Insanity From Cato

Supply-side is an instance of the often encountered problem of economists going with what should be true given a model and what actually is true.

It brings to mind another case of conservative economic theory that was popular in the 80's and the early-mid 90's: The "Coase Theorem". Essentially it was an argument which posited that bargaining could lead to efficient economic outcomes where externalities are present if there are no transaction costs. It was often used to argue that, for instance, environmental regulation was unnecessary because environmental problems could be managed through private contract. All we needed was more secure property rights.

Many pointed out the flaws in the theorem. It only works given the assumption of a two-actor game. If you have a single large company polluting the residents of an entire neighborhood of (less powerful) actors, then prisoner's dilemma effects virtually eliminate the prospect of bargaining and thus lead to inefficient outcomes. There were also the typical problems associated with Chicagoan analysis, e.g., "rational expectations".

Supply side is similar, if you know what to assume and what to omit, then any economic model looks good on paper. It's had its reputation as "the dismal science" for a long time for a reason.

"Supply-side is an instance of the often encountered problem of economists going with what should be true given a model [in lieu of] what actually is true."

Fixed.

Insanity from Cato...
Dog bites man...

Nice job.

When Molly Ivins was alive the Chicago Tribune and our home town paper both ran letters comparing her to Ann Coulter from people who seemed unable to tell the difference. Heck, a diamond and a lump of coal are both made of carbon.

Isn't it funny, though, that Ann Coulter has become such a widely recognized symbol for Pure Evil?

We've recently identified the male of the Coulter species (Beenadick Steinicus) so it's not surprising that people are going to try and balance this by claiming detection of other hitherto unknown species of Coulter!

I think I can point to an obvious area of disanalogy between Chait and Coulter. Chait uses harsh language, but then provides arguments and data to back it up. Coulter, by contrast, fills her books with a mix of outright lies and misleading propaganda.

I haven't read the book, but would I be right in guessing that Chait further differs from Coulter by not implying that violence is an appropriate response?

And that lying is okay if you do it for Jesus?

Great post Jason, but I disagree with the first commenter. The Coase theorem is widely recognized to be a deep economic and political insight. It is often used in policy arguments precisely because we want to try and use law to create equal bargaining power. Then, a la Coase, rational settlement can operate.

The commenter was wrong to imply that because Coase's assumptions never work out the theory is bunk. The fact that the assumptions are unsatisfied often shows that we need law to intervene to reach the best outcome, and it suggests how law should intervene. Coase's paper describing his theory is one of the most-cited legal papers of all time. (Not bad for someone who never went to law school!)

Coase won the 1991 Nobel prize in economics for his work.

Coase won the 1991 FAKE Nobel prize in economics. It's real name is

'The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel'

It was created in 1968 by the swedish national bank and was not in Nobel's original will.
In fact Peter Nobel, Afred's grandnephew (Alfred never married), has called for it to be abolished.

Chris,

My name is attached to the post above, so I don't see what the difficulty was with addressing me directly.

As for your comments, the Coase theorem is far more contentious a subject than you let on. It has a higher academic status than Supply-Side nonsense, but it's hardly universally accepted. The theorem itself, with its assumptions intact, is actually relatively trivial. To wit:

"Given well-defined property rights, low bargaining costs, perfect competition, perfect information and the absence of wealth and income effects, resources will be used efficiently and identically regardless of who owns them."

The problem is with applications of the theorem. Conservatives emphasize the first part of the above to the exclusion of all other aspects. Specifically, they ignore the fact that in most real world scenarios, internalizing externalities in market exchange presents transaction costs that are prohibitively high in the first place.

As for bringing the law in, that's also trivial. We have long understood that bringing the law into play can resolve power asymmetries and even out bargaining scenarios. Labor union protection is implicitly based on that very idea. The problem with conservative interpretations is they ignore these because, well, they don't fit in with their preconceived "market can do all" notions.

Tyler, I still disagree.

There's a lot of tension between your assertions that the Coase theorem is "trivial" and "hardly universally accepted". Which is it? Is it so basic that it is useless (as you seem to argue) or is it false?

If everything Coase teaches is "trivial" why is his work so widely cited and used? And why was he awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel?

If people misuse the theory for their own reasons, please criticize that - not the theory.

Example of the Usefulness of the Theory:
In law, a debate raged for years over whether "strict liability" or "negligence" was better. In strict liability, the actor who causes harm is automatically liable. In negligence, the actor who causes harm is liable only if he acted without sufficient concern for others. (In other words, honest mistakes are not punished.) Scholars argued for years over when we should use negligence and when we should use strict liability.

Coase effectively ended the debate by mathematically proving that the economic social outcomes are the same in both cases. This surprising result directly follows from the Coase theorem. Once the economic considerations are removed, the debate simplifies and the question is easily answered.

Chris,

"There's a lot of tension between your assertions that the Coase theorem is "trivial" and "hardly universally accepted". Which is it? Is it so basic that it is useless (as you seem to argue) or is it false?"

I should be more clear. What I was addressing was the policy recommendation aspects of it. As a case of analytical reasoning, it's relatively trivial: no transaction costs means efficient outcomes. As a policy recommendation, it rarely works in the real world. In markets involving externalities, the Coase theorem only works if you omit holdout problems, information asymmetries, relative bargaining power, freeloader problems and all other difficulties associated with public goods.

Since you are apparently coming at it from a legal standpoint, the analytical reasoning aspect of it may not be so trivial in your case. For actual economic systems analysis it is trivial, however. As a policy proposal for managing externalities it is dead in the water.

Press Release - 15 October 1991

The Royal Swedish Academy of Sciences has decided to award the Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel, 1991, to Professor Ronald Coase, University of Chicago, USA, for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.

Breakthrough in Understanding the Institutional Structure of the Economy
Until recently, basic economic analysis concentrated on studying the functioning of the economy in the framework of an institutional structure which was taken as given. Efforts to explain the institutional structure were usually considered unnecessary or futile. For instance, the existence of organizations of the type we call firms seemed almost self-evident. Observed variations in contract forms in the economic sphere were also regarded as a given fact, and the laws and rules of the legal system were perceived as an externally imposed setting for economic activity.

By means of a radical extension of economic micro theory, Ronald Coase succeeded in specifying principles for explaining the institutional structure of the economy, thereby also making new contributions to our understanding of the way the economy functions. His achievements have provided legal science, economic history and organization theory with powerful impulses and are therefore also highly significant in an interdisciplinary context. Coase's contributions are the result of methodical research work, where each segment was gradually added to the next over a period of many years. It took a long time for his approach to gain a foothold. When the breakthrough finally occurred during the 1970s and 1980s, it was all the more emphatic. Today Coase's theories are among the most dynamic forces behind research in economic science and jurisprudence.

Coase showed that traditional basic microeconomic theory was incomplete because it only included production and transport costs, whereas it neglected the costs of entering into and executing contracts and managing organizations. Such costs are commonly known as transaction costs and they account for a considerable share of the total use of resources in the economy. Thus, traditional theory had not embodied all of the restrictions which bind the allocations of economic agents. When transaction costs are taken into account, it turns out that the existence of firms, different corporate forms, variations in contract arrangements, the structure of the financial system and even fundamental features of the legal system can be given relatively simple explanations. By incorporating different types of transaction costs, Coase paved the way for a systematic analysis of institutions in the economic system and their significance.

Coase also demonstrated that the power and precision of analysis may be enhanced if it is carried out in terms of rights to use goods and factors of production instead of the goods and factors themselves. These rights, which came to be called "property rights" in economic analysis, may be comprised of full ownership, different kinds of usership rights or specific and limited decision and disposal rights, defined by clauses in contracts or by internal rules in organizations. The definition of property rights and their distribution among individuals by law, contract clauses and other rules determine economic decisions and their outcome. Coase showed that every given distribution of property rights among individuals tends to be reallocated through contracts if it is to the mutual advantage of the parties and not prevented by transaction costs, and that institutional arrangements other than contracts emerge if they imply lower transaction costs. Modifications of legal rules by courts and legislators are also encompassed by these arrangements. Property rights thus constitute a basic component in analyses of the institutional structure of the economy. In perhaps somewhat pretentious terminology, Coase may be said to have identified a new set of "elementary particles" in the economic system. Other researchers, to some extent under the influence of Coase, have also made pioneering contributions to the study of property rights.

Coase's Contributions: First Stage
In his first major study entitled, The Nature of the Firm, Coase posed two questions which had seldom been the objects of strict economic analysis and, prior to Coase, lacked robust and valid solutions, i.e. , why are there organizations of the type represented by firms and why is each firm of a certain size? A key result in traditional theory was to show the ability of the price system (or the market mechanism) to coordinate the use of resources. The applicability of this theory was diminished by the fact that a large proportion of total use of resources was deliberately withheld from the price mechanism in order to be coordinated administratively within firms.

This is the point at which Coase introduced transaction costs and illustrated their crucial importance. Alongside production costs, there are costs for preparing, entering into and monitoring the execution of all kinds of contracts, as well as costs for implementing allocative measures within firms in a corresponding way. If these circumstances are taken into account, it may be concluded that a firm originates when allocative measures are carried out at lower total production, contract and administrative costs within the firm than by means of purchases and sales on the market. Similarly, a firm expands to the point where an additional allocative measure costs more internally than it would through a contract on markets. If transaction costs were zero, no firms would arise. All allocation would take place through simple contracts between individuals.

An important element in the model is that there are two types of contracts: those which stipulate the parties' total obligations (or, the reverse, rights) and those which are deliberately made incomplete by not specifying all obligations, but intentionally allow a free margin for unilateral decisions by one of the parties. Such "open" agreements may be exemplified by employment contracts, which usually leave room for direction and giving orders. According to Coase's theory, the firm is characterized by the latitude for decision created by a particular cluster of such open contracts. The firm in fact consists of this array of contracts and is related to the rest of the world by other fully specified contracts regarding purchases of inputs, sales of products, and loans under prescribed terms.

Coase's formulation has proved to be exceedingly practicable and has given rise to intensive examination of the contract relations which characterize firms. It is now clear that every type of firm is comprised of a distinctive contract structure and thereby a specific distribution of rights and obligations (property rights). Coase's work on the firm has become the basis for rapidly expanding research on principal-agent relations. It has also influenced vital aspects of financial economics, such as the lively research devoted to explaining the pattern of financial intermediaries.

Coase's Contributions: Second Stage
In retrospect, it is easy to realize that these examinations of firms' basic characteristics would provide a basis for more general conclusions regarding the institutional structure of the economic system. Coase himself laid the groundwork in a subsequent stage.

In another major study entitled The Problem of Social Cost, Coase introduced the set-up in terms of rights or property rights. He postulated that if a property right is well defined, if it can be transferred, and if the transaction costs in an agreement which transfers the right from one holder to another are zero, then the use of resources does not depend on whether the right was initially allotted to one party or the other (except for the difference which can arise if the distribution of wealth between the two parties is affected). If the initial holding entailed an unfavorable total result, the better result would be brought about spontaneously through a voluntary contract, as it can be executed at no cost and both parties gain from it. In other words, all legislation which deals with granting rights to individuals would be meaningless in terms of the use of resources; parties would "agree themselves around" every given distribution of rights if it is to their mutual advantage. Thus, a large amount of legislation would serve no material purpose if transaction costs are zero. This thesis is a direct parallel to the conclusion in The Nature of the Firm that firms under the same conditions are superfluous. All allocations could be effectuated through simple, uncomplicated agreements without administrative features, i.e. , through frictionless markets.

This led Coase to conclude that it is the fact that transaction costs are never zero which indeed explains the institutional structure of the economy, including variations in contract forms and many kinds of legislation. Or, more exactly, the institutional structure of the economy may be explained by the relative costs of different institutional arrangements, combined with parties' efforts to keep total costs at a minimum. Alongside price formation, the formation of the institutional structure is regarded as an integral step in the process of resource distribution. Hence, economic institutions do not require a "separate" theory. It is sufficient to render existing theory complete and formulate it in terms of the primary components, i.e., property rights.

These conclusions concerning the radical effects of ever prevalent transaction costs are thus the main result of Coase's analysis. Somewhat paradoxically, circumstances have ordained that it is the preceding conclusion about the consequences of overlooking transaction costs which has come to be called the "Coase Theorem". Of course, the situation without transaction costs is only a hypothetical norm of comparison. However, it can facilitate the analysis of real-world conditions. It may also inspire studies of contracting which can actually be observed, in areas where earlier theory prematurely took it for granted that transaction costs are so high that contracts are inconceivable. Further examinations by Coase himself or students and others inspired by him have shown that in some such cases, transaction costs are not so high as to preclude a contract. Such contracts are found to have strong peculiarities, created by the parties in order to alleviate the drawbacks of high transaction costs. These observations are wholly in line with Coase's main conclusion. In cases where transaction costs absolutely prevent a contract, there is - as inferred by the theorem - a tendency for other institutional arrangements to arise, for example a firm or amended legislation. The circle is closed; this is exactly the message conveyed by The Nature of the Firm.

As regards legislation, in The Problem of Social Cost , Coase developed a hypothesis concerning the behavior of courts in rather frequent cases where two (or more) parties dispute rights and where agreements are impossible or extremely difficult because of high transaction costs. Coase found that courts probably try to distribute the rights among the parties so as to realize the solution which would have been the outcome of an agreement, if such an agreement had been possible. The underlying idea is that this is a natural and rational way for a court to reason if it is more intent on setting a precedent to generate expedient incentives for the future than solving a particular dispute. This means that common pleas courts serve as an extension of the market mechanism to areas where it cannot function due to transaction costs. This hypothesis has become immensely important because, along with the general formulation in terms of rights or property rights, it has become the impetus for developing the new discipline of "law and economics" and, in prolongation, for renewal of many aspects of legal science.

Links are an amazing Chris, and save a lot of space and energy. You could provide them next time you need to reference a press release. And no, I'm not going to waste my time going through it and checking it piece by piece. If you think there is something particularly important or relevant above, quote it.

Yes, Coase won an award from the Bank of Sweden (it's not an official Nobel) for his ideas. Robert Lucas and James Buchanan also won the award for ideas that are still largely fringe in the academic economic world. I don't know why you are so stuck on this particlar point. The "Nobel" in economics is not a sticker of approval, otherwise Hayek would be considered in higher esteem than Keynes.

If you actually want to address my arguments about the Coase theorem's relevance, go ahead. If you just want to rehash press releases, I'll leave Jason to handle that.

"If you actually want to address my arguments about the Coase theorem's relevance, go ahead." The press release is a nice summary of Coase's relevance, all in one piece.

Here's a question. Imagine that one University forms a contract with the Kinkos. Kinkos will provide a branch near campus and give students and faculty discount rates. A university across town, facing the same problem, decides to buy the town's family-run copy shop and make it the official University copy shop.

Why did the two Universities act differently? (And the answer clearly has important implications for the mergers and separations of companies.)

Although the final answer, of course, is that "it was cheaper" - all economists that tried to actually do the math never got it right. They were missing important terms. You cannot solve this problem without Coase's insight.

So anytime you see two companies merge (like Cingular and AT&T) remember that the companies considered Coase before they made their decision, even if you consider him irrelevant.

That's a pretty weak result you're using their Chris. You're essentially arguing that firms act to minimize transaction costs. Conceded, I guess. If you're point is only that Coase managed to bring more attention to transaction costs in the economy, I'll accept that up to a point.

It's his broader theorem that is problematic: "In a market with externalities and no transaction costs, resources will be allocated efficiently regardless of initial arrangements." He proved it true within an axiomatic framework, which may be interesting and "deep" in its own right. However, the almost uniform presence or high transaction costs and the hoary nature of proprietary arrangments in such markets render its empirical predictive value severely limited. Policy recommendations from it are thus problematic.

I remember listening to a speech by Coase, sorry that I don't have the transcript, where he addressed this point. He said that people misunderstood his theory. He knew that his axioms would never be satisfied, and we should design economic systems accordingly. He explicitly said that 'those trying to use my theory to reduce transaction costs and then argue that the market will settle things' have failed to understand it.

Before reading down, ask yourself this question. One state requires that couples jump through hoops before they can have a divorce. (Perhaps by requiring a finding of fault.) State #2 provides "divorce-on-demand". Based only on this information, which state probably has the lower divorce rate?

----

This from a biography of Coase:

So why were economists so excited by the Coase Theorem? The reason is that it made them look differently at many issues. Take divorce. University of Colorado economist H. Elizabeth Peters showed empirically that whether a state has traditional barriers to divorce or divorce on demand has no effect on the divorce rate. This is contrary to conventional wisdom but consistent with the Coase Theorem. If the sum of a couple's net gains from marriage, as seen by the couple, is negative, then no agreement on distributing the gains from the marriage can keep them together. All the traditional divorce law did was enhance the bargaining position of women. A husband who wanted out much more than his wife wanted him in could compensate his wife to let him out. Not surprisingly, divorce-on-demand laws have made women who get divorces financially worse off . . .

Tyler, in short, you compared Coase's theory to supply-side economics in your initial post and I disagreed. You compared a far-right theory that is not supported to a mainstream theory that is well supported, just because both are sometimes used by the right to argue for policy outcomes they prefer.

I have explained why Coase won the semi-Nobel prize and I've given several examples of problems that cannot be solved without Coase's insight. You can dismiss these as "trivial" if you want - I can't make you think that something is important - but I think you sound ignorant when you say that the father of the field of Law & Economics had nothing worth saying.

You write that "the right-wing response to Clinton's first budget . . .was unanimous and unambiguous: Raising taxes on the rich will curtail economic growth and cause a recession. . . . (Yet) The economy boomed like never before in the nineties. So the supply-siders scrambled for explanations."

I don't recall any economist, supply-side (micro) or Keynesian (macro), who predicted the Clinton tax hikes would cause a recession. Politicians and pundits maybe, but not economists.

Economic growth from 1993 to 1995 ususually weak for the early years of an economic expansion -- below 3.1%, compared with 4.3% from 1983 to 1989.

From 1993 to 1996, annual growth of real compensation per hour was essentially zero -- one tenth of one percent. You want to talk wage stagnation? Look at Clinton's first term.

The Internet sprang up in 1996, and with it the tech and telecom boom (which was not merely financial). That is called a "productivity shock."

The top tax on capital gains was cut from 28% to 20% in 1997. That is called "supply-side economics."

I'd be delighted to debate Mr. Chait or anyone else on the historical facts or academic literature regarding the economics impact of taxation, in print or in person.

Chris Edwards is not the only one to notice that Mr.Chait is ridiculously shrill and loves to call people names. This may be enjoyable to read, but it makes him look childish and weak.

"Economic growth from 1993 to 1995 ususually weak for the early years of an economic expansion -- below 3.1%, compared with 4.3% from 1983 to 1989."

This seems a bit disingenous. You're comparing a two year window of Clinton's term to the entire growth period of Reagan's term. So far as I know, the expansion didn't begin until 1983, two years after Reagan's tax-cuts were in effect. 1982 featured an unusually severe recession. It seems as though it would be difficult to find a correlation.

As far as wage-stagnation goes, as far as I know that has pretty much been the norm since the late 1960's, hardly unique to Clinton. No progressive or liberal I know of is perfectly happy with Clinton's economic policies.

I also notice that you don't deal with the "tax cuts increase revenue" claims, which are the centerpiece of supply side crackpottery.

This, from a law professor's blog:

What is the most cited law journal article of all time? "The Problem of Social Cost" by Ronald Coase.