The Fruits of Civilization (27-18) Ronald Coase

Ronald Coase

English economist Ronald Coase (1910–2013) is best known for his ideas on 2 subjects: the economic nature of companies, and the problem of externalities, which Coase thought could be cured by well-defined property rights.

The Nature of the Firm

Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur/coordinator, who directs production. The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. ~ Ronald Coase

In his 1937 article “The Nature of the Firm,” Coase concocted that the reason companies exist was to mitigate pesky transaction costs, a supposed flaw in the wondrous price-setting market mechanism. A transaction cost is the expenditure involved in completing a sale.

Coase set out to explain why some goods and services are bought and sold, thus presumably guiding the economy to optimal resource allocation, whereas portions of the economy are subsumed into an organizational matrix – a firm – which doles out resources of every sort by management fiat. His answer was that transaction costs, such as drawing up contracts for the quality and performance of each task output, meant that it was cheaper and easier to forego the market mechanism.

In actuality, Coase’s trivial hypothesis aside, companies exist out of the sheer necessity for teamwork, and the benefit of specialization. Coordinating work efforts for advantage, using division of labor, dates at least as far back as bacteria colonies (biofilms), over 3 billion years ago.

For a multi-faceted project or an ongoing business concern of any complexity, the most expeditious method is to coordinate people to perform well all the requisite tasks, where each person has a task-based role to play, and experienced expertise in fulfilling that role.

There are considerable efficiencies in having a methodical system for doing things, with people familiar with the different tasks needed to get a job done and knowing who to go to for help (coordination) – which is why experienced workers are highly valued.

All this rather obvious sociology is a bit much to be stuffed into the concept of transaction cost; which is to say that Coase’s analysis was utterly academic, and incidental to why firms exist.

Externalities

If we assume that the harmful effect of pollution is that it kills fish, the question to be decided is: is the value of the fish lost greater or less than the value of the product which the contamination of the stream makes possible. It goes almost without saying that this problem has to be looked at in total and at the margin. ~ Ronald Coase

In “The Problem of Social Cost,” (1960) Coase considered externalities: unintended byproducts of production. Coase again lassoed transaction cost as hidden contributor.

In the instance of an externality, conventional thinking had been that government was necessary to provide the necessary augmented signal to the price mechanism. A tax on pollution would internalize the cost of fouling the environment, and so prod a producer to clean up his act; or so the happy hypothesis went.

Coase instead suggested that, without transaction costs, no government intervention would be needed to address externalities: polluters and the people affected could work out whatever needed to be done by bargaining. This Panglossian perspective became known as the Coase theorem.

Coase recognized that neither tax nor bargaining could deliver optimality. Facilely accepting that pollution was an identifiable cost, Coase proposed that the government could cure the externalities problem by creating clear, transferable property rights: in this instance, the purchasable right to foul the environment.

From this obscene analysis came tradable emissions permits for air pollution. An artifice like a pollution market could only work if governments properly set the issue of market permits and their cost to levels that expressly limit the externality to the desired degree.

There should be little surprise in discovering that this sort of economic finesse is beyond the ken of bureaucrats. After a decade of dodgy trades at the beginning of the 21st century, Europe’s flagship environmental externalities program – the Emissions Trading System – utterly broke down.

Further, this whole conceptual trading scheme forgets that pollution is generally more environmentally destructive than anyone but environmentalists are willing to admit. So little is appreciated about the subtleties of the web of life, even by biologists.

Agriculture, manufacturing, mining, and fossil fuel production egregiously pollute freshwater supplies. Industrially polluting freshwater destroys it from ever being potable again, at any cost. Since freshwater is a limited, nonrenewable resource, and the pricing mechanism only captures the cost of its supply, not its exhaustion cost, a sensible trading system to pollute freshwater is impossible.

With freshwater scarcity becoming an increasing problem in much of the world, no one is suggesting a trading scheme for fouling water supplies. Yet, under Coase’s imagining, this is exactly what would solve the problem of water shortages.

The same applies to fertile soil as freshwater. It can take centuries for exhausted soil to recover its fertility. Obviously, there have been long-standing property rights and trading systems for real estate. The problem of infertile soil has repeatedly been temporarily solved only by expanding supply, which is deforestation.

Clearly, Coase’s theorem was ridiculous in suggesting a theoretical mechanism which has no practicable application.

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To corporate businessmen and government bureaucrats, business as usual is the only mantra. The immediate demand for quarterly profits and tax revenues obscure, if not obliterate, longer-term regard. CEOs and politicians have to continually deliver to their constituencies or face discharge.

More generally, governments don’t much care. All extant governments are plutocratic by nature: identifying with the wealthy who endorse sovereign debt by purchasing it. Without the outrageously rich, governments could not indulge their habitual deficits; hence, tax breaks for the upper crust that a government can ill afford has a perverse logic to it.

Putting a crimp on production rubs the fur of polity the wrong way practically everywhere. Business and governments do their best to ignore pollution, and other externalities, until the consequences become lethal in large numbers, or, at the least, threaten revolt by the masses.