0:36 Intro. [Recording date: May 8, 2012.] Russ: Ronald Coase, born in 1910. First, I want to ask you about your youth. How did you get interested in economics, and how did you end up in the United States? Guest: Well, I was born in London. I was born to parents who went to work at 12 years old. So they had very little education. So, I had very little education, either. I was very weak in my legs, and I went to a school for physical defectives run by the local council, and we were taught very little. I remember learning how to make a basket, had to weave it. That was the sort of thing I was taught. I had very little education until I went to the secondary school. Russ: How did you get from a school for physical defectives to become a graduate student in economics? Guest: Oh, I got a scholarship from the local council to go to the secondary school, the Kilborn [?] Grammar, and I went there. And while there, I studied, got a scholarship, and--I'm trying to think just what I did. Hard to--I really didn't start studying until I got to a secondary school, where I had a scholarship. Russ: And in your career, when you were younger, which economists had the biggest influence on you? Who have you come to respect as an economist over the decades? Guest: Oh, I didn't really study much at all. I didn't study economics until I got to the London School of Economics, which I went from the secondary school. Russ: And when you were there at the London School of Economics [LSE], which economists did you learn the most from? Guest: Well, Arnold Plant was the economist who taught me sectional [?] economics, and I knew I didn't really know very much then. I just studied with him. I took a degree in commerce. I never studied economics at all. We just studied a whole range of subjects like accounting and industrial law and so on. Or a commerce degree. Not an economics degree. And we really had very little economics at all.

6:31 Russ: Now, that's still can be true in graduate school. Economics has changed a lot since then. And you've been critical of what you call blackboard economics. What does that mean to you? Guest: Blackboard economics is economics which you can put on the blackboard, in which you study an imaginary system. It's not empirically based at all. It's not concerned with what really happens. It's what you imagine could happen and what you imagined didn't happen. So, I've been very critical of modern economics, which is too abstract. That's called blackboard economics. It's something you can put on the blackboard but that doesn't exist. Russ: So, what do you recommend? Guest: I recommend more empirical work. Study what actually happens and start from there. Russ: Modern empirical work in economics is very abstract, as well, though. It has a lot of statistics and aggregates. That's not what you mean by empirical work. I don't think you mean econometrics, right? Guest: Oh, no. I don't mean--the study that people do with a lot of statistics and so on, not finding out what really happens and getting conclusions based on the investigations, not on what actually happens but on bunches of statistics. My view is you should get down and study what actually happens. But economists don't do that, by and large. Russ: No, it's rare.

9:25 Russ: Let's talk about the problem of social cost. There was a famous dinner that took place at Aaron Director's house at the U. of Chicago, where everybody thought you were wrong when the dinner started. Including Milton Friedman, who was--according to George Stigler--your biggest and most frequent adversary at that dinner. He talked the most, according to Stigler. But by the end of the evening, they all came over to your side. What do you remember about that dinner? Guest: Well, it was [?]. As was said, people started off thinking that I was wrong. And I couldn't see why they thought I was wrong. What I'd done was to say two and two equals four. And they had said that isn't right, it's five. It was as simple as that. I don't know why they thought I was wrong, since I didn't say it wasn't obvious. Russ: Well, at least to you. I think that they probably thought it was two plus three. So they thought two plus two equals four, but they thought you were talking about five, I think. Guest: Well, whatever it was, it was a complete misunderstanding. Russ: That must have been a lot of fun, the end of that dinner. Guest: Well, it was. But I couldn't understand why they didn't understand what I was talking about before. It was all a bit of a mystery to me. I thought I was stating the obvious and they couldn't accept it. Russ: But in one evening, they couldn't. Sometimes it takes a lifetime for people to change their minds about such things. It's pretty amazing that that group did it in only a few hours. Guest: Well, it did. It changed their views. It changed their views in a very sensible way, because they went on to talk about something called the Coase Theorem, and I never liked "the Coase Theorem." Russ: It is a common phrase. And I'll tell you why in a minute. But why don't you like it? Guest: I don't like it because it's a proposition about a system in which there were no transaction costs. It's a system which couldn't exist. And therefore it's quite unimaginable. Russ: Yeah. It's a straw man on a blackboard, would I think be the best way to describe it. For those who haven't read the paper, you should. It's accessible to anyone who understands English. That's the only language you have to understand. You don't have to understand the language of mathematics. And the idea of the paper is that you are assigning property rights in the face of an externality, in the face of harm being caused by one to another. The first part of the paper says that if--if transactions costs are zero-- Guest: Well, in a way, it's unfortunate that I did that. I only did this in order to explain my views. I thought, let's talk about a system where there were no transaction costs. But it's an imaginary system. There always are transactions costs. Russ: Well, it's like Galileo assuming there is no friction. But of course there is. So you better plan on it. And it depends on--sometimes that friction is better important, sometimes it's less important. But the idea is that if there were no transactions costs, then when you assign property rights to the two parties, because there are no transactions costs, then it's easy for the parties to reassign rights, making side payments. But I always was taught--and I was taught this by Deirdre McCloskey when I was in Econ 300 at the U. of Chicago--was that the real lesson of your paper was that because transactions costs are not zero, you should assign the property rights very carefully. And ideally you should assign them to the party--you should assign property rights so that the person who has the least cost of bearing the externality does so, because they might not be able to reassign the rights. It might be too expensive to renegotiate. So that the assignment of property rights is very important. That's what he told us the Coase theorem was. I know you don't like the phrase, but it's not so bad if at least he gets the insight right. I think the problem in the literature use the first part--if there are no transactions costs as a straw man, to say that you were wrong. Because of course, if there were transactions costs--but you knew that. It was a terrible, unfortunate turn of events in the literature. Guest: Yes. It was a discussion at cross purposes which the [?] had a completely wrong idea of what I was getting at. It took a whole evening of all these economists to get it right. But then in the end they didn't get it right, because they amended something called the Coase Theorem, which I don't like.

16:16 Russ: So, part of your paper was a reaction to A. C. Pigou, who argued that, in the face of an externality--positive or negative--we need to change the price that people face. If it's a positive externality, we should subsidize it. If it's a negative externality, we should tax it. And your point is that that's not necessarily true; and that in particular, sometimes it's better to do nothing and let the people who are harmed find an alternative way to avoid the externality or pay for reducing the harm by the person whose actions are creating it. And yet, despite your paper, and despite--now it's been over 50 years; and it had a huge influence. Many people say it created the whole field of Law and Economics. It forced economists to look at transactions costs; it forced them to look at externalities in a different way. And yet the Pigou approach remains very much the standard way that people think about these things, even despite the fact that, I think, you did a very good job of calling it into question. Do you think I'm right? Guest: Oh, you are right. Why people make the mistakes they make, I can't understand. But they go on doing it. And economics doesn't progress in the way I'd like to see progress. But a few [?] is very common in all human activities. Russ: Well, it's particularly common when it's hard to experimentally test results in complex systems. So, people can persist believing lots of things that aren't necessarily true. It could be true. But they can't prove that they're true. They can't confirm their suspicions and ideas. In social science, very difficult. If you had your way--which no man does--but if you had your way, what would you like that paper to have achieved? What would you want to have happen in the real world from having written that paper? What policy implication the paper has for legislative and legal systems? Guest: I don't know that you couldn't end up with the policy unless you study how things actually happen in the real world. And that's what I'd like to see people do. Not all this abstract theorizing, all this mathematics. I'd like to see people go study how things actually work. Then you would learn something. Because by and large, that's what economists do. That's why I call it blackboard economics. It's abstract. Russ: And of course, in the policy world, politics plays a big role. It's not just a search for the truth. I think about your 1959 paper on the Federal Communications Commission (FCC), which had some of the ideas of the problem of social cost in it. And you talked about the advantages of assigning property rights and letting people buy and sell access to the air for broadcasting. Which eventually something like that happened. It took about 40 years. Guest: Yes. Russ: Were you surprised at that? Guest: No, not after you've studied how things actually operate. It's a surprise that it took as little time as 40 years. No, it's not possible to study how things are dealt with without realizing the importance of the stupidity of human behavior. It's awful when you think how the war needn't have happened--the First World War, which I lived through, was an absolute tragedy, with millions of men were killed for now apparent reason. And the Second World War, when Hitler started it, needn't have happened at all. It could have been stopped years before. But no one did it. And Chamberlain, if you remember, went and saw Hitler a year or two before the war started, got a peace [?], which he waved in the air. He said this is "peace in our time." And the war started only two years afterwards. Russ: Yeah, it was a bad prediction. And I can't say I remember it the way you do, but I do remember it. Speaking of that time, did you have contact with Keynes and Hayek, two great economists of that era in England? Guest: Yes. I was very friendly with Hayek. I liked him, and he liked me. But we didn't have great contact. He tended to deal with these big questions, and I'm always interested in how the actual system operates. Therefore, in much smaller matters than Hayek. Russ: And how about Keynes? Did you know Keynes? Guest: I can tell you--I was helping when Britain was trying to get a loan from the United States immediately after the war, and I was talking to one of Keynes's assistants. And Keynes came in the room and walked over to us and the man I was talking to us said, "This is Coase, who is helping us with the statistics. I don't think you know him." And Keynes said, "No, I don't." And walked off. And that's my life with Keynes. Russ: That's short. That's very funny.

24:55 Russ: Let's talk about your 1937 paper, "The Nature of the Firm." You were trying to answer a question--an interesting question, remains a good question; it was a good question in 1937, it's still a good question, which is: If capitalism and markets and prices, the Hayekian system of communicating information via price signals, if it works so well, why do firms exist? Because firms are almost by definition top down rather than bottom up. They use command and control rather than purchases within the firm, although there are exceptions to that. Some firms do use price signals for their decision-making inside the firm. But many firms do not. Their decisions are made not by prices but by fiat, by decisions on the top. Now, you wrote that paper when you were very, very young, the first part of it, correct? Guest: That's right. I wrote it while I was an undergraduate. It seems obvious to me. If you go into a firm and you say to someone: Why did you do this? He'd say: Because I was told to do it. He doesn't talk about pricing at all. Almost of all the things you do within a firm are not controlled directly by prices at all. Your boss tells you what to do and you do it. Russ: How did you come to write that paper as an undergraduate. Guest: Oh, I was interested in how firms actually operate, and if you start studying how firms actually operate you find that they are not concerned with prices directly at all. A person who is working in a firm does what he's told. That's the way it operates. Russ: So, a firm is an island of socialism in a capitalist world. Guest: Oh, well, I was a socialist at that time. I had [?] some influence [?]. I didn't start with the views I now have, but I was a socialist; my parents voted for the Labour Party, and one important person that we knew was who was Ernest Bevin [?], General Secretary of the Transport and General Worker's Union, which was the largest union in Britain. So in those early days I was a socialist. And that may have had some effect in leading me to "The Nature of the Firm." Very likely. Russ: So, your insight was that firms act like socialists because it's cheaper. Guest: That's right. Russ: And it's cheaper because it's not free to use the price system. Guest: It's cheaper because the price system is a very expensive system. If you think of all the things you have to know in order to make a bargain it's obvious it's not a cheap system. And a system that avoids negotiations is one that saves a lot of costs. Russ: So, one of the things that I love about that paper is it forces you to think about these costs, which you might not notice. It forces you to notice that some systems that you think might not work so well actually might work better than you think. But it's hard to test those ideas, right? One of the implications of the paper is that when transactions costs are high, you are more likely to use command-and-control. But it's hard to measure transactions costs; it's hard to quantify the theory. Is that correct or is it irrelevant. Guest: It's very relevant. But the state of economics is such that people don't try to measure these things, to study them, and so people can engage in discussions and explanations without any real knowledge of what happens in the real world.

31:47 Russ: So, in modern Industrial Organization, although your paper has had a huge impact and began a whole field within Industrial Organization focused on institutional issues, the new institutional economics, which influenced many, many other scholars, at the same time there was the blackboard part of Industrial Organization, which is Game Theory, and other aspects of Industrial Organization. But Game Theory became the predominant way that people thought about the behavior of the firm. Where Game Theory is focused on strategic interactions between players with significant market power. What was your reaction to that literature and its influence on the study of the firm? Guest: I think the influence was wholly bad, because people developed high theoretical approaches instead of approaches based on what actually happens. And it's only recently really that people have begun to study what really happens as against engaging in what I call blackboard economics. Russ: Do you think we understand--when I look back at the last 70 years of thinking about the firm, I'm not sure we've made much progress. It's true that people do occasionally spend some time at looking at what actually goes on. There's one view that says the people who figure that out keep it to themselves, because it's profitable. But other people than yourself, people like Harold Demsetz, have decried the state of modern theories of the firm. The defenders of Game Theory certainly have remained enthusiastic about it, despite your critique. And it is still a dominant approach, I think, for business students. I think many business students still are taught a great deal of Game Theory. The question is: What would you want them to learn instead? It's one thing to say: Economists should learn more about firms. But have we learned anything in the last 70 years that would be useful to a future executive or manager? Or student of economics? Guest: I don't think so. I think the treatment by economists has by and large got worse, if that's possible. I think the time has come when we should study what actually happens, study firms and how they operate and learn from that. That one thing is going to happen. In that narrow sense, I'm optimistic. Russ: But you could argue that that approach of studying what actually happens at firms, that that's the essence of, say, the Harvard MBA, which is a case study approach, where you look at particular examples of what firms did in different situations. Sometimes it's an issue of strategy or marketing. And rather than make a grand, general theory, you go on a case-by-case basis. The problem with that is that every case is a little bit different, so it's hard to generalize, hard to have a body of knowledge. Maybe all you end up with is a body of cases. Guest: Well, we shouldn't give up an approach because it's hard. Life is hard. We shouldn't be looking for easy ways to do things but for ways to solve the problem. Russ: I agree with that.

36:37 Russ: Let me ask you a little bit about politics. Your paper on the "Problem of Social Cost" and your paper on the lighthouse, "The Lighthouse in Economics," which was published in 1974, which we have yet to talk about. It's a wonderful paper, one of my favorite papers. I remember in graduate school coming across it and being so excited about it. These papers have been used by people who are laissez faire, or free-market oriented, to suggest the obvious case for government intervention in the case of externalities or government intervention with a tax, or in the case of the lighthouse, with public provision of a public good. But that case is not so obvious. What is your feeling about the political implications of those papers? Guest: I'm just a person who thinks that the government should give up everything. How much the government should give up will be found by studying how the government operates. But the assumption that governments always do the right thing is not true. They make lots of errors, and where they are most likely to make errors can be found by studying how governments operate. My approach to the subject of what governments should do is to be based on studies of how governments actually operate. And I've had a lot of experience. I worked for the British government for many years, and I saw how decisions are made. And stupidity is very common. Russ: Well that's why competition and trial-and-error are often a better solution than one size fits all. Guest: In some areas. I wouldn't say that's true in all areas. If you study military and the conduct of war and so on, you find the errors are enormous. I don't know whether you are familiar with what happened leading up to the war [WWII], but it was absolute stupidity. Hitler could have been stopped early on, but no one did it. And the result was a horrible war, the [?] which we still experience today. Russ: No doubt. But we were talking about understanding what government actually does, and you emphasized that it's important to study government. You were at the U. of Virginia when James Buchanan and Gordon Tullock and others were pioneering what came to be called Public Choice. What was it like there and what do you think of that work? Guest: Well, I was there at the time when Buchanan was trying to build up a department, and I went there from Buffalo to be part of that. What we didn't realize was that the Dean at Virginia thought we were all a lot of right-wing extremists, and he opposed everything we were trying to do. And finally succeeded in preventing Buchanan from what he wanted to do, which was to build up a department. And Buchanan left, Tullock left, I left. Warren Nutter didn't leave because when he got an offer of a job at, I think, UCLA, the Vice-Chancellor vetoed it. The reason was that Warren Nutter, who was making estimates of the Russian production ended up with a figure no where near the official figure of the British government. This was thought to be due to his bias. We now know the one that whose own figures were too high. Russ: As if the British government didn't have a bias, either. Going back to Buchanan and Tullock and Nutter--what did you think of their work? And what do you think of it now? Is it the kind of economics you like or not like? Guest: Well, by and large it goes along lines that are not mine, and so I admired them; I didn't necessarily agree with them. I just got on with my own work. Russ: Yeah, you've always listened to your own drummer. Thank God. It's a different drummer, and it's made economics a much more interesting field because of that.

44:43 Russ: Let's turn to your latest work, which is on China. How did you get interested in China? Guest: Well, I've been interested in China very superficially for a long time. I was very impressed by reading Marco Polo; and this was China in the 13th century. And it was a country in many ways ahead of what was going on in Europe or in Britain. And I thought it was a country that had great potential. And I still do. Russ: So, your new book is titled How China Became Capitalist, and is co-authored with Ning Wang: How capitalist is China? Guest: Well, it is very capitalist, but it is not capitalism as we know it. It's capitalism with Chinese characteristics; and this you would expect. But the country is being transformed and it's not being transformed as people in Europe commonly think as a result of the Chinese government's operations, but as the result of what we call the Marginal Revolution--change is taking place despite the Chinese government. There are these village enterprises. Unemployed people who start businesses. It's all going forward in China without the control of the Chinese government. The Chinese government commonly doesn't know what's going on. Russ: But there's still a large government role in the economy, and they steer a lot of resources. As I understand it, the government has done a lot of the building, much of it infrastructure, probably not going to be useful, not productive. You are emphasizing the importance of the things they don't know about; but they do know about some things, and they are very active. Correct? Guest: The government is doing a lot of things, most of them being failures. It's an economy which is under the Chinese Communist Party, but the Chinese Communist Party commonly doesn't know what's going on. Russ: How do you think that happened? There was a point where they had a much tighter control over things. Why did things loosen up to allow things to happen that they didn't know about, and why did those things become so much more important? Guest: Well, I think China is a very big country, and it's very difficult to control. It's very difficult to know what's going on. And so things can happen. There's a Chinese saying, and I don't know that I have it completely correct: The mountain is high and the emperor is far away. Russ: That's a nice expression, even if you have it wrong. It's a very Hayekian expression. It's about the knowledge problem, right? There's local knowledge that only the people in the vicinity have. I would add: The mountain is high, the emperor is far away, and sometimes he has no clothes. Guest: Yes, well. Russ: Do you think Chinese prosperity is--we talked earlier about Warren Nutter's estimates of Russian production and that they were much lower than the official estimates and ended up being lower than what we found out to be actually the case. I wonder if anybody actually has any idea of what's actually going on in China, especially when so much of what is measured is probably government activity that I'm not sure they are measuring it correctly. I'm not sure you can measure it correctly. I'm not sure. The standard of living there has improved--there's no doubt about that. How much, I think is hard to say. Do you think it will persist? Guest: Well, Fogel [?] has made his estimates, which are very great on the future; and I think he's probably right. Whether the growth in China as he has estimated, we don't know. But it could be. It could be higher, because there is a large possibility for further growth in China. The output per capita, the productivity of what is in China, is now very low. Output is great because their population is great. Russ: Right. People, I think on many fronts, misunderstand the impact of China's success and its significance. I believe it's a good thing for the world, and a good thing for the Chinese people, because the Chinese people are part of the world, so I'm happy to see them doing better. But a lot of people think it's bad for the United States, and I don't agree with that. Do you? Guest: No, I don't. Our productivity per head is far greater than that in China. And likely to continue. Russ: What do you think is the state of property rights in China, these days, as someone who has spent much of his life thinking about the importance of property rights and the assignment of property rights and the costs of reassigning property rights. How is China doing on that front? Guest: Very badly. China has a long way to go to catch up with the West in terms of productivity, in terms of the institutions required to make a really good economic system. And that's why I think we are going to see further growth in China. It's got a long way to go. Russ: And of course we don't know if their political system will create the right incentives for that growth. Guest: All it gives are bad incentives. But [?] happens largely outside the government control. The [?] farming, for example, agriculture, has developed opposed by the government or even illegal by the government, but it's gone ahead because the government cannot control everything; and the same is true in many other areas. So, you have an extraordinary situation where under the Chinese Communist Party, you have had a growth of markets and private ownership and so on. Russ: In those private settings, are there contracts? Informal contracts? Are they using the legal system but in the wrong way? Guest: It's a very undeveloped legal system. And things have happened without a proper legal system. That's why it's now being developed; why we can expect the growth in China is going to continue. It's because there is a long way to go. And it's not very innovative. They produce large parts of their stuff on the basis of orders from abroad. What is produced is not determined in China but is determined in Europe and the Americas. Russ: And right now they are the workshop of the world. Whether they will be something different in 25 years, I guess remains to be seen. Guest: That's right. They do things that other people describe and want done. But that won't continue. And as China becomes more innovative, their production will become more valuable and more significant. We know very few Chinese--I'm trying to think what the word is--trademarks. Russ: Patents. Guest: It's all developed in America and Europe. And then the Chinese do the things to order. Russ: That will change. Guest: And these changes in Chinese production will go up and become more valuable. And it's got a long way to go. And it's a big country. A quarter of the world's population.