Uneasy Money

The world is full of surprises, a fact with which rational-expectations theorists have not yet come to grips. Yesterday I was surprised to find that a post of mine from May 2016, was attracting lots of traffic. When published, that post had not attracted much attention, and I had more or less forgotten about it, but when I quickly went back to look at it, I recalled that I had thought well of it, because in the process of calling attention to Wicksteed’s anticipation of the Coase Theorem, I thought that I had done a good job of demonstrating one of my favorite talking points: that what we think of as microeconomics (supply-demand analysis aka partial-equilibrium analysis) requires a macrofoundation, namely that all markets but the one under analysis are in equilibrium. In particular, Wicksteed showed that to use cost as a determinant of price in the context of partial-equilibrium analysis, one must assume that the prices of everything else have already been determined, because costs don’t exist independently of the prices of all other outputs. But, unfortunately, the post went pretty much unnoticed. Until yesterday.

After noticing all the traffic that an old post was suddenly receiving, I found that the source was Tyler Cowen’s Marginal Revolution blog, a link to my three-year-old post having been included in a post with five other links. I was curious to see if readers of Tyler’s blog would react to my post, so I checked the comments to his post. Most of them were directed towards the other links that Tyler included, but there were a few that mentioned mine. None of the comments really engaged with my larger point about Wicksteed; most of them focused on my claim that Wicksteed had anticipated the Coase Theorem. Here’s the most pointed comment, by Alan Gunn.

If Wicksteed didn’t mention transaction costs, he didn’t discover the Coase theorem. The importance of transaction costs and the errors economists make when they ignore them are what make Coase’s work important. The stuff about how initial assignment of rights doesn’t matter if transaction costs are zero is obvious and trivial.

A bit later I found that Scott Sumner, whose recent post on Econlib was also linked to by Tyler, added a comment to my post that more gently makes precisely a point exactly opposite of Alan Gunn’s.

Very good post. Some would argue that the essence of the Coase Theorem is not that the initial distribution of property rights doesn’t matter, but rather that it doesn’t matter if there are no transactions costs. I seem to recall that that was Coase’s view.

I agree with Scott that the essential point of the Coase Theorem is that if there are zero transactions costs, the initial allocation doesn’t matter. To credit Wicksteed with anticipating the Coase Theorem, you have to assume that Wicksteed understood that transactions costs had to be zero. But the zero transactions costs assumption was the default assumption. The question is then whether the observation that the final allocation is independent of the initial allocation is a real discovery even if the assumption of zero transactions cost is made only implicitly. Wicksteed obviously did make that assumption, because his result would not have followed if transactions costs were zero. Articulating explicitly an assumption that was assumed implicitly is important, but the substance of the argument is unchanged.

I can’t comment on what Coase’s view of his theorem was, but Stigler clearly did view the Theorem to refer to a situation in which transactions costs were zero. And it was Stigler who attached the name Coase Theorem to Coase’s discovery, and he clearly thought that it was a discovery because the chapter in Stigler’s autobiography Memoirs of an Unregulated Economist in which he recounts the events surrounding the discovery of the Coase Theorem is entitle “Eureka!” (exclamation point is Stigler’s).

The chapter begins as follows:

Scientific discoveries are usually the product of dozens upon dozens tentative explorations, with almost as many blind alleys followed too long. The rare idea that grows into a hypothesis, even more rarely overcomes the difficulties and contradictions it soon encounters. An Archimedes who suddenly has a marvelous idea and shouts “Eureka!” is the hero of the rarest of events. I have spend all of my professional life in the company of first-class scholars but only once have I encountered something like the sudden Archimedian revelation – as an observer. (p. 73)

After recounting the history of the Marshallian doctrine of external economies and its development by Pigou into a deviation between private and social costs, Stigler continues:

The disharmonies between private and social interests produced by external economies and diseconomies became gospel to the economics profession. . . . When, in 1960, Ronald Coase criticized Pigou’s theory rather casually, in the course of a masterly analysis of the Federal Communications Commission’s work, Chicago economists could not understand how so fine an economist as Coase could make so obvious a mistake. Since he persisted [he persisted!], we invited Coase . . . to come and give a talk on it. Some twenty economists from the University of Chicago and Ronald Coase assembled one evening at the home of Aaron Director. Ronald asked us to assume, for a time, a world without transactions costs. That seemed reasonable because economists . . .  are accustomed . . . to deal with simplified . . . “models” and problems. . . .

Ronald asked us to believe . . . [that] whatever the assignment of legal liability for damages, or whatever assignment of legal rights of ownership, the assignments would have no effect upon the way economic resources would be used! We strongly objected to this heresy. Milton Friedman did most of the talking, as usual. He also did much of the thinking, as usual. In the course of two hours of argument the vote went from twenty against and one for Coase to twenty-one for Coase. What an exhilarating event! I lamented afterward that we had not the clairvoyance to tape it (pp. 74-76)

Stigler then summarizes Coase’s argument and proceeds to tell his understanding of the proposition that he called the Coase Theorem.

This proposition, that when there are no transactions costs the assignments of legal rights have no effect upon the allocation of resources among economic enterprises, will, I hope, be reasonable and possibly even obvious once it is explained. Nevertheless there were a fair number of “refutations” published in the economic journals. I christened the proposition the “Coase Theorem” and that is how it is known today. Scientific theories are hardly ever named after their first discoverers . . . so this is a rare example of correct attribution of a priority.

Well, not so much. Coase’s real insight was to see that all economic exchange involves an exchange of rights over resources rather than over the resources themselves. But the insight that the final allocation is independent of the initial allocation was Wicksteed’s.