Coase’s Critique of the Neoclassical Model–Coase Minus the Coase Theorem

Coase Minus the Coase Theorem, is among other things an attempt to retrieve the meaning of Ronald Coase’s famous article, The Problem of Social Cost, 3 J. L. & Econ. 1 (1960) As I try to show, Coase advanced a serious critique of the neoclassical model in that piece–namely, the notion that the neoclassical model, by excluding law from its ambit, is hopelessly flawed. That main point and Coase’s considerable argumentative support have been lost throughout the years in ways that have seriously compromised economic analysis of law–in particular Chicago L&E.

Perhaps it is not surprising that the most cited article in American legal thought has been so persistently and repeatedly misunderstood, but Ronald Coase’s The Problem of Social Cost, has. Things got off to a bad start early with Stigler’s formulation of the “Coase Theorem.” This made its way into print in 1966 with the publication of the third edition of George Stigler’s “Theory of Price.” Stigler underscored what he took to be the key insight of Coase’s article, namely that with zero transaction costs, the allocation of legal entitlements would not affect efficiency.

Over the decades, the overwhelming majority of lawyer-economists came to accept, (however wrongly) that this was the major contribution of Coase’s article. Still how odd. After all, Coase nowhere mentions the “Coase Theorem” in the article (the closest we get is page 8). As for transaction costs—it is defined in one paragraph on page 15. If that’s the punch line, what then is the rest of the article about? (More on that later.)

Having reduced Coase’s broadly-ranging article to a mere theorem, Stigler compounded the problem by focusing on the wrong branch of the theorem—opining that (owing to zero transaction costs) law often has no effect on efficiency. For a very brief moment, some pioneers of law and economics followed through on this idea, championing the notion that insofar as most exchange situations were characterized by zero transaction costs, the best thing law could do was to “leave matters alone”—that is to say, avoid imposing positive transaction costs through interference with contractual exchange. “Void as against public policy”—that was precisely the sort of legal imperative to be avoided. This laissez-faire approach did not have much of a future. Not only was it predicated on false assumptions, but it did not provide much in the way of a research agenda: Indeed, there wouldn’t be a whole lot for law and economics scholars to say if the compulsory refrain was: “Stop this law thing! Create property rights and leave things well enough alone!” To be sure, you can get a few readable articles out of that. Maybe 30 or so. After that, diminishing returns set in fast.

So, of course reversal was imminent. It happened quickly. Soon positive (in fact, prohibitive) transaction costs were seemingly everywhere. Enter then Kaldor and Hicks and “hypothetical markets” and the sustained attempt to model laws on what bargained-for exchanges would have produced in the absence of transaction costs. This was the famous and once omnipresent “replicate the outcomes reached in a zero-transaction cost world” iteration of the Coase theorem. This misunderstanding of Coase’s work has lasted quite a while. It spawned a capacious research agenda. Not only was there the need to identify all possible transaction costs—a task which, if one read Coase carefully would be nearly endless (notice that language itself is, inter alia, a transaction cost)—but there was the need to identify all those bargained-for exchanges that were not happening yet would be, but for the presence of prohibitive transaction costs. This was, for the reasons just stated, an ambitious research agenda with a long future. But it too was built on a foundational mistake. For an extended description of the misunderstandings of Coase’s work in this regard, see my Appreciative Comment on the Coase Theorem—A View from the Left. Coase, for his part came to reject explicitly the “replicate the zero transaction cost world” approach. As he put it in 1988: There’s not much point in dedicating ourselves “to a detailed study of the world of zero transaction costs, like augurs divining the future by the minute inspection of the entrails of a goose.”

In that same year, Coase complained trenchantly that the Coase Theorem was getting all the attention much to the detriment of the latter half of his article. At about that time, I noticed something rather odd about Chicago’s “replicate the market” use of the Coase Theorem—namely, that at the level of form, this approach repeated exactly the same mistakes that Coase originally detected in the Pigouvian approach. How was this possible? I wrote another piece to show how Chicago L&E had managed to repeat exactly the same mistakes. This was The Problem of Transaction Costs.

It was not until I reread Frank Knight’s Some Fallacies in the Interpretation of Social Cost and delved seriously into the work of Robert Lee Hale (and then Wesley Newcomb Hohfeld) that I focused on the full significance of Coase’s critique against the neoclassical model. And, of course, I wrote another piece: Coase Minus the Coase Theorem–Some Problems with Chicago Transaction Cost Analysis, which came out a few months ago. Following through on the earlier pieces, the argument focuses on the three main points that Coase argued in The Problem of Social Cost. These are conveniently found in the concluding section of his article:

 1.   The mistaken presumptions of the Pigouvian approach                                                  2.  The fallacies of the neoclassical model (notably its presumption that pricing markets work costlessly)                                                                                                              3.  The need to rethink factors of production in legal (not physical) terms.

The bottom line of Coase Minus the Coase Theorem is that Coase came to realize in a Hohfeldian way that law and laws play a crucial role in establishing the identity and magnitude of production factor costs. This recognition is, according to Coase, fatally missing from the neoclassical model with its assumptions of zero transaction costs—its assumption, in other words, that pricing markets work costlessly. This was the core of what Coase was saying. He was most certainly NOT saying that…

1.  the real world is often characterized by zero transaction costs,
2.  we should try to approximate the outcomes parties would reach in a zero transaction cost world.

Coase’s corrective to the erroneous neoclassical assumption of costless pricing markets is to recognize that law and laws must be taken into account in ascertaining the efficiency of market arrangements. For that purpose, and this is the kicker that undermines conventional Chicago law and economics, the neoclassical model is not up to the task. It is not up to the task precisely because it always already fails to take law and laws into account. Playing catch up by trying to apply the model to law (that is Chicago L&E key agenda) is not a viable option: The model is not equipped to adjudicate the efficiency of law and laws because the model is always ab initio lacking a sound method to the analysis—to wit, an economic account of law and laws on the identity and magnitude of production factor costs.

Demsetz agrees with Coase that the neoclassical model excludes law and its institutions from the model. But, Demsetz wants no part of Coase’s effort to acquaint the neoclassical model with law and laws.  On the contrary, wishing to preserve the integrity of the neoclassical model, Demsetz contests Coase’s efforts to include law and its effect into an assessment of economic performance. Whatever help this may provide the economists (they do after all use the model for a variety of purposes) it will not help the lawyer-economists who are concerned with the economic performance of law and laws.

Did Coase have anything constructive or prescriptive to say on that issue? Yes he did and this is the last part of the puzzle—the clincher so to speak: The mystery is that Coase’s constructive suggestion is so strikingly modest and so sketchy.    The question is why?  Why so abstract, so sketchy, so lacking in technical specificity?    The answer is that Coase had uncovered a problem he was not then (or later) able to resolve.   Neither was anyone else.

What Coase advised was to abandon the widespread Pigouvian (one might almost substitute “microeconomic” for “Pigouvian” here) effort to compare an actual state of affair to the neoclassical model’s idealized mage of pricing markets (decentralized, divisible goods, etc.). Instead Coase counseled a kind of opportunity cost approach. Specifically, Coase advised abandoning evaluation of economic performance according to an actual-ideal model (i.e. how well does the actual approximate the ideal?) in favor of a more free-ranging comparison of the present “social arrangement” (his words) with proposed improvements. In other words: Is a proposed change in the present “social arrangement” likely to lead to better or worse economic performance?

Notice that elliptical term “social arrangement.” What is a social arrangement you might reasonably ask? It is a particular mix of the usual Coasean social coordination systems—to wit, a particular mix of market, firm, and government. How then you might ask are we supposed to evaluate whether a proposed change in the mix is better or worse according to Coase? That’s the ten thousand dollar question as we use to say. It’s not just a question of what standard to use (i.e. willingness to pay) although Coase has interesting things to say about that. It’s also (and more problematically) a question of making an evaluation according to some presumably unitary model of the behavior of firm, market, and law? Uhm… what model is that? Don’t have one. Hence, Coase’s heuristically helpful though methodologically empty suggestion that we compare different “social arrangements.”  Now, please note that I am not knocking Coase in my article. Coase is on the right track. I am merely pointing out the methodological modesty of this stance. I don’t know that Coase thought this was a modest stance. I am not sure he appreciated—maybe he did/maybe he didn’t—the magnitude of the problem he uncovered. It’s just that relative to the confident claims to knowledge of Chicago L&E, Coase’s constructive suggestion emerges less an answer than a very tentative and abstract sketch of what such an answer might look like. (More on that later.)

For now, it would be fair to say that Coase…

1.  Made some devastating arguments against the neoclassical model
2.  Perceptively diagnosed the sources of its flaws
3.  Offered an insight about the kind of analysis that ought to be developed….

… the latter remaining to this day incomplete, underspecified, and surprisingly (given all the work performed in the meantime under the aegis of L&E) virtually nowhere.

Now, my understanding of Coase departs so much from the received wisdom that it can be difficult to grasp.  I can sum up the point of my latest effort succinctly (trusting the reader to glean for herself or himself the nuance and the details from the article itself). Here goes:

1. In order to perform a valid economic analysis of law using the neoclassical model, that model needs to be repaired along the lines that Coase suggested. That is to say, that some means must be found to supplement the model with the effects of law and laws on the magnitude and identity of production factor costs. Without such supplementation the model remains, per Coase, inadequate to perform economic analysis. It fails to account for a huge variable (law and laws) in the setting of the identity and magnitude of production factor costs.

2. The situation is not and cannot be ameliorated by applying the flawed neoclassical model to the evaluation of law and laws. It may be that this enterprise is looking for the right thing (the thing that it is missing—surely that is right) but it is still looking for it with a flawed model—one that cannot, as a theoretical matter, deliver the right analysis. (That this model may in an ad hoc way deliver the right results on occasion is not to be denied, but then again that is neither here nor there).








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2 Responses to Coase’s Critique of the Neoclassical Model–Coase Minus the Coase Theorem

  1. John Carlson says:

    Pierre, Several times you mention the “magnitude and identity of production factor costs.” What does that mean?

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