably calculated is this view of the human race, emancipated from its chains, released alike from the dominion of chance, as well as from that of the enemies of its progress…” — Condorcet
The discipline of economic science seeks to formally represent human action. Because human action is teleological, the discipline includes a normative dimension. Consequently, every breakthrough in the field is metascientific, expanding the power of the intellect not just over nature but over mind itself. To use a Platonism, our discoveries in the discipline provide us with a glimpse ever further beyond the cave. The goal of this piece is to investigate one of the discipline’s key findings and understand its implications for the teleology of economic growth.
In this piece, we will be examining the Coase Theorem. In this case, ‘Theorem’ is actually a misnomer. Ronald Coase, who went on to receive the 1991 Nobel Prize in Economic Sciences, published The Nature of the Firm (NF) in 1937 as the culmination of ideas he had as a precocious undergraduate [6]. In the piece, his conclusions implied at least a weakening of the awkward barrier placed between micro and macroeconomic analysis. However, it was not until his piece The Problem of Social Cost (PSC), that he described the broader implications of his ideas [5]. Both pieces will be used to derive the Theorem, then we will study its implications for Western Civilization.
There are several motivations for studying the Theorem. It has counterintuitive implications for long term growth, regulation, and technology. From a normative perspective, the Theorem is a guide for both policy and profit makers who strive to uphold the ideals of economic liberalism. And, now more than ever, civilization requires innovation founded upon ideas aligned with the Theorem to slow and turn America’s vast regulatory sprawl.
Deriving the Coase Theorem
To understand the Theorem, one must begin with NF. The work begins with an honest question, “Why do firms exist?”. Writing in Late Modernity, an unwarranted cynicism toward capitalism permeates our culture. One consequence of this attitude is an amnesia surrounding the existential purpose of firms. Coase demonstrates how “firms” are simply institutions that emerge to balance two categories of costs.
Coase brilliantly articulates the discontinuity between the models of macro and micro analysis. In the realm of the former, efficiency is reached through the pricing mechanism on an open market exchange, the Smithian “Invisible Hand” guides prosperity. However, the latter shows us that within firms, efficiency is reached through a command (albeit miniaturized) economy, what is known as entrepreneurship. The qualitative difference in economy type, Coase cleverly points out, arises from the competing pressures of internal and external costs. External costs are associated with transactions including informational and contractual friction, internal costs are associated with coordination and they (often) rise as firms scale, particularly beyond the threshold of a firm’s economy of scale. Firms emerge because they minimize the internal and external costs to coordinate efforts required to achieve a particular end.
In 1937, this alone was a breakthrough idea. Economists had hardly established such a solid normative grounding for firms’ existence; as a phenomenon, firms were taken at face value. However, the ultimate revelation of his Theorem is its capacity to serve as a model of growth. We will look at this in the final section.
His idea’s implications are further detailed in PSC. PSC utilizes the newfound significance of transaction costs and applies them to an analysis of an open economy to provide a theory on markets and externalities. In the next section, we demonstrate further the Theorem’s implications through a thought experiment and formalize the conclusions.
Understanding the Theorem
Suppose we live in a small economy composed of two firms: a farm and a factory. The factory’s development process uses a noxious aerosol. This aerosol is dispersed throughout the region and increases the farm’s annual rate of blight outbreaks. The politically correct reaction is to restrict the factory’s agency and rights; ‘zero aerosol pollution’ is an intuitively good sounding phrase. However, a closer examination reveals otherwise.
Let’s assume the factory produces a total revenue of $8m per year. Because of the factory’s production level, the farm estimates it loses a total of $4m every year from aerosol induced blight. First, we can establish that at least one bartered outcome is Pareto efficient. If the farm is granted the right to clean air, then the factory will be incentivized to pay the farm $4m for the right to clean air and continue operating at full production. $8m worth of production is simply worth more to the factory than the $4m crop loss is to the farm. Resources have been allocated according to their relative worth to each agent: the outcome is efficient.
Second, we demonstrate that the final outcome is invariant with respect to the initial allocation of property rights, demonstrating that bartering inevitably leads to the Pareto efficient outcome. Suppose the factory is granted its legal right to produce. While there will be no money-rights exchange, the final outcome is the same: the total cost of the aerosol is $4m to the farm, but production rights are worth $8m to the factory. Thus, the factory continues to produce and the total cost to the economy is $4m associated with the crop loss. The outcome is identical: $8m is generated by the factory’s production and a total cost of $4m comes from crop damage.
To formalize the theorem, it can be said that if each party has clearly defined property rights and transaction costs are low, then (i) the bargaining parties will reach a Pareto efficient outcome and (ii) the identical final outcome will be reached regardless of the initial allocation of rights. It’s a wonderful demonstration of microeconomic agents’ ability to resolve externalities without macro-command intervention. As each technological revolution has shown, the suffering societies bear as a consequence of regulation turn out to be in vain. We just need more ambitious technologies and cooperation between entrepreneurs and the current regulatory bodies.
Note the significance of clear property rights and low transaction costs as requisites for efficiency. A common criticism of the Theorem is its lack of practical application: in real life transaction costs are rarely negligibly low and property rights are frequently ambiguous. However, the delicate nature of the Theorem merely signals opportunities for technology and scalable business models capable of establishing these properties. The Theorem demonstrates that ‘externalities’ are merely frontiers disguised in our contemporary, risk averse parlance.
Implications for Productivity and Growth
“You shall not remove your neighbor’s landmark, which the men of old have set, in your inheritance which you will inherit in the land that the Lord your God is giving you to possess.” — Deuteronomy 19:14
The Theorem harkens back to an all too forgotten pocket of knowledge described in the political philosophy of John Locke. It was recognized early in the history of liberal thought that the establishment of property rights and economic growth were approximately tautologous. Locke’s claims have been proven mostly correct through the trajectory of his political brainchild: the United States. America’s political foundations are Lockean and his vision was realized by the fulfilled prospects of the early American settlers. An effective way of understanding America’s progress and prosperity is through a Coasean analysis. A great paper on these matters is Bleakley’s piece on the prosperity of the Georgia Frontier [4]. Antebellum Georgia had a tremendous amount of land open to new settlers. The government decided to dole out the land by lottery.
A short term downside to distribution by lottery was the uneven allotment grantings. The problems were not of the actual inequality, but the sizings of the distribution inhibited the efficiency of typical farming methods. Some allocations were too small to be effectively farmed through standard operations. One farm’s disproportionate size was essentially a negative externality imposed upon an undersized farm. As a result, the land was devalued by 20% for almost 150 years. There were occasional bursts of prosperity as the land was traded and consolidated into more efficient holdings. A striking confirmation that ‘externalities’ are merely frontiers in ideological disguise.
If we generalize the growth strategies of early America and the Industrial Revolution(s), two developments of exceptional progress in the West, we find they were immense coordinating acts which lowered the internal costs of production. The former resulted from establishing rights and incentivizing individuals to efficiently internalize factors of production (as shown in the Georgia frontier example above). The latter generated wealth by aggregating production and transportation processes. For example, the assembly line and railroad projects were both breakthroughs in internal coordination which led to new radically greater scales of production. Both of these modalities of progress represent the internalization of productive factors.
Most of this World’s land has been purchased and cultivated. While the latter half of the 21st Century holds underwater cities, cultivated deserts, and perhaps a colonized Mars, we’ll have to ensure liberal/technological civilization does not collapse before the next great expansive feats are successfully undertaken. The great ideas of the early 21st Century will invariably include the astute identification of mechanisms for transforming “unknowable” externalities back into manageable frontiers.
And while I personally yearn for a return to growth in this expansive manner, we must not overlook the progress produced in this century thus far. The great fortunes of 21st Century have been built by a qualitatively different modality. Let us examine the unfolding of the ‘Uber for x’ phenomenon, the gig economy. Whether this be a transportation or lodging software, it is likely that you have used one. Without the former, an economy could be described as having a negative externality of driving time: there are individuals who own cars and have time to drive which could be better used driving around other individuals. The same can be said for lodging applications. There are individuals who own lodging property which would traditionally be unavailable to other individuals. The application lowers the transaction cost to share the property at a cost mutually beneficial to both parties. Imagine the bureaucratic nightmare which would ensue if a regulatory body was established to facilitate these kinds of transactions. The industrial or internal growth modality has been dominated by macro-command bureaucracies, thus, capitalist efforts have adjusted to those of the scalable, micro transactional.
The Lost Frontier
To provide some macro context, regulatory expenditure has bubbled since the New Deal programs consolidated their power in the Federal government’s 1960–70s progressive majorities, overturning a culture of engineering and exploration into one guided by the precautionary principle.
Regulatory expenditure has been growing steadily at a rate of 6% annually for fifty years now. During the same period, annual GDP growth was 2.7%. Some consequences of this include outrageous zoning requirements. It has become increasingly challenging to construct visionary projects. Additionally, the cost of living in cities has grown by five times between the period of 1970 to 2010.
Perhaps worst of all, is the American healthcare system. The cost to commercialize a drug has doubled every decade for the past seventy years. Roughly a third of the cost is associated with the increasing burdens placed by our regulatory bodies [3]. What reason is there to suspect our regulatory bodies is capable of enhancing outcomes which drug producers are incentivized to work towards? Tort laws and the loss of market share incent firms to produce “safe and effective” drugs. We must also consider the implicit deaths caused by restraining a promising treatment to the realms of “basic” R&D for 7+ years. A superior arrangement would allow consenting adults — particularly the desperate and terminally ill — to opt into trials at early stages of the development process. Individuals would simply pay a risk adjusted price, discounted based on the drugs relative lack of empirical confirmation.
Thus, I end with a call to action. The next wave of technology begins by examining where regulatory expenditure and price inflation are the highest, determining the micro entry points where entrepreneurial power can be established to coordinate with and eventually displace the rapidly expanding (and constitutionally questionable) administrative state. Following these principles will help our civilization reclaim the lost frontier.
Works Cited
- “Regulators’ Budget Report.” Mercatus Center, 15 Sept. 2019, www.mercatus.org/publications/government-spending/regulators’-budget-report.
- Sisson, Patrick, et al. “The Affordable Housing Crisis, Explained.” Curbed, Curbed, 15 May 2019, www.curbed.com/2019/5/15/18617763/affordable-housing-policy-rent-real-estate-apartment.
- Dimasi, Joseph A., et al. “Innovation in the Pharmaceutical Industry: New Estimates of R&D Costs.” Journal of Health Economics, vol. 47, 2016, pp. 20–33., doi:10.1016/j.jhealeco.2016.01.012.
- http://www-personal.umich.edu/~hoytb/Bleakley_Ferrie_Farmsize.pdf
- Coase, Ronald H. “The Problem of Social Cost.” Classic Papers in Natural Resource Economics, 1960, pp. 87–137., doi:10.1057/9780230523210_6.
- Coase, Ronald. “The Nature of the Firm.” The Economic Nature of the Firm, pp. 79–95., doi:10.1017/cbo9780511817410.009.
- Locke, John, et al. Second Treatise of Government ; and a Letter Concerning Toleration. Oxford University Press, 2016.
