Ronald H. Coase: Chicago School or Virginia School Economist?

It is not uncommon for Ronald Coase to be identified as a “Chicago School” Economist. For several reasons, this would not be an unfair characterization. First, Coase joined the faculty of the University of Chicago Law School in 1964, and remained there until his retirement in the early 1980s, during which time he had also been the Editor of The Journal of Law and Economics until 1982. Secondly, as a student at the London School of Economics, Coase, like other economists of the Chicago School, had been greatly influenced by the work of Frank Knight, particularly Risk, Uncertainty, and Profit (1921). Although Coase had regarded himself as a socialist in his youth, his training at the LSE under Arnold Plant and his study of the workings of the operation of markets in public utilities, postal services, and lighthouses solidified his free-market convictions, as is often identified with Chicago School economists, such as Milton Friedman, George Stigler, or Gary Becker. Moreover, the tendency for government regulation to serve special interests, rather than the public interest, also affirmed his skepticism of government intervention. It would seem, then, that Coase carried all the trappings of a Chicago economist.

However, as economist Steve Medema has argued, the “relationship between Coase and the Chicago School could be considered a case study in the dangers of assuming some sort of Chicago homogeneity” (Medema 2010, p. 262). Indeed, Coase shared similar public policy conclusions as his contemporaries at Chicago. But to identify an economist by his or her free-market policy conclusions, instead of the methodology by which they arrive at such conclusions, renders indistinguishable the distinction between the Chicago School and the Austrian School, or between Chicago and its intellectual cousins at the University of California, Los Angeles (UCLA), University of Washington, or the University of Virginia (UVA) for that matter.

 

In terms of methodology, I would argue that Coase would be better identified as an economist of the Virginia School, from which Public Choice theory was born at the Thomas Jefferson Center for Studies in Political Economy and Social Philosophy (TJC) at the University of Virginia (UVA) under James Buchanan and Gordon Tullock. Though Buchanan, Tullock, and other faculty members, such as Rutledge Vining and G. Warren Nutter, had been trained at the University of Chicago, what distinction, if any, exists between the “Virginia School” and the Chicago School? Moreover, how can we attribute the distinction of “Virginia School” to Coase?

Though Coase’s own work shares many policy conclusions with that of public choice theorists, particularly skepticism of government intervention to mitigate supposed market failures, the relationship between Coase and Public Choice introduces another danger of homogeneity, since other branches of Public Choice have emerged as well, besides that which emerged at UVA (and later Virginia Tech and George Mason University). These include the “Bloomington School” of Vincent and Elinor Ostrom and the “Rochester School” of William Riker. Moreover, Public Choice was also developed by economists at the University of Chicago, including Gary Becker, Sam Peltzman, and George Stigler (see Mitchell 1988 and Mueller 1976).

 

What I wish to highlight here is a point that Peter Boettke and I have made in paper recently published in Public Choice, titled “Where Chicago Meets London: James M. Buchanan, Virginia Political Economy, and Cost Theory” (2020), in which we argue that the Virginia School of Political Economy emerged from the marriage of subjective cost theory that had been developed at the London School of Economics (LSE) under F.A. Hayek and Lionel Robbins, and price theory from the University of Chicago.

 

The work of Frank Knight had been a cornerstone of the education of students at the University of Chicago and the LSE alike in the pre-WWII era, and Knight had been highly influential in Coase’s education. But whereas price theory at Chicago had been primarily Marshallian, in which costs are taken to be objective, price theory at the LSE had been primarily Wicksteedian, in which supply curves are simply the demand curve of suppliers, and therefore part of the total demand curve for a good or service, the value of which is subjective. In his own recollection of the LSE of the 1930s, Coase remarks that, unlike at Chicago, at the LSE, “Marshall was in the calendar of saints but few of us prayed exclusively to him. Marshall was one among many economists studied”, and goes further to state that, “[i]n fact, we thought his views on cost confused” rather than clarified the analysis of market processes (1982, p. 34).

 

Therefore, what Coase shared with Buchanan and other economists of the Virginia School, which made them distinct from their intellectual cousins at Chicago (see Wagner 2017, 2020), is the fact that they saw opportunity costs not as constraints to which economic actors passively respond, but as variables defined by the act of choice itself. Because of this, Virginia School economists, such as Coase, directed their analytic attention to choice among constraints, and thus saw institutions, organizations, and other contractual arrangements as a by-product of individuals striving to realize the gains from exchange. Virginia School economists therefore took a constitutional perspective, which focuses on analyzing “the rules of game” and how the modification of institutions could generate positive-sum forms of interaction. Therefore, whereas their contemporaries of the post-WWII Chicago School took Pareto-optimality as an assumption that characterizes real-world market outcomes, Coase and the Virginia School understood the conditions of Pareto-optimality to be a by-product of individuals devising institutional arrangements, not only to reduce transaction costs, but also to exhaust the gains from trade.

 

This distinction is best highlighted not only by how economists at the University of Chicago first reacted to what later became known as the “Coase Theorem,” but also how the Coase Theorem is still interpreted today. “The Problem of Social Cost” (Coase 1960) had been written in response to what Friedman, Stigler, Harberger, and other economists at the University of Chicago had perceived as a fundamental error in Coase’s analysis of Pigovian welfare economics, as had been first argued in the “The Federal Communications Commission” (Coase 1959). However, what needs constant reminding is not only that both of these papers were written when Coase was a faculty member at UVA, but also that, at UVA, his ideas were regarded as an evolution of the common knowledge that he, Buchanan, Nutter, and Vining had inherited from Frank Knight. Surprisingly, as George Stigler (1988) recounts in his autobiography, it was among Knight’s former pupils, including Friedman and himself, at the University of Chicago that Coase’s ideas were considered a revolution that overturned Pigovian welfare economics.

 

Though the Coase Theorem has become a cornerstone of law and economics and institutional economics generally, Coase’s central message cannot be fully understood unless we first realize how he understands the nature of costs. As he recounted repeatedly, the Coase Theorem was never meant to direct our attention to a world in which transaction costs are zero. In such a world, markets will have already exhausted all the gains from trade, and institutions are therefore redundant. Rather, what Coase was trying to stress is how positive transaction costs represent future profit opportunities for their reduction, and how entrepreneurs will profit from perceiving a way to reduce transaction costs by devising institutional arrangements, thereby creating the gains from trade.

 

As Coase has highlighted throughout his work, from seminal paper “The Nature of the Firm” (Coase 1937), to his last book, How China Became Capitalist (Coase and Wang 2012), the benefit of institutional and organizational arrangements, such as contracts, firms, money and property rights, are that they reduce the costs of making an exchange (i.e. transaction costs). Costs are not a constraint independent of human choice, but are an artifact of human choice, and therefore can be manipulated by restructuring the payoff structure embodied in institutions through human creativity. It is this understanding of market processes that Coase shared with his colleagues at UVA, and distinguished him from his colleagues that he would later join at the University of Chicago. It is in this respect that Coase should be considered economist of the Virginia School.

 

 

 

 

References

Candela, Rosolino A., and Peter J. Boettke. 2020. “Where Chicago Meets London: James Buchanan, Virginia Political Economy, and Cost Theory.” Public Choice 183(3-4): 287– 302.

Coase, Ronald H. 1937. “The Nature of the Firm.” Economica 4(16): 386–405.

Coase, Ronald H. 1959. “The Federal Communications Commission.” The Journal of Law and          Economics 2: 1–40.

Coase, Ronald H. 1960. “The Problem of Social Cost.” The Journal of Law and Economics 3: 1–44.

Coase, Ronald H. 1982. “Economics at LSE in the 1930s: A Personal View.” Atlantic Economic      Journal 10(1): 31–34.

Coase, Ronald H. and Ning Wang. 2012. How China Became Capitalist. New York: Palgrave Macmillan.

Knight, Frank H. 1921. Risk, Uncertainty and Profit. Boston, MA: Houghton Mifflin.

Medema, Steven G. 2010. “Ronald Harry Coase.” In Ross B, Emmett, ed. The Elgar Companion to the Chicago School of Economics (pp. 259–264). Northampton, MA: Edward Elgar.

Mitchell, William C. 1988. “Virginia, Rochester, and Bloomington: Twenty-Five Years of Public Choice and Political Science.” Public Choice 56(2): 101–119.

Mueller, Dennis C. 1976. “Public choice: A Survey.” Journal of Economic Literature 14(2): 395–       433.

Stigler, George J. 1988. Memoirs of an Unregulated Economist. New York: Basic Books.

Wagner, Richard E. 2017. James M. Buchanan and Liberal Political Economy. Lanham, MD:         Lexington Books.

Wagner, Richard E. 2020. “Chicago Political Economy, and Its Virginia Cousin.” GMU Working       Paper in Economics No. 20-11. Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3597754

 

 


Rosolino Candela is a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics, and Associate Director of Academic and Student Programs  at the Mercatus Center at George Mason University

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Cost and the Agony of Choice

I recently had cause to re-read part of James Buchanan’s Cost and Choice, which remains one of the most important treatments of the idea of cost in the history of economics. Chapter 3 of the book is the core of his argument and it lays out an important distinction that is often overlooked in other treatments of cost.

 

Buchanan starts with a methodological distinction between what he calls the “predictive theory” of orthodox economics and the “more general theory of choice.” In a move that can be found elsewhere in his work, Buchanan understands the predictive theory to be the equilibrium models that populate much of formal economics. Those are based on two key assumptions. First, humans are homo economicus, concerned with maximizing utility or profits. Second, they have all of the relevant knowledge necessary to engage in that maximization process. That is, meaningful uncertainty is absent.

If all of the conditions of the predictive theory hold, we can, indeed, predict what people will do facing a particular set of data. As Buchanan notes, in this world, “Individuals do not choose; they behave predictably in response to objectively measurable changes in their environment.” Another way to put this is that if an actor is assumed to maximize utility and that person knows all that is necessary to fill in their utility function, what they will “do” is not a choice. It is simply implied by the maximization assumption combined with those particular data. As we teach in intro, when you know your cost curves and your revenue curves, and are assumed to maximize profits, you don’t “choose” the price and output combination in any meaningful sense of the word. That combination is the logical implication of the location of those curves. Utility and profit maximizers in the predictive theory stand there and can do no other.

The simplest way to see the distinction between the predictive theory and the more general theory of choice is a bit of introspection. When real humans actually make choices, we feel the “agony of choice” that is utterly absent from the predictive theory. Which entrée should I order at the restaurant? Which college should I attend? Which medical treatment should I adopt? All of these choices involve an internal struggle over assessing the costs and benefits and thinking through alternatives, and imagining future regret. The discomfort we experience when facing genuine choice is the result of conflicting goals we might have and the structural uncertainty that is the human condition. Those are all absent in the predictive theory where there are no alternatives to the outcome implied by the data given the maximization and knowledge assumptions.

In the more general theory of choice, human actors are not assumed to only care about pecuniary concerns and they face genuine uncertainty about the future. As Buchanan puts it, in the predictive theory, “cost is reckoned in a commodity dimension” while in the theory of choice it is “reckoned in a utility dimension.” The assumptions of orthodox theory allow us to attach a financial or physical dimension to our understanding of cost, as represented by the marginal cost curves of basic microeconomics. But once we put those assumptions aside, we can only understand cost in utility terms.

This is where Buchanan’s core contribution comes in. What does cost look like in a world where people have multiple goals and are dealing with true uncertainty? Cost in such a world is the actor’s “own evaluation of the enjoyment or utility that he anticipates having to forego as a result of selection among alternative courses of action.” (I would note that it would be more precise to say “want satisfaction” rather than “enjoyment or utility,” especially if “utility” is understood in hedonic terms.) He lays out six implications of what he calls the “choice-bound conception of cost:”

  1. Most importantly, cost must be borne exclusively by the decision-maker; it is not possible for cost to be shifted to or imposed on others.
  2. Cost is subjective; it exists in the mind of the decision-maker and nowhere else.
  3. Cost is based on anticipations; it is necessarily a forward-looking or ex ante concept.
  4. Cost can never be realized because of the fact of choice itself: that which is given up cannot be enjoyed.
  5. Cost cannot be measured by someone other than the decision-maker because there is no way that subjective experience can be directly observed.
  6. Finally, cost can be dated at the moment of decision or choice.

 

I don’t want to walk through each of these, as I’ve covered many of them in a previous contribution. What I do want to note is that all of these implications derive from the absence of homo economicus and the presence of real uncertainty. This combination makes cost subjective and anticipation-driven. We don’t know for sure whether the steak will be better than the salmon, or whether standard drugs will be better than chemotherapy. Cost is the hurdle we must get over in order to choose. We have to decide that the want we anticipate satisfying by one option is more valuable than what we anticipate from the next best option. That process of weighing those anticipated outcomes is the agony of choice, and it is what is absent from the predictive theory and the standard neoclassical models that emerge from it.

Standard theory might allow us to make predictions about behavior, given its assumptions, but it fails us as a way to understand choice.

Another way to see Buchanan’s contribution is to think in terms of the Austrian idea of discovery and markets as processes of social learning. In the predictive model, there is nothing to discover and there can be no regret. Behavior is implied by the assumptions and the data, and the maximizing combination is always chosen. There is nothing to learn. In the theory of choice, we are always in a process of discovering whether or not the various options in front of us can satisfy our wants in the ways we anticipate. If we choose the steak and it’s not very good, we have learned something for next time we eat at that restaurant. We can experience regret and it can inform future decision making. We learn from our choices and we improve ourselves in the process.

The relationship between cost and real choice Buchanan outlines in his description of the general theory of choice depicts humans who are much closer to the kind of people who inhabit the world of the humanities, and especially the creative arts. They are richly understood humans who experience that agony of choice and face uncertainty about the future. And they are humans who are capable of regret, learning, and improvement. In his essay “Natural and Artifactual Man,” Buchanan writes that “Man wants liberty to become the man he wants to become.” This is a description of the choosing person who inhabits the general theory of choice. The automaton in the predictive theory cannot be understood in those terms.

Whatever the value of the predictive theory, and it certainly has value as a preliminary exercise for understanding economic relationships, it cannot help us to understand genuine choice in a world of uncertainty. And it therefore cannot help us understand the very human experience of the agony of choice, the regret of error, and the joy of learning.

 

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Cooking Official Statistics Is Not Easy, for Now

After the Bureau of Labor Statistics announced a drop in the unemployment rate—from 14.7% in April to “only” 13.3% in May—a friend emailed me to share his suspicion that the unexpectedly low figure was a propagandist lie. The probability of that is not zero, I explained to him, but it is extremely low.

These data are gathered (through a monthly survey of 70,000 households), assembled, analyzed, and summarized by bureaucrats from the Census Bureau and the BLS, many of whom are professional statisticians. Bureaucrats could of course be co-opted or corrupted by political leaders, as they were in Argentina and Greece not so long ago. But there are reasons why this is less likely to happen in America.

Any attempt at political interference in official statistical data (which would probably be a crime under federal law) could be resisted or blocked at many points in the process. Successful conspiracies involving a large number of people are rare because, like in the Prisoner Dilemma game, anyone has an incentive to defect before anyone else does. A political manipulation at the last stage would be visible to many who have participated in the process. (The BLS Commissioner apparently only sees the report once it is completed.) Any success at political manipulation would quite certainly be followed by some resignations. High-level bureaucrats have an incentive to preserve the value of their personal brands. A professional statistician suspected of having acquiesced to data fraud may be unable to find another job in his field. Moreover, a political manipulation would be interpreted as meaning that US statistical agencies having become of the Greek or Argentine sort. The credibility of all federal statistical agencies would suffer—and may take decades to recover. Treasury yields would probably increase as creditors would suspect that the federal deficit and debt numbers, for example, are cooked too.

Another part of the difficulty would be to reconcile false unemployment statistics with other numbers calculated by other federal statistical agencies, like the Bureau of Economic Analysis (at the Commerce Department), which will, at the end of July, provide a first estimate of second-quarter GDP. And note that cooking a number one month may require cooking it again the following month and so forth, increasing the probability of the fraud being discovered.

Think also of the Department of Labor’s Inspector General, who may investigate any suspicion of statistical manipulation. It is true that federal Inspectors General may now be scared of investigating political malversations after President Trump removed five of them in different agencies over the past few months. But who knows, the Department of Labor Inspector General may still investigate out of personal integrity or because his legal responsibilities require it.

Fortunately, then, lying is not always easy in a government limited by the rule of law and constrained by numerous centers of power. We could say that, like in Rudyard’s delicious novel The Man Who Would Be King (1888), even the king cannot do everything he wants.

The intriguing error in employment data made by the BLS over the past three months does not change my opinion. As my co-blogger David Henderson explained, an error by interviewers led to misclassify the workers furloughed due to the coronavirus as employed instead of “unemployed on temporary layoff” as they should have been. Without this error, the correct unemployment rate would have been closer to 20% in April and to 16% in May, as opposed to the published figures of 14.7 and 13.3%. This big error blunts the impact of the pandemic and especially of government measures to combat it.

The notification of this error in the BLS’s June 5 report covering May (available at https://www.bls.gov/bls/news-release/empsit.htm#2020) reads as follows:

However, there was also a large number of workers who were classified as employed but absent from work. As was the case in March and April, household survey interviewers were instructed to classify employed persons absent from work due to coronavirus related business closures as unemployed on temporary layoff. However, it is apparent that not all such workers were so classified. BLS and the Census Bureau are investigating why this misclassification error continues to occur and are taking additional steps to address the issue.

If the workers who were recorded as employed but absent from work due to “other reasons” (over and above the number absent for other reasons in a typical May) had been classified as unemployed on temporary layoff, the overall unemployment rate would have been about 3 percentage points higher than reported (on a not seasonally adjusted basis). However, according to usual practice, the data from the household survey are accepted as recorded. To maintain data integrity, no ad hoc actions are taken to reclassify survey responses.

(The constraint of maintaining data integrity exists to prevent intentional manipulation.)

A notice similar to the one above appeared in the report for April (published May 8) as well as in the report for March (published April 3); see also https://www.bls.gov/bls/news-release/empsit.htm#2020 for these reports. The same data collection error was committed three months in a row.

Let’s hope the BLS and the Census Bureau continue investigating until they find how the error happened. And let’s hope that their Inspectors General are (still) ready to do their own investigations if necessary.

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Bill Whalen and David Henderson Conversation

On June 4, my Hoover colleague Bill Whalen interviewed me about my latest article for Hoover’s Defining Ideas, “Just Say No to State & Local Bailouts,” June 3. I had heard and seen a talk by Bill on Zoom a week earlier and was impressed with his deep knowledge of California politics. His show is titled “Area 45.”

The interview was really a conversation, something I prefer to a standard interview. Bill has a charming personality, with just the right amount of humor.

In the first 20 or some minutes I make the case that I made in my article, in response to Bill’s questions. But he also raised an issue I hadn’t addressed in my article: whether on grounds of emergency aid, California’s state government should be given a bailout. I said no and I said why.

Some highlights from the rest of the conversation:

23:20: Why I worry that Senate Majority Leader Mitch McConnell will go along with some kind of bailout.

36:00: My case for bonds instead of tax increases. (My first choice, of course, is budget cuts.)

37:10: Why, if the feds do bail out California’s government, I would prefer aid with no strings over aid with strings.

38:30: States going their own way on coronavirus policy and why that’s important.

41:00: Related to what’s directly above: The states as laboratories of democracy and why that’s so important.

41:27: Why economists and other social scientists are almost orgasmic about the forthcoming data.

45:20: Eat the rich.

45:40: I’m seeing it as rich people saying “eat the rich.”

 

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Bloody Tulsa: Trump, History, and the Absurdity of Voter Choice

Election cycle maneuvering seems to be in full swing, and so the political silly season has descended upon us once again. With all of the unrest surrounding us this year – COVID curfews, demonstrations over police violence, and a nascent recession that can only be exacerbated by these other factors – this promises to be quite the interesting cycle. It is not simply that 2020 has presented a duo of major party candidates, Trump vs. Biden, that may just be worse than 2016’s historically bad contest between Mr. Trump and Hillary Clinton. Current events may presage ballot initiatives regarding police funding, qualified immunity, the proper level of prosecution for rogue officers, and other similar matters that fall under the aegis of social justice. Indeed, for certain voters, the Downs paradox (the concept that for rational, self-interested voters, the benefits of voting are generally exceeded by the costs) just might be turned on its head. 

I realize that for many, the notion of “social justice” is a pejorative of the highest magnitude, but as my friend and fellow EconLog contributor Steve Horwitz has observed over at Libertarianism.org, the foundational classical liberal precepts regarding a just society require vigilance to ensure that our institutions remain just:

With the George Floyd killing and associated protests raising a number of issues involving race, the police, and state power that have long interested libertarians, the relationship between libertarian thought and calls for “social justice,” coming almost exclusively from the left, has found its way into the spotlight.

Justice, by nature, is social, as it invariably involves the redress of grievances between counterparties with different interests. This, however, is an argument for a different day. What interests me in the backdrop of these happenings is the choice of date and venue made by President Trump to officially kick off his reelection campaign.

 

Ninety-nine years ago, the Greenwood community in the city of Tulsa, Oklahoma was the victim of one of the most devastating instances of interracial violence in American history. Driven by a false report of an assault by a Black teenager, Dick Rowland,  on a White teenager, Sarah Page, White residents of Tulsa descended upon Greenwood in an orgy of fire and blood. Prior to the incident, Greenwood had been a successful, if segregated, community of some 10,000 African Americans comprising roughly thirty-five blocks of the city and known colloquially as the Negro Wall Street. After a lawless night of looting on March 31, 1921 by an angry white mob, several of whom had even been deputized by local law enforcement, Greenwood lay in ashes, with hundreds dead and some $25.8 million of property damage in today’s dollars.

The economic success of the residents of Greenwood, who lived in the area precisely because it was the only place in Tulsa where they were allowed to live, had long been a sore spot for the other residents of Tulsa. The fear was that with rapidly growing wealth the blacks of Greenwood would begin to demand greater political power, and they would have the economic wherewithal to achieve it, As such, they were a threat to the status quo, and in the absurdity that often comes with group threat theory, what was in fact an innocent encounter between Rowland and Page served as a pretext to eliminate that perceived threat. To further illustrate this point, despite numerous investigations, there were few convictions in the aftermath of the Tulsa massacre, nor was there any attempt on the part of either the city of Tulsa or the state of Oklahoma to provide remuneration to the dispossessed victims. Many of the suddenly impoverished residents of Greenwood simply left, their abandoned properties acquired at a discount by those who had burned them out.

 

That this is where President Trump has decided to begin his campaign for reelection is made even more interesting by the date on which he will appear in the city. June 19 is a day celebrated by many African Americans as Juneteenth, or Jubilee: the day in 1865 on which the Emancipation Proclamation was signed. Although the extractive, exploitative economy of slavery was not really ended until the passage of the Thirteenth Amendment, the Emancipation Proclamation was still a powerful symbol to former slaves. Thus, in the sort of absurd timing that can only occur during an election cycle, we have a President restarting his campaign cycle in the city with the worst racial incident in American history on a day celebrated as a day of freedom by many African Americans during a period of heightened racial tension. 

I doubt that Mr. Trump did such a thing purposefully, or was even aware of the strange symbolism that his choice of date and location would evoke, but in this strange cycle, in this strange year of instability, the underlying notion of structure-induced equilibria – that majority rule in complex societies is inherently unstable – becomes ever more apparent.

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Why We Need to Keep Talking About George Floyd

I must begin by pointing out that this is really not what I wanted to be writing about. This is EconLog, for crying out loud; a virtual property of Econlib.  They don’t just let anyone natter on here, and for that reason, I would rather my introduction to the readers here be a message of freedom and hope. It was a mere few days ago that NASA launched a rocket built by SpaceX into space, ferrying humans to the International Space Station from American soil for the first time since 2011, signaling the successful culmination of a public-private partnership (sort of) that may one day see mankind colonize the stars.  But…I can’t engage you in a whimsical fantasy of our descendants enjoying Andorian ale in a bar on the joint colony at Titan.

Those of us tethered to the ground have been subject to pandemics, government overreach, massive loss of employment…and then there’s George Floyd. Those of us possessed of the masochism inherent in formal training in the social sciences have an obligation to review the world as it is, making data-driven observations, providing deep analysis of proximate causes, and generating recommendations aimed at making improvements and finding solutions. This last is the most difficult, because in matters involving race, I don’t necessarily know that here are any solutions outside of “we all need to be better.” Nor, in truth, am I an indifferent observer. As an African American myself, I have known too many George Floyds to remain indifferent.

It must be noted that the murder of George Floyd by Minneapolis Police officers, and the resultant riots raging across the American landscape aren’t entirely about race. As Reason’s Christian Britschgi has so ably observed, a combination of coronavirus lockdowns, joblessness, and other related factors combined to form a perfect soup that boiled over the day Derek Chauvin and his cohorts essentially strangled Floyd to death. This, however, is an outcome, not a cause. While this matter isn’t entirely about race, it’s still about racial relations in America. As ostensible thinkers in the classical liberal tradition, those of us dedicated to the natural rights of all men often shrink from in-depth discussion of such matters, when we may be the only parties left with any shred of moral authority to lead the charge.

So, we’re going to have that discussion, no matter how uncomfortable it might be. We’re going to discuss public choice and path dependencies. The ruinous War on Drugs and its unholy offspring, the carceral state, are also on the docket.  Institutional bias, uneven enforcement of laws that, by all right, shouldn’t even be laws…they’re on the table as well. The first step to solving a problem is admission that the problem exists, and we’re going to get to the root of it.  We’re going to analyze through the filters of economics, sociology, political science, history…because we must. To channel Acemoglu, history happens when critical junctures mate with institutional drift, giving birth to persistent paradigms.  We are, as the fires attest, at a critical juncture. To create new paradigms, we must facilitate changes within our institutions.

I will, of course, talk about other things. It is an honor for me to be here, and this isn’t the only issue that needs discussion. Nevertheless, this will be an ongoing conversation, and it is my hope that both author and readers benefit from it. The American apartheid system known as Jim Crow was relegated to the dustbins of history because men and women of good conscience did not bury their heads in the sand at a critical juncture in time, but the work is not yet done. It is up to us to find its completion, so that we can truly fulfill the obligations inherent in our credo “we hold these truths to be self-evident that all men are created equal.”

 

 


Tarnell Brown is an Atlanta based economist and public policy analyst.

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Transaction Costs are the Costs of Engaging in Economic Calculation

This year marks the 100th anniversary of the publication of Ludwig von Mises’s seminal article, “Economic Calculation in the Socialist Commonwealth,” which marked the first salvo in what later became the socialist calculation debate. Though the contributions of F.A. Hayek to that debate, and to economic science more broadly, have been well recognized, what is somewhat forgotten today is that the fundamental contributions of another economist were also born out of the socialist calculation debate. I am referring to none other than Ronald Coase.

 

As Coase outlines in his Nobel Prize Address, he had been a student of Arnold Plant in the Department of Commerce at the LSE, who introduced him to Adam Smith’s invisible hand, and the role that the price system plays in coordinating the allocation of resources to their most valued uses without central direction. The insights of Coase, like Mises, were both motivated from the attempt by the Bolsheviks to implement central planning in Soviet Russia. As Coase writes, “Lenin had said that the economic system in Russia would be run as one big factory. However, many economists in the West maintained that this was an impossibility,” a claim first put forth by Mises in his 1920 article. “And yet there were factories in the West, and some of them were extremely large. How did one reconcile the views expressed by economists on the role of the pricing system and the impossibility of successful central economic planning with the existence of management and of these apparently planned societies, firms, operating within our own economy?” The answer put forth to this puzzle was what Coase referred to as the “costs of using the price mechanism,” (Coase 1992, 715). This concept, which later came to be known as “transaction costs,” was first expounded in his seminal article, “The Nature of the Firm” (1937) and later developed in subsequent articles, “The Federal Communications Commission” (1959) and “The Problem of Social Cost” (1960). But, it is interesting to note that Coase also states that “a large part of what we think of as economic activity is designed to accomplish what high transaction costs would otherwise prevent or to reduce transaction costs so that individuals can freely negotiate and we can take advantage of that diffused knowledge of which Hayek has told us” (1992: 716).

My point here is not to trace the historical origins of the parallel insights drawn by Mises and Coase, or other economists working in the Austrian tradition and the transaction-cost tradition for that matter. Rather what I wish to suggest here is that what Coase (not just Hayek) had been stressing in his insights learned from the socialist calculation debate cannot be fully appreciated without placing his contributions in the context of what Mises had claimed regarding the problem of economic calculation. Reframed within this context, I would argue that the concept of transaction costs can also be understood as the costs of engaging in economic calculation. However controversial my claim may seem, this reframing of transaction costs as the costs of associated with economic calculation has a precedent that can be found not only in Coase, but also in more recent insights made by economists working in the Austrian tradition (see Baird 2000; Piano and Rouanet 2018).

How do transaction costs relate to the problem of economic calculation? According to Coase, the most “obvious” transaction cost is “that of discovering what the relevant prices are” (1937: 390). The costs of pricing a good (i.e. transaction costs) are based, fundamentally, on the costs of defining and enforcing property rights in order to create the institutional conditions necessary for establishing exchange ratios, hence prices, in the first place. This also entails not only cost of negotiation and drawing up contracts between trading partners, but also discovering who are the relevant traders partners are, as well as discovering what are the actual attributes, such as quality, of the good or service being exchanged.

Carl Dalhman (1979) argues that all such transaction costs can be subsumed under the umbrella of information costs, but the nature of such information is not one that can be obtained only through active search per se, as if all such information is already “out there” and therefore acontextual. Rather, the very nature of such information is not just tacit and dispersed (Hayek 1945), but contextual (see Boettke 1998). The discovery of relevant trading partners, the valuable attributes of a good being exchanged, and the price to which trading partners agree, emerges only within a context of exchangeable and enforceable private property rights. This last point is precisely the argument that Ludwig von Mises had meant in his claim that economic calculation under socialism is impossible! Outside the context of private property, subjectively held knowledge cannot be communicated as publicly held information without first establishing the terms of exchange in money prices to allocate resources to their most valued uses.

In his Presidential Address to the Society for the Development of Austrian Economics, published in The Review of Austrian Economics as “Alchian and Menger on Money,” Charles Baird (2000) best illustrates the point I’m making here. Carl Menger (1892) and Armen Alchian (1977) had made distinct, though complementary stories as to why money emerges spontaneously, namely to reduce transaction costs. Menger argued that money emerges to avoid the costs associated with the double coincidence of wants between exchange partners. On the other hand, Alchian emphasized that money emerges to reduce the costs of calculating and pricing the value of the various attributes of a good, such as in comparing the quality of different diamonds. Money prices reduce the costs of pricing the quality of diamonds, thereby providing information, discovered by middlemen, to non-specialists about what kind of diamond they are purchasing (i.e. higher quality or lower quality). As Baird writes, “Menger’s story is incomplete. But so, too, is Alchian’s. On the other hand, both stories are complete on their own terms. Clearly what is needed is someone to put these two stories together” (2000: 119). Thus, reframing transaction costs from an Austrian perspective, money, firms and other institutional arrangements emerge to reduce the costs associated with economic calculation.

In a lecture written to honor F.A. Hayek in 1979, later published posthumously in The Review of Austrian Economics, James Buchanan boldly declared the following: “The diverse approaches of the intersecting schools [of economics] must be the bases for conciliation, not conflict. We must marry the property-rights, law-and-economics, public-choice, Austrian subjectivist approaches” (Buchanan 2015: 260). The link that “marries” these distinct schools, including the Austrian School, is the notion of transaction costs. However, this underlying link cannot be understood without first reframing, I would argue, the concept of transaction costs as the costs of engaging in economic calculation. The “marriage” of these intersecting schools, as Buchanan and others have suggested, highlights distinct aspects of the economic forces at work in the market process, as well as the alternative institutional arrangements that emerge to reduce the cost of transacting and thereby exploit the gains from productive specialization and exchange.

 

 


Rosolino Candela is a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics, and Associate Director of Academic and Student Programs  at the Mercatus Center at George Mason University

 

 

References

Alchian, Armen A. 1977. “Why Money?” Journal of Money, Credit and Banking 9(1): 133–140.

 

Boettke, Peter J. 1998. “Economic Calculation: The Austrian Contribution to Political Economy.”  Advances in Austrian Economics 5: 131–158.

Buchanan, James M. 2015. “NOTES ON HAYEK–Miami, 15 February, 1979.” The Review of         Austrian Economics 28(3): 257–260.

Coase, Ronald H. 1937. “The Nature of the Firm.” Economica 4(16): 386–405.

Coase, Ronald H. 1959. “The Federal Communications Commission.” The Journal of Law & Economics 2: 1–40.

Coase, Ronald H. 1960. “The Problem of Social Cost.” The Journal of Law & Economics 3: 1–44

Dahlman, Carl J. 1979. “The Problem of Externality.” The Journal of Law & Economics 22(1): 141–162.

Hayek, F.A. 1945. “The Use of Knowledge in Society.”

Menger, Karl. 1892. “On the Origin of Money.” The Economic Journal 2(6): 239–255.

Mises, Ludwig von. [1920] 1975. “Economic Calculation in the Socialist Commonwealth.” In F.A.     Hayek  (Ed.), Collectivist Economic Planning (pp. 87–130). Clifton, NJ: August M. Kelley.

Piano, Ennio E., and Louis Rouanet. 2018. “Economic Calculation and the Organization of     Markets.” The Review of Austrian Economics, https://doi.org/10.1007/s11138-018-0425-4

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