On a Fallacy in the Coase Theorem and the Theorem of Transaction Costs Substitution

1 The Legendary Debate of the Century

First about dates. “The Problem of Social Cost” appeared in the 1960 issue of the Journal of Law and Economics, but that issue did not appear until the early summer of 1961. On the other hand, the Coase Theorem did not appear in that “social cost” paper—in my view, the so-called “Invariant Theorem” attributed to the 1960 “social cost” paper is not a theorem. Rather, the theorem was first enunciated in 1959, in a more beautiful paper by Coase on “The Federal Communications Commission.”^[4] In that 1959 piece there is one sentence that says: “The delineation of rights is an essential prelude to market transactions.” This statement is the Coase Theorem in its complete form.

The introduction of transaction costs in the following 1960 piece, though important, only supports the working of the theorem stated in 1959. However, as will be seen later in this paper, it is in the introduction of transaction costs that Coase committed a serious error.

There were considerable confusions on the exact issue which led to the legendary debate in Aaron Director’s home in the spring of 1960. What is known for certain is that when the FCC paper was submitted to Aaron Director at the University of Chicago, a galaxy of stars at Chicago opposed to a key point Coase made. Exactly what that point was, is a question some future historians of economic thought would want to know. Coase told me it had something to do with a parking lot. His strongest critic at that time, Reuben Kessel, also told me it was about a parking lot. Reuben passed away in 1975, and now I find two places in the FCC paper where the phrase “parking lot” is mentioned. I put both of them below for the readers to consider.

On page 14 of the FCC paper, Coase wrote:

If one person could use a piece of land for growing a crop,

and then another person could come along and build a house

on the land used for the crop, and then another could come

along, tear down the house, and use the space as a parking lot,

it would no doubt be accurate to describe the resulting situation

as chaos. But it would be wrong to blame this on private enterprise

and the competitive system. A private-enterprise system cannot

function properly unless property rights are created in resources,

and, when this is done, someone wishing to use a resource has to

pay the owner to obtain it. Chaos disappears; and so does the

government except that a legal system to define property rights

and to arbitrate disputes is, of course, necessary. But there is

certainly no need for the kind of regulation which we now find

in the American radio and television industry.

Then on page 25:

It is clear that, if signals are transmitted simultaneously on a given

frequency by several people, the signals would interfere with each

other and would make reception of the messages transmitted by

any one person difficult if not impossible. The use of a piece of

land simultaneously for growing wheat and as a parking lot would

produce similar results. As we have seen in an earlier section, the

way this situation is avoided is to create property rights (rights, that

is, to exclusive use) in land. The creation of similar rights in the use

of frequencies would enable the problem to be solved in the same

way in the radio industry.

We today would not see anything wrong with the arguments in the two paragraphs above, but in 1959 the understanding of the social cost issue was relatively weak even at Chicago: they were still on the level with Pigou.^[5] It was on the issue of the radio frequency interference and the parking lot interference that Aaron Director urged Coase, who was then at the University of Virginia, to come to Chicago to clarify his position. Coase responded that he would not give a lecture but would be glad to discuss the issue with a selected group of economists.

The discussion that turned out to be a heated debate is legendary, and no doubt will be recorded in the future history of economic thought. There now exist a number of different versions of that debate, including one of over 100 participants. My version must be accurate, because among the 10 participants I was acquainted with eight of them. The 10 participants were Martin Bailey, Milton Friedman, Arnold Harberger, Reuben Kessel, Gregg Lewis, John McGee, Lloyd Mints, George Stigler, Ronald Coase, and Aaron Director.

After dinner, in Aaron’s home, Ronald opened with the question: when a factory pollutes the residents nearby, should this factory be held liable for the damage? Or should the residents pay the factory owner to reduce the pollution? The proper answer, as we know it today, is that on efficiency grounds it does not matter, so long as the right to pollute or not to pollute is clearly delineated so that the market will work its magic.

McGee told me that during the debate Harberger was moving furniture around in Director’s house to form a fence to check the movements of the cattle, yet Al did not recall himself doing so. There were rumors that the Coase Theorem was first stated by Milton Friedman, who was present in that legendary debate, and not by Coase himself. Yet when I pressed Milton on that rumor, he denied the glory, saying it all belongs to Coase. Coase, however, told me that after more than 2 hours of debate, he was a bit doubtful of his own thinking, although he still believed he was right: it was the 30 minutes of Friedman summarizing the main points of his arguments in that evening, with such great clarity, that he knew he was home free. Stigler’s version supports Coase’s version. He told me that after more than 2 hours of debate the issue was undecided. Milton stood up and opened fire, and the bullets hit everybody except Coase. Harry Johnson, who was in London at that time, sent a cable to the Economics Department at Chicago the next day, saying that he heard an Englishman has discovered a new continent again. Reuben Kessel, who had been the strongest opponent to Coase’s argument, told me in 1972 that we would have to go all the way back to Adam Smith to find an economist of Coase’s level.

After this legendary debate and as the participants were leaving Director’s home, McGee recalled, they were mumbling to each other that they had just witnessed intellectual history. Aaron Director, who was editor of the Journal of Law and Economics at that time, told me two matters of interest. First, Coase told me he was rushing to submit the manuscript to Aaron because the deadline of submission was already passed, so he wrote and submitted the 1960 paper section by section. But Aaron told me he could not care less when would Coase complete that paper: his journal could wait for years if needed be. Second, knowing the Journal of Law and Economics paid authors at that time, I asked Aaron how much his journal paid Coase for that 1960 piece, he replied that the University of Chicago regulated the fees paid to authors by the page, otherwise he would give Coase all the money at his disposal. Knowing Aaron, my guess is that he would not mind closing his precious journal down after Coase’s 1960 paper.

I must take pride to add here that Aaron liked my works! In the spring of 1969 I presented my paper on the choice of contracts in Stigler’s workshop. A day later I alone was having lunch at the Quadrangle Club at Chicago, I saw Aaron walking slowly towards me. I politely stood up, and Aaron said, “The paper you presented yesterday is the best I have read in several years.” Then he turned and walked away. I was still standing, and tears came down from my eyes. And when after some 12 years of research I finally published “The Contractual Nature of the Firm”^[6] in 1983, Aaron had someone brought me a simple message: After Steve’s paper, the quarrel on what a firm is exists no more.

2 The Unfortunate Neglect of Frank Knight

It is unfortunate that in Coase’s 1959 paper on the FCC and his 1960 paper on social cost, no reference is made on a magnificent 1924 paper, entitled “Some Fallacis in the Interpretation of Social Cost,” written by Frank Knight.^[7] Knight made exactly the same point in 1924 as Coase did in 1959 and 1960. Coase went to the University of Chicago in 1931, from London on a travelling scholarship, and audited Knight’s lectures. He must be familiar with Knight’s classic work.

Knight’s 1924 paper rebuts Pigou’s work on social cost.^[8] He took issue on Pigou’s famous example of two roads. Two roads, both going from Town A to Town B, one road is narrow but well-paved, and the other is broad but poorly surfaced. Pigou argued that the congestion of cars will occur on the good road, with the drivers slowing each other down, hence a social cost problem exists, and this problem could be resolved if a tax is imposed on the use of the good road, while those using the broad but poor road, though with more cars but still with no congestion, are not harmed. Hence a tax imposed by the government for the use of the good road will reduce the divergence between private and social costs.

The following comment by Knight on this two-road example is profoundly brilliant, which in my view is a Coase Theorem of the 1924 version.

Knight wrote:

Professor Pigou’s logic in regard to the roads is, as logic,

quite unexceptionable. Its weakness is one frequently

met with in economic theorizing, namely that the

assumptions diverge in essential respects from the facts

of real economic situations. The most essential feature of

competitive conditions is reversed, the feature, namely, of

the private ownership of the factors practically significant

for production. If the roads are assumed to be subject to

private appropriation and exploitation, precisely the ideal

situation which would be established by the imaginary tax

will be brought about through the operation of ordinary

economic motives.

Yes, this is the 1924 version of the Coase Theorem, 36 years before what was enunciated by R.H. Coase.

To my knowledge, Pigou never replied to Knight’s challenge, except his famous two-road example was deleted in the later edition of The Economics of Welfare.

It is important--very important-- to note that by “assumptions” Frank Knight meant the constraints assumed! And this is the spotlight guiding literally all my own research. I was delighted that in an earlier write-up of Frank Knight in Wikipedia, my name was one among five economists influenced by Knight, but then was disappointed that in a later version on Knight, the names were changed.

I wish to note that in December 1968, in Bob Mundell’s lavish cocktail party, I had the honor of meeting Knight and told him in person how much I adored him and learned from his 1924 paper. He looked at me for a long moment, and said, “That was a long time ago!”

3 Ocean Fishery and the Dissipation of Rent

Another unfortunate omission of Knight’s pathbreaking work of 1924 is found in yet another important paper, the one on ocean fishery as a common property resource. This beautiful piece, written by H. Scott Gordon in 1954, made no reference to Knight, but the geometric diagrams Gordon used were essentially Knight’s diagrams, as tilted mirror images and relabeling the axes.^[9] What Knight drew to describe Pigou’s two roads now becomes two fishing grounds in Gordon’s paper.

The important--very important--conclusions in Gordon’s insightful work is that the ocean rent that may be captured in fishing is absorbed into the cost of fishing labor and therefore is dissipated under competition, because the ocean fishing ground is not privately owned. To my knowledge, the term “dissipation of rent,” which I use often, was first coined by Gordon. In my view, the frequent use of this concept of rent dissipation is one distinguishing feature of what later became known as the Washington School of Economics.^[10]

However, Gordon’s analysis of the dissipation of rent in ocean fishery is flawed. As I pointed out in my 1970 paper on the structure of a contract, the complete dissipation of rent in ocean fishery requires the number of competing fishing boats be approaching infinity.^[11] I reached this interesting result by extending Cournot’s duopoly analysis while allowing free entry with homogeneous fishing inputs. That is, even if the ocean is under common ownership so that no competing fishing boat has the right to exclude other entrants, some ocean rent will be captured by each fishing-boat owner so long as the number of fishing boats is in some way restrained. This is my explanation why unions of various types are so commonly observed in ocean fishery! In fact, my analysis says that the more restrictive it is on the number of fishing boats, the more the ocean rent will be captured by each of the boat owners.

4 A Key Error in the Coase Theorem

Let me now turn to what in my view is a serious error in the Coase Theorem. I take issue with a key statement he made at the beginning of Section 4 of his 1960 paper, when he stated his analysis is based on “the pricing system is assumed to work smoothly (that is, costlessly).” This is the noted assumption of zero transaction cost and the functioning of the market. However, as pointed out in my work Will China Go Capitalist?, published in 1982,^[12] I wrote that if transaction costs were truly zero there would be no market:

If all transaction costs, broadly defined, were truly zero,

it would have to be accepted that consumer preferences

would be revealed without cost. Auctioneers and monitors

would provide free all the services of gathering and collating

information; workers and other factors of production would

be directed freely to produce in perfect accord with

consumer preferences; and each consumer would receive

goods and services in conformity with his preferences. The

total income received by each worker (consumer), as

determined costlessly by an arbitrator, would equal his

marginal productivity plus a share of the rents of all resources

according to any of a number of criteria costlessly agreed upon.

In other words, production and consumption activities can in

principle be carried out without a market, to produce the same

result as though costless markets were in operation.

This view is important, and Kenneth Arrow immediately agreed with me when he read it. Coase also agreed with me a little later. However, the full implications of this view took me nearly 25 years to obtain.

5 The Theorem of Transaction Costs Substitution

The great puzzle is that there are in fact markets in the real world, and by our daily observations there are numerous types of transaction costs associated with these markets. If all transaction costs were truly zero there would be no market, then it makes no sense to say that markets exist because of the presence of transaction costs. Why do markets exist after all?

My journey to solve this major puzzle involved several steps. First, different types of transaction costs often cannot be logically separated, as a toll collector at the entrance of a highway performs both the functions of collecting tolls and policing against intruders. Second, under this inseparable rule and pushing this rule to the limit, transaction costs must include all those costs that cannot be conceived to exist in a one-person or Robinson Crusoe economy. On this point George Stigler agreed, and it was later elaborated in my paper entitled “The Transaction Costs Paradigm”.^[13]

Third, the dissipation of rent is a cost, and because this dissipation can only be the result of competition, it cannot be conceived to exist in a one-man economy. Therefore, rent dissipation is transaction cost. For example, if the price of a product is restricted by control to below the market price, customers would have to stand in line for, say, half an hour for a purchase, the value of standing time must be added to the price of the product to the buyer to obtain its true value. Hence the value of the product reduced is a dissipation of rent.

Fourth—and this the key--of the numerous criteria that may be used to determine winners or losers under competition in society, only the market price entails no dissipation of rent. This is because in a free market one has to produce something before he can offer to exchange for something else. The ratio of that exchange is the market price, and because one has to produce something to participate in this competition game, there is no dissipation of rent.

Hence comes a beautiful “Theorem of Transaction Costs Substitution”: In order to reduce rent dissipation under competition in a society, all the transaction costs incurred in the market—lawyers, bankers, policemen, middlemen, etc.— are meant to support the use of the one single criterion of determining winners which entails no rent dissipation, namely, the market price! In other words, the transaction costs incurred in the market are meant to substitute or reduce the dissipation of rent—another type of transaction costs—which must arise when the market price is not used.

The idea that the market price is the only criterion of determining winners and losers that entails no dissipation of rent was known to me when I was a graduate student, and an elaborate theoretic treatment of the subject is seen in my piece on price control, published in 1974.^[14] However, putting other elements together to obtain the above Theorem of Transaction Costs Substitution took a long time. There are numerous other important implications associated with this theorem, because the choice among different contracts necessarily entails transaction costs substitution.^[15] However, if confined to the substitution between the costs of using the market price and the dissipation of rent, the theorem is relatively simple and straight forward. In my view, this latter substitution is at the core of the theorem of transaction costs substitution which I propound here.

In 1979, when China was just talking about opening up, I published an article in the Chinese language, bearing the title “One Thousand Rules, Ten Thousand Rules, in Economics There is Only One Rule.”^[16] This piece forcefully argues that of the numerous rules that may be used to allocate resources under competition, nearly all entail rent dissipation. All except one—the market price—which entails no rent dissipation. Some friends told me that that article was widely circulated in Beijing, leading to complaints that the government turned to charge prices for everything.

It was not easy for me to convince my Beijing friends, however, that private property rights are essential for the emergence of markets and the use of market prices. It is at this critical point that Coase’s idea of clear delineation of rights works magic. The Chinese culture is allergic to the word “private”, but clear delineation of rights they were eager to accept. This is the central contribution of Coase’s works on the economic transformation of China.

It is interesting to note here that in my 1981 pamphlet bearing the title Will China Go Capitalist?, which correctly predicted that China will reform to become a market economy, the underlying elements of an implicit theoretic structure is essentially the same as the Theorem of Transaction Costs Substitution which I discuss here. It took more than 30 years to put the elements together to form an integrated theorem.

6 Episodes to Remember

In closing, I would like to recall a fond memory in my last meeting with Coase.

It was in December, 1990 when Ronald was awarded the Nobel Prize. Because that was the 90th anniversary of that prize, all the living Nobel laureates were invited to Stockholm for a massive gathering. My wife and I were also invited to attend this gathering. The reason is that in the evening before the Prize was awarded, there was a dinner party for all Nobel laureates in economics, and I as the only non-winner was asked to give a talk at that dinner, on behalf of Coase, because Ronald had to rest to prepare for the excitement coming the next day. Two economists gave talks during that dinner party, Kenneth Arrow and I myself.

Ronald, Marian, Milton, Rose, my wife and myself were together for several days. Two days before the award ceremony, Ronald delivered his Nobel Lecture. During that lecture, my wife and I were arranged to sit next to Rose and Milton. It was a huge hall, filled with people, and a thunderous standing applause sounded when Ronald was slowly walking down the aisle towards the podium. We all stood up, and Milton was standing next to me. I whispered to Milton: “Do you think this guy deserves this prize?” He replied: “You mean Ronald? He should have won it a long time ago!”

Ronald had a deep feeling for China ever since he was a boy, but had never visited China. In 2013, a few months before Ronald passed away, he was to travel to China to see me. Everything was arranged. His expired passport was renewed, and my wife reserved a hotel suite with a nice view for him and his helper. He was to join us in Shanghai on October 1, the beginning of a ten-day holiday. I had arranged a team of doctors to stand by just in case medical assistance was needed. I had also alerted several universities in that region for Ronald to visit. I wanted Ronald to know how unique a hero he was in the eyes of millions of Chinese youths. China owed this man for his ideas, and I wanted Ronald to see the gratitude with his own eyes.

But It was not to be. Ronald passed away on September 2, 2013, at the age of 102.