A commenter at EconLog pointed me to a video of Harold Demsetz criticizing Ronald Coase‘s paper on externalities and transaction costs. There is an appropriate nod to Frank Knight’s argument against Pigou, but the new critique of Coase is completely unconvincing. At the end he acknowledges the existence of “free rider problems” on the commons, but doesn’t explain how that’s different from Coase’s externality problem. He claims that courts introduce the inefficiency by ruling badly, but that strikes me as completely wrong. A world without courts would have the same problem. To take his soot-emitting factory example, what if there were many people doing laundry whose clothes became sooty, and they were unable to organize effectively to strike a bargain with the factory-owner? He mentioned global warming from carbon-emissions, which is a sort of extreme example of having too many parties to effectively make transactions. Even approaching his centennial, Coase should have no problem picking this argument apart.
February 18, 2011
Entitled to an Opinion 
February 20, 2011 at 7:21 am
I didn’t hear Demsetz postulating a market without courts. If he’s done that he’s even goofier than Coase, but that’s not what I heard in this video. What I hear him stressing is the importance of property rights, which generally require courts and executive entities to enforce them.
Demsetz correctly observes that where property rights cannot be properly defined, or for political reasons are not properly defined, the problem lies outside the ambit of neoclassical economics. It’s not a failure of a market, it’s a failure to establish a market, due to a failure to establish workable property rights. Thus, the proper, Knightian, response to the inefficiencies Pigou complained about is not to criticize the market but to establish one, by defining a regime of property rights that will lead to an efficient market in the problem area, which definition and initial allocation requires far more than an arbitrary court decision as Coase would have it. We should stop taking property rights for granted because property, and not contracts, lie at the core of our market economy.
What Demsetz stresses is that in Coase’s model the court makes an arbitrary, and therefore usually inefficient, allocation of initial property rights. I’d add that Coase’s account is very different than the way common law courts actually work, which is by following a highly evolved, very non-arbitary way of resolving these torts (hardly ever by creating new kinds of property rights since those are already highly evolved). So the problem, and here I disagree with Demsetz and think “externality” is a good name for it, this externality that the high-transaction-cost world fails to fix (and as I’ve explained a zero-transaction-cost world also actually fails to fix) is a problem with the law, not a problem with the market.
Demsetz in other words is basically complaining, correctly, that Pigou and Coase are blaming the market when they should be blaming the law for not establishing the non-arbitrary rules of property (and I’d add tort etc.) that the market needs to work.
February 21, 2011 at 8:51 am
The failure of a market to exist (as is supposed to be the case with asymmetric information) is a market failure. A world without market failure is supposed to be Pareto optimal. If neoclassical economics fails to take into account ways in which real-world markets fail to cover certain areas, that’s a shortcoming of neoclassical economics. And I believe one of the points made in the transaction cost literature is that it may be impractical for government to even establish a market for some things.
The point that an arbitrary court decision can be inefficient was made by Coase himself in his original paper, which is where transaction costs come in. It sounds like you’re claiming that in the absence of transaction costs decisions still can’t be arbitrary, can you elaborate on that?
Maybe there’s not some limited amount of blame to go around. We can blame police for not catching criminals, and blame criminals for committing crimes.
February 21, 2011 at 4:39 pm
The point that an arbitrary court decision can be inefficient was made by Coase himself in his original paper, which is where transaction costs come in.
But transaction costs are not the only nor even the most important reason the court decision is inefficient. There is no utopia of market perfection that we can achieve merely by lowering transaction costs.
We can blame police for not catching criminals
Or we can postulate, like some neo-neoclassical economists do about the market, that the police should be able to solve every problem, so that the failure of the police to cure my beloved of cancer is a “police failure.” And the only thing standing in the way of the police being able to do this is “transaction costs” or some similarly vague generality.
February 21, 2011 at 4:32 pm
The failure of a market to exist (as is supposed to be the case with asymmetric information) is a market failure.
No. That claim assumes that (1) neoclassical economists argued that markets can solve every problem, which is an insane utopian position, obviously violated by for example families, voluntary non-profit activities, vertical integration, etc., and never held by any of the original classical or neoclassical economists, and (2) that the institutional and especially the legal conditions for the existence of the market (secure property rights and other laws of the appropriate kind) are in place, which as Knight et. al. demonstrated they often are not.
If neoclassical economics fails to take into account ways in which real-world markets fail to cover certain areas, that’s a shortcoming of neoclassical economics.
No, it just means that the assumptions that the original neoclassical economists made, and admitted to making, before the field was taken over by cargo cult scientists who think they are studying simple physical laws rather than institutions, often are not satisfied.
So we do have here a failure of neo-neoclassical economics, a cargo cult science that thinks it is studying natural laws rather than the interactions of people in an environment full of non-market institutions, and so forgets about the assumptions that the neoclassical economists were making. It’s not a failure of the original neoclassical economists (Marshall, Jevons, et. al.) nor of at least some Austrians like Hayek who stressed the crucial role of legal institutions as a prerequisite for working markets. It’s a failure of the cargo cultists who like Marx pretend that they are studying the forces of nature: the post-Knight Chicago School, Keynesianism, and of course the many varieties of neo-Marxism.
February 21, 2011 at 8:32 pm
I think your example of police and cancer is quite poor. Not knowing how to cure cancer is not a market failure. It is still pareto optimal with cancer uncured. There is always a production possibilities frontier, and it is not a market failure that we have not crossed it.
Making assumptions that are wrong is often considered a failure, though like Friedman I don’t think that is necessarily the case.
For some reason I always thought Marx was relatively close to the old American Insitutionalists and as much a political scientist as an economist. Karl Polanyi is one of the most well known critics of modern economics for ignoring how markets are embedded in non-market institutions, and he’s fairly popular with modern Marxists.
February 21, 2011 at 10:21 pm
I didn’t say my beloved’s (thankfully hypothetical) cancer is uncurable, or cannot yet be cured by somebody. The hypothetical is just that it can’t be cured by police forces.
May 11, 2011 at 8:30 am
I think you misunderstood his argument, although I am relying on an article, not the talk. In his recent article he distinguishes two cases:
1. Where the legal system assigns property rights in the wrong place, and negotiation to fix that problem is costly.
2. Public goods where there is a free rider problem, and even costless negotiation would not solve the problem (as people would lie about their preferences.)
He correctly points out that case 1 is not a market failure (it’s government failure), and case 2 is a market failure. Then he argues that case 2 is not best viewed as a transactions cost problem, but rather a public good problem–you cannot exclude non-payers for clean air.
May 11, 2011 at 7:12 pm
I’m unable to access the paper, so I’ll have to rely on your description.
Like I said, I don’t get the distinction between public-good free-rider problems and externality ones. To take my laundry example, if all the clothes-washers belonged to one big firm, it wouldn’t have transaction costs with the individual washers, and could more easily negotiate with the factory. I had been under the impression that the problem of people strategically hiding their preferences was part of transaction costs, but I could be wrong.