0:33 Intro. [Recording date: October 23, 2013.] Russ: Our topic for today is the intellectual legacy of Ronald Coase, the Nobel Laureate who passed away in September at the age of 102. And Coase was a guest on EconTalk in May of 2012. Don, today's guest, is a long-time teacher of law and economics and contributor to the literature; and I thought it would be nice to talk about Coase's legacy. So we are going to talk about his most important papers today, of which there are relatively few but incredibly influential. Guest: Coase wrote more than people realize he wrote, but when you compare his total corpus to that of most Nobel Prize winning economists, it is relatively small. Russ: Shockingly small. In terms of number. Guest: Yeah. In terms of insight per word. [probably meant words per insight--Econlib Ed.] Russ: And influence on the profession as well. We're going to focus, just to give people a heads' up, on four of his papers. The two most important are "The Nature of the Firm," which was published in 1937 in Economica, and "The Problem of Social Cost," which was published in 1960 in the Journal of Law and Economics. I'm hoping we'll have time at the end to give significant time for "The Marginal Cost Controversy," which is 1946 in Economica and "The Lighthouse in Economics," Journal of Law and Economics, 1974. We'll put links to those; there are also books that have collected those essays. But those are the big four. He did, as you point out, other things as well, and they are all interesting. But those are the four we are going to focus on today, I think that had the most lasting impact.

2:34 Russ: Let's start with "The Nature of the Firm", published in 1937--a long time ago--and yet a paper that still gets a lot of attention. Guest: "The Nature of the Firm" and "The Problem of Social Cost", these are the two that were understandably singled out by the Nobel Prize Committee in 1991 when he was awarded--justifiably--the Nobel Prize. That paper grew out of a trip that Coase had made, with a fellow student I believe, to the United States, a research trip. He was a student at the London School of Economics (LSE), where he encountered Friedrich Hayek; Hayek was one of his professors. His main professor was Arnold Plant. Arnold Plant was very interested in accounting and did some work in the economics of accounting. As did Coase. Coase got a fellowship in the early 1930s to the United States, and he studied actual business organization. At some point it dawned on him that the way economists talk about the firm, the firm is a black box. To this day we don't really talk about what goes on inside the firm. Russ: Things go in--labor, materials--things come out--products, services. Guest: Firms are, as we economists say, production functions. They have certain technologies for transforming inputs and they take the input prices given, or if they are monopsonists somehow, and then they produce things up. And Coase said, well, that may be okay for certain theoretical purposes but let's investigate more: Why are there firms? A straightforward question. Asked what are firms, but Why are there firms. And very few economists until that time--I say very few but maybe none, but certainly very few economists asked the question: Why are there firms? We've asked what are firms, but why are there firms? And Coase's answer in a nutshell are there are firms because there are transaction costs. Firms, for Coase are institutional devices for dealing with transaction costs, for minimizing the consequences of transactions costs. And we can talk in more detail about exactly what his theory about the firm was. But it's interesting that Coase wrote that paper, "The Nature of the Firm", in 1931. So he was 21 years old when he wrote a paper for which he won the Nobel Prize 70 years later. Russ: I should say, it's Wednesday, October 23, 2013, so Coase was kind of the Xander Bogaerts of economics. That's an inside-baseball reference for Red Sox fans. Go ahead, Don; I'm sorry about that. Guest: Well, it's okay. I was going to get a good sports reference in. Because the fall classic starts tonight with the Red Sox and the Cardinals. And so Coase wrote the paper when he was 21; you think, well, what did I do when I was 21? I was struggling with calculus. And it wasn't published until 6 years later. I'm sure he polished it a bit. But to this day, "The Nature of the Firm", which is a very straightforward article, remains the foundation of all the best theoretical work that economists do on the theory of the firm. Much has been built upon that foundation. But Coase's original insight remains. Russ: It's more than a foundation in the way that, say, Adam Smith's work on The Wealth of Nations is a foundation. Which it is. But Coase's article is worth reading today not just for--of course, The Wealth of Nations is, too; you can still learn something today from The Wealth of Nations--I don't know if there are many articles written in 1937 that a modern economist can read profitably, understand, and be stimulated by. And when you said it's straightforward, I think what you meant was: It's not theoretical. It's not technical. It's not mathematical. Guest: It's theoretical; it's not mathematical. Russ: It's not mathematical. It's bristling with insight and interesting observations. Guest: Yes. And the fundamental insight is this: Coase asked, look, we economists have this theory that resources are allocated according to prices. Sellers sell to willing buyers and there is this process, and goods and services get moved around the economy from where they are valued less to where they are valued more. So why do we need firms? Why doesn't all production take place across what I call 'ownership boundaries'? Why does General Motors, for example, own the Fisher Body Co., to take a famous example later used? Why did it buy the Fisher Body Co.? Why does it make bodies for its own automobiles? Russ: And by doing so lose the power of the price system to induce competition, excellence, innovation? All the things that we like as economists about the market process, when they are put inside a firm, have become a top-down, to be blunt, socialist, command-and-control system that seemingly gives up all the advantages of price and competition. Guest: It is, a firm is what Hayek called--and remember, Coase was a student of Hayek--an 'organization'--it is administered from the top and it's conducted according to some conscious direction. And Coase said, so why do we have this? If the market is so great, why do we have these, I think it was Dennis Robertson who called them 'islands of conscious power' in a sea of markets? Why do we have these things? And Coase said, well, it's because, look, markets, as wonderful as they are, contrary to what basic economic theory might imply, markets have transactions costs. Contracting in a market is not costless. People have to worry about the honesty of the people with whom they are contracting; they have to worry about: will the quality of the thing that I'm contracting to buy be what I expect? Russ: Sometimes it won't be; I have to then deal with the implications of that. I have to have a contractual or legal way to cope with the surprises. Guest: Yes. There are a variety of different sources of transaction costs. And Coase said, when the transaction costs of using the market are sufficiently high, it's worthwhile to take those transactions out of markets and put them into the firm. Now, the firm itself is not a costless thing to operate. There are costs of operating a firm. I call these 'administrative costs.' So you have a cost of using the markets on one hand versus administrative costs on the other hand. Russ: And those costs are? Guest: Well the manager of the firm has to consciously direct workers: You guys, when you finish doing that, move those intermediate products from there to here; and you people, do it this way; paint them green or paint them red, make sure you ship them to Toledo or make sure you ship them to Tijuana. So it has to be-- Russ: But that's the smallest. The bigger challenge is you have to figure out what technology to use. Guest: Yes. Russ: What skills to use. What mix of people and machinery. Normally you just say: Let's go find the cheapest one that meets--when you go out in the marketplace you are not thinking about this at all. You are just thinking, I want to find the cheapest one that meets my quality expectations. All of a sudden you have to wonder: Am I doing this the best way? And you may not be. So there are the costs of discovering mistakes, etc. You've got loafing--which again, in the competitive external market, you just say, Well, you're late; we're done. I'll find somebody else. But here you are saying, the guys, well we had this bottleneck, how do you know it's real? Seems to me the monitoring and quality control of product and decision-making process within the firm is by far the biggest cost. Guest: Yeah, yeah, of course, of course. You are right. The general lesson here is: Coase is a realist. So, look, markets aren't perfect; administrative direction isn't perfect. They both have their costs. And in a competitive economy when people are allowed to experiment with different operational forms and markets aren't constrained by excessively by regulation to fit some model, then what will happen is over time firms will emerge, depending on the industry, depending on existing technologies, that minimize the entire costs of transforming raw materials into final products for delivery to consumers. You still have costs of using markets; you have administrative costs. But if firms get too large then the administrative costs at the margin outweigh the costs in the markets, so firms will shrink. If the costs of using the market are too high at the margin then firms will emerge to reduce those costs and substitute the lower administrative cost with the cost of using the market, all the while lowering the total costs of transforming raw materials into final outputs. It's an astonishingly simple insight, but no one had it until Coase discovered it.

12:06 Guest: And this is a theme that runs throughout all of Ronald Coase's work. He recognized when economists overlooked obvious questions and he asked questions that, once they are asked seem important to ask but no one thought to ask them before Ronald Coase asked them. And that's a really important role to play. And "The Nature of the Firm" is an example of that. Why are there firms? I've often said about that, that it's easy to understand the nature of the firm if you've think of it first as really a theory of vertical integration. It works for horizontal integration as well, or even conglomerates. Russ: Explain what you mean by 'vertical integration.' Guest: 'Vertical integration' is the economists' term for the integration within one firm of different stages of production. So, I used earlier the example of General Motors and Fisher Body. General Motors makes the bodies, then it attaches the bodies to the chassis, then it puts the motor--so you have these different stages of production extending back from the raw material, extractive, stages where you get iron ore out of the ground all the way to the final stage where you run a dealership that delivers the final product to the consumer. Russ: And of course any of those stages you could either outsource--meaning get it from outside the firm-- Guest: use the market-- Russ: or you could produce them in-house. And they do a mix of both. Guest: Yes. And you could imagine, theoretically, one firm, Giant Corp., having its own iron ore exploration division, extracting ore from the ground, smelting ore, turning it into steel, turning that steel into auto bodies-- Russ: having its own rubber plantation-- Guest: rubber plantation; for a while I think Henry Ford did indeed have that. All the way to actually owning the dealership. We don't see that. We see General Motors doing some of it but not all of it. It contracts out parts of it both in early stages of production and in latter stages of production. And Coase's theory remains the starting point for economists' understanding why in particular circumstances certain processes are integrated within a firm and why in other circumstances the processes occur across ownership boundaries in markets. Russ: I never thought about it until just now--a similar set of factors come into play when I decide what to do on my own inside my house versus what I hire someone to do. Guest: Yep. Russ: So, we talk in economics about comparative advantage, which, one way I like to think about comparative advantage is self-sufficiency is the road to poverty. If you try to do everything for yourself, you are going to be very poor because you have a limited set of both time and skills. But if you think about it, there are a lot of things inside your house that you end up doing for yourself because of transaction costs. I'll just speak for myself; most of us, I think, are in this situation. I take out my own garbage. I change my own lightbulbs. There are a thousand things I do around my house that I could hire someone to do. And in fact, the previous owner of our house hired someone to change all the lightbulbs in a whole set of lights in our house because they were up high, and he didn't want to get the ladder, and he didn't want to climb the ladder, he didn't have the ladder, he didn't want to climb the ladder. So he paid someone actually to change the lightbulbs, at least for some of the lightbulbs. But the point is that if I could instantaneously say, oh, I'll give you $.75 to change a bunch of lightbulbs, I might decide not to do that myself. I might pay someone. But the costs of finding that person, getting him to my house, waiting for him, letting him in, all those "transaction costs"-- Guest: Dealing with the risk that that person may be dishonest or incompetent. Russ: Correct. So there are a lot of things that I do inside my house that I don't have a comparative advantage; and you'd think in a way I would contract out for them. But I don't. And that's because of this factor, which is a beautiful application. Guest: Just really quickly, I heard yesterday that Jerry Jones, the owner of the Dallas Cowboys, when he's sitting in the owner's box watching a game, he has someone beside him to clean his glasses, so when his glasses get dirty--I don't know if it's true but I heard someone say it and it sounded like they were telling the truth. So that's really contracting out to another party. Russ: Yeah. But for him, evidently--I clean my own glasses. Guest: So do I. Russ: So, for me, the cost of having someone next to me to do that isn't worth it. But for him, evidently in his situation--maybe he's not very good at cleaning them, as well. He may be inferior. May be a case of absolute advantage, in that case.

17:02 Russ: So, as you said--I want to spend a few more moments on this paper. You said it's a simple insight. One view is that it's like many insights as you say by Coase-- Guest: No one had it before Coase. Russ: Correct. So it's one of these things, oh, that's obvious. But it wasn't obvious at the time. But it wasn't just that it was obvious and now we know it. It has implications and has had implications for research in industrial organization; and of course, we are going to apply it in a minute to the case of externalities and public policy. Which is what Coase came to do in the next paper we are going to talk about. But talking to James Buchanan--besides the fact that it "explains" why firms socialism within the firm--and of course some firms use market competition do things in house but they still try to leverage the price system. They might have competing divisions. I know there are retailers that their stores, they have an in-house arm that creates clothing for their retail stores but the retail store is allowed to buy from anyone. So they are not forced to buy from the in-house supplier. They can buy from anyone. So there is competition forcing that inside supplier to compete with the outside suppliers. There are all kinds of creative ways that firms try to leverage and get the power of competition of markets. But is there anything else you want to say about the influence this paper had on how economists think about firms and organization? Guest: Oh, sure. And we'll talk about this in an even broader context in a moment, I'm sure. But the underlying insight here is the importance of transaction costs. Until "The Nature of the Firm" was published, economists paid little attention to transaction costs. In fact, I don't know that they paid any attention to them at all. I confess I haven't read Alfred Marshall's book on industry. Maybe it's in there. But certainly "The Nature of the Firm" brought to the fore the importance of transaction costs. Oliver Williamson, one of the co-winners of the 2009 Nobel Prize, much of his work is built on and is inspired by Ronald Coase's work. And the generalization that has occurred--which Coase noted and was proud of--is that it became a theory of commercial contracting. We have all sorts of--we initially think of as firm versus not-firm. Well, you have different kinds of contracts. A franchise contract, for example. The McDonald's down the street may be owned by McDonald's; probably not. It's probably owned by a separate individual or a separate company. Russ: It's an innovation, that structure. Guest: And so where Coase's insight has been taken since 1937, by Oliver Williamson, by Armen Alchian, by Harold Demsetz, by many others, is in a direction of explaining the contours of contracts and the details of contracts that otherwise would remain mysterious absent Coase's insight into transaction costs. Why have franchise contracts, for example-- Russ: And what is their nature? What do they contract on? What are they worried about? Guest: Exactly right. What explains how they change over time? All of these explanations into the nature of commercial contracts find one way or another roots in Coase's 1937 article. Which is an astonishing thing, considering that a 21-year-old youngster wrote that. Russ: In a field where--that is not the nature in our field. There are fields where 21-year-olds make important contributions but not often in economics. Guest: There is in mathematics; but there is no mathematics. This is a straightforward insight. Just a quick footnote: the importance of that article--I think I'm correct in saying this--really took off in 1951, I believe, so some 14 years after it was published, when it was reprinted in the AEA (American Economic Association) Readings in Price Theory that was edited by George Stigler and Kenneth Boulding. I think the article was not given the attention that it subsequently got until it was reprinted in that famous reader. And when that famous reader came out, that's when we really see an explosion of work done on the theory of the firm. Russ: I want to say one more thing about it and get your reaction. A paper we've talked about many times on this program is "The Use of Knowledge in Society," by Friedrich Hayek, which is 1945, American Economic Review. So, that paper, the theme of that paper is that prices convey knowledge and aggregate knowledge. There's a lot to be said about that paper; maybe we'll do a podcast on just that paper some time. That would be fun. But, that paper was about the power of prices to solve what came to be called the 'knowledge problem'--the fact that a lot of the most valuable knowledge isn't stuff you can look up. It's not stuff you can compile in a report. It's stuck in the heads of people. And how do you leverage that knowledge--how do you get that knowledge to come into play when it's scattered among individual brains, scattered across time and space? And what Coase is saying really is that there are times when you forgo--the timing of these articles is kind of ironic; Coase is writing in 1937, perhaps influenced by conversations with Hayek as you suggest, but Hayek writes in 1945 and what Coase is saying before the fact is: sometimes you are going to give up that aggregation of knowledge, that ability of prices to convey knowledge, and you are going to solve that problem--because you've got to solve it, and there's a whole modern management literature about the culture and history and knowledge of an organization, sort of a obsession for a while and then in the 1990s, I don't follow this literature any more but how does an organization preserve the knowledge embedded in its employees given that 1. They are scattered around the organization, and 2. They die; 3. They transfer, they quit, they get fired, they leave. And they take with them embedded in their brain a bunch of stuff. How do you get that knowledge out of them into some sort of accessible way? Of course you can't. There's no easy way to do it. But especially in this context we are talking about, when you give up the competitive market-driven outcomes that come from competition and price-equality [?] competition, how does the firm solve that problem? They have to find a way to solve--not solve it, but deal with those issues. Guest: Coase was all about tradeoffs. Quoting Tom Sowell now, but it's a very Coasean notion: there are no solutions; there are tradeoffs. You can reduce this cost only by increasing this cost. What you hope is that the reduction in this first cost is greater than the increase in the subsequent resulting higher cost on this other front. You want to make sure the economy is competitive--we were already clear: Coase was a very, very free-market guy. So that this balance is made as best is possible and when external factors change, that the balance itself can change to reflect changes in external reality. Russ: And, to take a modern day application, the ability of the Internet to allow firms to find out--one of the most simple transaction costs that arise when you use the outside market, which is: What is the price? It takes time. When you want to go buy a car, you can't look up: What's the price point now? Well, now we almost can. A lot of people have access to the information. And I'm really thinking about the supply chain. You're a firm and you want to buy something from the outside; you can at a very low cost, very quickly find out two very important things: the price itself--not a lot of legwork any more--and secondly whether people are happy with the quality. You get a lot of information that before had to be gained with a lot more uncertainty. So you'd expect that to change how firms organize, what they produce versus outside. Guest: These things are happening all the time, and so you don't want a rigid template for what the world "should" look like except to say it should be competitive; entrepreneurs should be free to experiment with different methods of organization. Coase published that paper, "The Nature of the Firm"--you mentioned Hayek. An even deeper paper, maybe his most profound paper, is his "Economics and Knowledge" paper published in 1937, the same year. And this is when Coase and Hayek are close together in London. And what those papers share is an appreciation of the--let me use a modern--the pixelization of knowledge. That knowledge is not a whole. It's spread out, it has to be captured, it has to be utilized; different people utilize it differently, have different subjective reactions to it. You can see in Coase's work a lot of Hayekian influences. Which themselves maybe just go from Hayek and Coase was respecting the results of the intellectual climate of the LSE in the 1930s. Russ: London School of Economics. We're going to move on now to another paper but I want to mention that long-time listeners will recognize that we've talked about the nature of the firm in lots of other podcasts. We'll put up links to it. I did a podcast with Mike Munger on it and it may have come up in other places--I think it did--along obviously with the actual interview with Ronald Coase in 2012.

28:01 Russ: Let's move on. Let's move on to "The Problem of Social Cost", which was, really--is it the single most-cited paper in economics? Guest: It was for a very long time. It would not surprise me if it still is the single most-cited paper in any economics journal. It was published in the Journal of Law and Economics. There's a great story behind that paper. George Stigler has a story in his 1988 autobiography, "Memoirs of an Unregulated Economist". And the story, at the time that he wrote it he was on the economics faculty at the U. of Virginia with Jim Buchanan and Gordon Tullock and Leland Yeager. And he presented it in a seminar at Chicago; and of course he sent it on ahead of time. And there was a dinner party the night before the presentation. I've heard different stories. I can't remember which one is Stigler's. It was either at the apartment of Aaron Director or the apartment of Milton Friedman, but anyway, you had many future Nobel Prize winners there--Coase himself, Milton Friedman, George Stigler. Aaron Director was there--many other luminaries. Allan Wallis, in the economics profession. And Stigler says that when Coase arrived, when Ronald arrived at the dinner party, there was only one person in this room of 20-odd people who thought that Coase was correct. All these people were astonished that a person as careful as Coase would get something so fundamentally wrong. Russ: That one person of course being Ronald Coase. Guest: Right, the only person who believed that Coase was correct was Coase. And Stigler said by the end of the evening, everyone in the room understood that Coase was correct. So here you have an insight that today when you talk about it, it's going to sound almost trivial. And yet some of the greatest economic thinkers in history when they first encountered it, it was so unbelievable to them, so unfamiliar, that they rejected it out of hand. Ronald Coase cannot possibly be correct. By the end of the evening they all knew that he was correct. Stigler called it the most exciting intellectual evening of his life, this discussion of Coase's "Problem of Social Cost" paper. There's a prelude to that paper, and that's the work that Coase did--Coase, by the way, was British, although he spent much of his, his most productive years of his professional career at either the U. of Virginia or the U. of Chicago--so in the United States. He did a 1959 paper on the Federal Communications Commission (FCC), and one part of that paper involved the allocation of the electromagnetic spectrum--how do we allocate it? Russ: For radio. Guest: For radio or, I can't remember, television. For broadcast purposes. And, you know, Coase realized: regulators don't have to worry too much about getting it right. Just create property rights in it, make sure those property rights are secure, and then we can trust the forces of the market to ensure that each piece of the electromagnetic spectrum, if it's not initially possessed by its most valued owner, will eventually wind up with it's most valued owner. This is simply an application of things we recognize about the economy in a routine way. If you value my watch more than I value it, you'll offer me a price for it, and I'll sell it to you. No one thinks that's astonishing. This happens all the time. It's very routine. And Coase said, look, those same market forces operate for nontangible property rights in the same way that they operate for tangible things. And that's one of the fundamental insights of the 1960 paper, "The Problem of Social Cost." The proposition--or I assume it's the proposition that Stigler referred to. By the way, Stigler is the person who named it the 'Coase Theorem'. Russ: Unfortunately. To some extent. Guest: Yes. The proposition was that if transactions costs are sufficiently low--some people would say if they are 0; they have to be sufficiently low, people can transact--then the legal authority, maybe a court, a bureaucracy, an all-powerful monarch, it doesn't matter. If that legal authority's goal is economic efficiency--that's a big if and we can come back to that--and transactions costs are sufficiently low, the legal authority needn't worry himself, herself, itself terribly much about how to initially allocate the thing--who do I give it to? do I give it to these people over here? Just create property rights in it, give them out--it doesn't matter really who you give them out to. Those property rights will eventually wind up in the hands of the people who value them most, who can put them to the best economic use. If I'm given a part of the electromagnetic spectrum and I'm a terrible broadcaster, if I think that the best thing to broadcast is cricket noises, and then you think that the best thing to broadcast is population music, then eventually you'll purchase from me my part of the electromagnetic spectrum because you can put it to better use than I can. Now if transactions costs are sufficiently high, then it does matter how property rights are initially allocated. Russ: Expensive to negotiate, we can't find each other.

33:54 Russ: So, up to here, on the surface, this looked like the flip side of "The Nature of the Firm." Because it basically said, if costs are low, use the market. Let the invisible hand work. Let competition and other things work. But of course to me, that's the--and I learned this from Deirdre McCloskey when I was a first year grad student at Chicago--the transaction costs aren't zero, and they are often not sufficiently low. So to me, the insight of the Coase Theorem is not that one. It's not-- Guest: Well, that is the Coase Theorem. The insight of Coase's paper is not that. And Coase said many times over the years-- Russ: And he did on EconTalk as well-- Guest: that he very much regretted that that's what is regarded as the Coase Theorem, as the main takeaway from that paper. Russ: Because it became a straw man. It became a way for people to dismiss the paper by saying, Well, since transactions costs, they are not zero; they are never zero; this whole paper is just a curiosity. So before we do the second half of what Coase really thought is the deep insight--which I agree is the deep insight--it's worth noting that at that dinner party where people didn't accept it, they didn't accept that first one. Guest: They didn't accept that first one. And it's a curious thing to reflect on. Once it's stated it becomes obvious. Why would people be any less willing and able to exchange disembodied property rights than they are willing to exchange physical things? If the transaction costs in both cases are sufficiently low, they'll do it. Now, in both cases the transaction costs might not be sufficiently low. But there's nothing fundamental about property rights per se that makes them a different thing to exchange than physical things. So that's the first part. It's really the simplest part of Coase's argument. Let me say, I think Coase in a way overreacted to the popularity of the Coase Theorem. I do think it is an important insight. Russ: It shouldn't be neglected. Guest: It is important. Transactions costs are sufficiently low in many, many instances. I think in the case of the electromagnetic spectrum, they probably are sufficiently low. There's a pretty well organized market, I think, in those sorts of things; and if CBS owns more of the electromagnetic spectrum than NBC and NBC can put it to better use, they both have incentives to transfer that part of the electromagnetic spectrum that can be better used by NBC from CBS. We see transactions taking place every day. So transactions costs often are sufficiently low. In many cases. Russ: I never really thought about it, but Coase is, in a way, saying economics, markets work, when transactions costs are low. Again, it just sounds trivial and simple. But to take another example, Julian Simon, who we both have a great deal of respect for, his solution to the fact that airlines have an incentive to overbook, but that imposes a cost on them because sometimes somebody gets bumped and is angry, so they have to be very careful with how they do that--they came up, Julian Simon came up with the idea of, well, let's just--they should overbook, because there are advantages of not having empty seats; and it turns out that too many people show up then you can auction off the--and they don't literally auction them off. They say, the first three people who come forward are going to get a free ticket. And now all three parties are better off: the airline, the person who was bumped who still gets to stay on the flight who didn't have a seat. And in a way, that's the Coase Theorem in action. Because before this innovation, you are sitting there thinking: I really want to go to Chicago, but it's sold out. I need to find somebody who is on that flight who is willing to get off the flight. And of course that's really hard to do. You knock on doors to people to travel to Chicago? Do you call up people and say, Who is going to Chicago who I can outbid? And what this does is it's a way to allow this to happen in a low-transaction cost way. Guest: I hadn't thought of this; that's a good point. That desirable action, that useful action, is integrated into the firm. The airlines take it over. Again, it doesn't work perfectly. Nothing works perfectly. But it works pretty smoothly.

38:54 Guest: So, as with the firm, Coase wanted to explain things we observe in reality that seem at odds with basic theory. The firm seemed at odds with basic theory: if markets work so well, why do we have firms? The law, as it exists--Anglo-American law, at least, the one that Coase was looking at--why is its structure as it is? What explains the details of nuisance law and property law and contract law? What Coase is driving at in "The Problem of Social Cost", one of the things he was driving at--it's a really deep, multi-layered paper--was that because we are living in a world where transactions costs are often sufficiently high to block what would otherwise be mutually advantageous exchanges, the law itself takes on a character. The law itself takes on details. It takes on contours, it takes on substance, that is best explained, just like the firm, as institutions to deal with these transactions costs, to minimize the ill consequences of transaction costs. Russ: And in particular, he was interested in what economists call 'externalities', where my actions harm you-- Guest: Social cost-- Russ: or help you. And why is it in those situations some legal structures make more sense than others? So let's talk about some of those examples and what comes into play with transactions costs and what he was trying to explain. Guest: Well, of course, the most famous example was the railroads and the farmer. So you have railroads going through a field--that's a socially useful activity. But railroads throw off sparks and sparks always run a risk of igniting crops growing nearby. So the railroad imposes a cost on the farmer. That's how it's normally said, how we normally think about it. So, we need a way to deal with this. Russ: We need a way to protect the farmer from the harm of the railroad is the way it's usually said. So we've got to punish the railroad for its actions. Guest: Yes. So, the first pass at this: If the transaction costs between the railroad the farmer are sufficiently low, then the law doesn't matter that much. Russ: Explain what the law would be. The different choices that the law would make. Guest: All the law would have to do is simply declare one or the other as owning the right. Okay, Mr. Railroad, you have the right to run your train. Or, Mr. Farmer, you have the right to be free of sparks. If they can bargain--let's say the farmer is given the right. This is the Coase Theorem: the railroad will buy from the farmer the right to run trains across or near his land up to the point where the value to the railroad of running that train is equal to the value of the risk to the farmer of having his crops burn. The farmer will be willing to sell to the farmer to run the risk of burning his crops. And the same thing would work if the railroad had been given the right. If the farmer thought it was more valuable to keep the railroad away, the farmer would pay the railroad to stop. Russ: Or to put up some barriers to keep the harm from happening. That's another way to think about this. Guest: The lowest-cost ways of dealing with these things would emerge. Russ: And that's really important, though, because we don't know what's the lowest-cost way. The regulator might not know. So for me, one of the insights of the Coase Theorem is: do you impose a regulatory solution from the top down or do you let it emerge from the bottom up? And what Coase was suggesting was that if--and again, if--transactions costs are relatively low, the low-cost solution will emerge through the natural interplay of these negotiations. And then the parties will have the incentive to improve that going forward. Guest: Yes. This part of Coase's paper is a powerful explanation of the nature of secure property rights. People who are secure in their property rights and can exchange those property rights, they have incentives to either exchange them if they can or to take steps to minimize the damage to them. Or to put it another way, to maximize their value. You don't need a top-down regulator saying doing this or do that, don't do this or don't do that. People will do that on their own. It's a really powerful insight. But a deeper insight--and this is one that Coase also emphasized, but it's so deep I think it still is not sufficiently appreciated, is the mutuality of harm. When we talk about externalities, when we economists talk about externalities, we typically, for whatever reason--it seems easy to identify the harmer and the harmee. Russ: [?] and the perpetrator. Guest: The tortfeasor and the tort victim. But Coase said: Look, it's not that easy. Take the railroad and the farmer example. It looks like the railroad is imposing costs on the farmer. But let's face it: Suppose the railroad had been there first, and then the farmer came by and started growing crops. Then why don't we say the farmer is responsible for his own risks? It's true the sparks physically come from a passing train, locomotive. But the farmer himself has some responsibility for where he sets up where he grows his crops. It's not clear that all the causality runs from railroad to farmer in terms of the harm. We have to look at it both ways. When we recognize that all the harm is mutual, then it's easy to recognize that the appropriate adjustment--the appropriate adjustment is not obvious. It's not necessarily the case that the railroad should stop running as many trains, that the railroad should take steps. Russ: Maybe it should be that the farmer shouldn't grow close to the railroad. That may be the cheapest way to cope with this problem. Guest: Yes. That's exactly right. And so one insight, one of the many particular insights, from this is that Coase would predict--did predict--that the manner in which the law actually classifies a perpetrator as distinct from a victim is that the perpetrator is the party that the law determines somehow is the lowest-cost avoider of the harm. If the railroad can avoid the cost at a lower cost than the farmer, then when the railroad runs its trains by, we say the railroad 'causes' the harm. And so the railroad should be the party taking steps to minimize the harm. If, on the other hand, the determination is made that the farmer is the lowest-cost avoider, then we say the farmer is the perpetrator and the farmer should take the steps.

46:43 Russ: When I teach this, I summarize it by saying, 'It takes two to tango.' And the idea that externalities are mutual, this mutuality you are talking about, is disturbing. It's jarring. Because we often want to, and sometimes should impose a moral judgment on harm. So, if I came and I hit you in the face with my fist and that annoys you, if you are not careful you could say, in a Coasean way: Well, it's your problem; you should enjoy it; or you should just say it's no big deal; it's just as much your problem as mine. We all are repulsed by that logic, correctly. And so I think one of the most powerful aspects of Coase is, taken to an extreme, I think it's dangerous to say, well, all we care about is minimizing the cost. That's not true. We do care about, many times, something more than minimizing the cost. We care about morality; we care about justice. But at the same time, what Coase forces you to acknowledge is that sometimes the morality you impose on an economic situation is false. It's not just a different metric. It's wrong. It opens your mind to the possibility that you haven't imagined, that there's a different way to handle this social problem. Guest: That's right. Russ: An example I've used--I may have used it on the program in the past, I apologize--is that if you are hiking in Montana, you will encounter horse manure. And it's your job to avoid it. No one expects the horse owner to clean up after his horse. Although in Manhattan, the horse wears a diaper, in Central Park. Because it has culturally emerged--or it may be legal, but I think it's cultural-- that there it's unpleasant; it's unexpected. But in Montana there is no moral blame placed on the horse owner. If you step in the output of his horse, that's your problem. Why weren't you more careful? In the city streets of Chicago, when I was there in the winters and springs of and falls of the late 1970s, dog owners did not clean up after their dogs. Everybody understood--it was culturally totally acceptable--to leave that on the street; and only a fool would step in it. Keep your eye out. Keep a lookout. And today that's not true. That has culturally changed for a bunch of reasons. Some of it is technology: I think the cheapest thing is plastic bags. And a hundred other reasons. Guest: Better understanding of the transmission of disease. All sorts of things. And a similar point--it's the same point, again, these are examples--and you start seeing the Coase Theorem everywhere after you think about it. When I spend the summer in California, in California it's the driver's responsibility not to hit pedestrians. Pedestrians in California are extremely aggressive. They are much more likely to cross the street carelessly. Because they are aware of the culture there. You come back to the East Coast, and it's Walker Beware. And drivers are less careful. And so if you've been out walking in California for a summer, if you grew up in California and you move to New York or Manhattan or Washington, D.C., you better be careful. Because there is a different set of expected norms about whose responsibility it is. Who owns property rights in the street. And the cultural norm in Washington, D.C. and New York is the driver owns the road. And in California, it's much more the pedestrian owns the road. And there's nothing moral about that. Your first thought is, well, of course it's the driver's responsibility not to hit people. And it is. True. But there's a continuum of care. Which is another insight you get from Coase. It's an entirely[?] rich paper. Guest: There's a flip side to the important point you made. And that is our moral assessments are surprisingly determined by these economic factors. If you hit me in the face, unprovokedly you punch me in the face, it's true in a very technical sense that we both caused it. My face, if my face weren't here, it wouldn't hit; if I had moved it, then your punch wouldn't have landed on that. Russ: Yeah, I'm just swinging my arm. Side to side. Guest: But morally, we reckon the code--if you want to reduce it to the economics, you are clearly the low-cost avoider. I'm not expecting you to hit me in the face. You swing. You are the low-cost avoider. Therefore the blame falls there. Our very moral senses are determined in large part by transactions costs. Russ: Correct. Guest: A lot of people don't[?] like that because we like to separate morality-- Russ: It's unsettling. So on this issue of morality and how the costs play a role reminds me of this issue that arose when legislation introduced tradable emissions coupons for sulfur dioxide. And a lot of environmentalists were offended by this, because of the morality of it. They said: A firm shouldn't be able to buy the right to pollute; polluting is harmful, and I don't care, we don't care about the efficiency or other things; it's just wrong; that's just immoral. Economists' reaction was very different. Guest: Yep. That particular issue arises in different related circumstances. Economists say, well, yeah, but pollution is not without benefits; it's the by-product of a beneficial process. And so if you think that--pollution is not amoral because it has, the thing that produces it has beneficial consequences. Why would you assume, as a matter of morality, that the harm is necessarily at the margin, necessarily greater than the benefit? Do you want to live in a society without any pollution? You can do that, without any industrial pollution. But we'd have no pharmaceuticals, we'd have no petroleum fuel. We'd have a very different lifestyle. Our lives would be much more miserable. And so the economist points to the benefits of at least the process that pollution causes. Economists--and Coase was very good at this, by the way--dismiss that kind of talk of morality more easily than do other people because we recognize that there are costs and benefits to almost any action. Russ: And, in this case where the firm "buys the right to pollute", it's going to ultimately almost always end up passing those costs on to the consumer of the product. Who I would argue morally is the person who should pay for it. So, if there is pollution, that's the way it should be. Guest: Excellent. Russ: And people say, yeah, they should pay for it, not the firm. Well, the firm, don't worry. They do pay for it. Not the firm. I wish we could talk some more about this; I've been meaning for a long time to write an essay on it, on the Coase paper and the insights, the things I've learned from Coase. I have a preliminary version of it up on the Library of Economics and Liberty website, a related paper at least, and we'll put a link up to that, on the Napster issue that arose, which to me is an application of Coase's insights.

54:36 Russ: But we're going to move on. It's late in the day. I want to talk briefly about the other two papers, "The Marginal Cost Controversy" and "The Lighthouse in Economics." Let's take 5 or so minutes for each one to summarize why they were important. Guest: The "Marginal Cost Controversy," the 1946 paper, and it has a very--like all Coase's papers--it has a very simple insight. Economists will argue, efficiency requires output up to the point where marginal cost equals price. Russ: And define 'marginal cost.' Guest: Marginal cost is the cost to producing one additional-- Russ: A little bit more. Guest: A little bit more. One additional unit of output. So, it was this famous example back in the 1940s; it's still famous. The uncongested bridge. And so what could be the price of crossing an uncongested bridge, say, a motorist crossing an uncongested bridge? What should be the toll? Well, says the naive economist, it should be zero, because the cost of--putting aside the small wear and tear, ex de minimus [?]--the cost of crossing an uncongested bridge is 0. And so that person shouldn't be charged a price. Russ: Shouldn't be discouraged from crossing. We want them to cross. Guest: That's right. If you charge a toll, you'll have fewer people crossing the bridge. You'll have a social inefficiency. People who would get more value from crossing the bridge will be dissuaded from doing it even though they know the social cost to them of crossing the bridge is less than the value they would get. So we can't have positive pricing of such things. And Coase--we don't have enough time so we won't get into it--this article, too, is a multi-layered article with many deep insights. But the one I like best--and other people have made it. Coase made it in a particularly clear way. He said, Look, one purpose of pricing--remember Coase was a student of Hayek--is not simply to--remember, prices convey information. Not simply to allocate goods and services. They convey information. And so if we allow bridge owners to charge what the market will bear, then yes, if the bridge is uncongested and you have a positive price of, say, $2 to cross, if you look only at the individual drivers[?] some of them who shouldn't quote-unquote who should cross won't cross, social efficiency. However, if we force the price down to zero--some economists advocate that that's the socially efficient price--we lose the informational content of the price. We lose the informational content of how valuable is it to build new bridges. How valuable is to expand bridges. And so Coase, a year after "The Use of Knowledge in Society," Coase is pointing out in "The Marginal Cost Controversy" the important informational role of pricing and how that information would be sacrificed, destroyed, if some of the more naive economists' solutions for efficiency were implemented. If uncongested bridges, as an example that apply, if the price were forced down to marginal cost where marginal cost here is zero. Coase said, No; price should be what the market bears. Russ: How do you do that in the case of a bridge, where the government built the bridge, the government is setting the toll? Where are you going to get this informational value in that setting? Guest: Well, the insight--I can't remember exactly--imagine a private bridges. A private bridge owner. It's not inefficient for the private bridge owner to charge what the market will bear even in an uncongested times, because the efficiency of the information made by prices-- Russ: to other poetential bridge-goers-- Guest: Yeah. It has to be weighed against the inefficiency of dissuading the margins and people who shouldcross the bridge. Coase went on in the paper--he discussed mutli-part pricing schemes and explained the value of those and how they are superior to top-down regulation or outright subsidies.

59:00 Russ: And what about the lighthouse? Which I have to say, when I read it in graduate school--I think that was probably my favorite paper in many ways, because it's so simple; it's a little historical episode and it's eye-opening. It's a fabulous paper. And I thought, this is the greatest. Guest: It's very careful economic history done by--most people don't think of Coase as an economic historian. But he did do--and this certainly was an economic history paper. And he was taking aim at standard textbook economics. As he did so often. Russ: And by the way, I forgot, it has to be mentioned: the Problem of Social Cost was in many ways a reaction to Arthur Pigou--which we forgot to mention. Guest: Oh, Coase really disliked Pigou's work. Russ: Yeah. So, the so-called Pigovian tax, which is that when you have a negative externality you should impose a tax on the so-called 'perpetrator'--the apparent perpetrator--was what Coase was reacting to in saying that sometimes that's not always the right policy. I mention it only because the Pigovian tax, a carbon tax, is often mentioned as a way to "solve" global warming. And I think what Coase would have said, and maybe he said it; I think I mentioned on this program, is that that's one way to solve it; it may not be the best way. The best way might be to let global warming occur, if indeed it's happening, and to let human beings respond to it; and that might be cheaper than forgoing current output which the tax will produce. Guest: Coase said, basically: The world is a lot more complicated than your simple theory, Mr. Pigou. I think it's not too much of an exaggeration to say that much of Coase's work, certainly in after 1937, was a reaction to naive Pigovian blackboard theory. It looks very nice, very scientific, but Coase understood that the real world has complexities in it that most economists overlook when they do their theories. Russ: So, going back to the lighthouse-- Guest: A lighthouse is a very standard public good. A lighthouse is erected on the shore. It casts its beam. And any boat that needs guidance in storms or darkness to a harbor can look at the beam. So the reasoning goes in the standard textbook--Paul Samuelson's textbook that Coase singled out, or one of the ones that he singled out in his article--reasoned, well, so no private owner has an incentive to build a lighthouse because you can't charge for the benefits. You can't exclude. Russ: Everybody can free-ride. Everybody can say, I won't pay because then I can still get the light. Guest: And Coase said: let's look at the actual history of lighthouses in Great Britain. And he did that. He looked at the actual history of lighthouses in Great Britain. It's too simple to say that what he found was that, oh, yes, they were all built by private enterprise in Great Britain. Russ: Correct. Sometimes it gets parodied that way, either by its proponents who love that conclusion; people who tend to be market-oriented, like us; or by the antagonists who want to challenge Coase's thing and say that's what he said. Guest: That's not what he said. Russ: As always. Guest: But he showed that in the history of lighthouses in Great Britain, it was in many cases driven by private enterprise. The contractual arrangements that harbor-builders and dock- or harbor-owners, people who manage[?] harbors, would arrange with boats coming in were ingeniously designed to enable lighthouses to collect fees, allow the suppliers of lighthouse services to collect fees for the provision of those services. The naive view that a lighthouse is a straightforward public good, unless it's provided outright by government and funded exclusively through taxation--and lighthouses in early on in Great Britain were not funded in this way. They were funded by--I forget the term--harbor fees. They were funded in large part by fees that boat owners did pay. And this is an example of Coase saying, well, let's look at the history. And the history of lighthouses is far more complex than the notion you get by reading the standard textbook story about a lighthouse.