Thoughts on economics and liberty

Extract from the centennial Coase lecture


Some months after my FCC paper was published with the error in it, I was invited by (34:08) Stiegler to give a paper at the industrial organization workshop I accepted on condition that I could also have a discussion of my error. A meeting was arranged which took place at Aaron Director’s home with about 20 Chicago economists present. Aaron Director, George Stigler, Milton Friedman and others. I have only the haziest idea of what happened. The discussion was hot and heavy and lasted about two hours with Milton Friedman the most active in the discussion. In the end, it was agreed that I was right. The effect on the (34:53) participants or at any rate, most of them, and certainly on George Stigler was dramatic. Steven Cheung in his piece on me in the new Palgrave dictionary of economics says that according to McGee who was present and now I quote: “As the delegates left Aaron Director’s house in a state of shock, they murmured to themselves that they had witnessed intellectual history.” End of quote. I did not share this feeling I could not understand why a statement the equivalent of two plus two equals four should be treated on a par with e = mc2 (35:39). As I’ve said I’ve had no clear recollection of the discussion. What I do seem to remember as a turning point was when Harbor said: “If you cannot show that the marginal cost schedule changes, he can run right through”. Stigler wrote an account of the discussion in his memoir of an unregulated economist. But I do not think it is entirely accurate. The tale of the vote before and after the discussion is pure fiction, although I don’t doubt that had there been a vote it would have come out as he (36:22) described. His account of how I argued also does not strike me as being correct. It’s just not my style. However, his statement that I used the example of the stray cattle damaging the crops of a neighboring farmer is undoubtedly correct. I suspect the my argument in Aaron Director’s home was much the same as that to be found in the first few pages of the problem of social cost.

After the meeting I was asked to write out my arguments for the Journal of law and economics and that was how the problem of social cost came to be (37:06) written. In that article I didn’t confine myself to what I had said at the meeting. I Illustrated the nature of the problem by reference to English nuisance cases. I showed that the conclusion the puzzled the Chicago economists was also dependent on the assumption of zero transaction costs although they’re likely in fact to be quite large I discussed what results were likely to be if you include the transaction costs. I discussed the delimitation of property rights and I ended the article with the discussion of Pigou’s views (37:46) which have been largely adopted by the economics profession and I showed that they were erroneous. The article was a great success it’s helped to create the modern subject of law and economics. It has been cited more than any other article in the modern economics literature. However, much of this attention does not relate to what I said in that article but to something called the Coase theorem. This was invented by George Stigler and stated that under perfect competition, private and social costs will be equal. Cooter’s (38:37) reformulations comes closer to what people usually have in mind when they refer to the Coase theorem. The initial allocation of legal entitlements does not matter from an efficiency perspective so long as the transaction costs of exchange are nil. I’ve never been enthusiastic about Stigler’s Coase theorem. And you’ve got to be careful giving other people’s names to propositions. I don’t like the concept of perfect competition nor the assumption of zero transaction costs to (39:22). To make these assumptions is to have a discussion about a world that does not exist, probably indeed one that could not exist. Of course, economists who are used to doing this were able to engage in this discussion of the Coase theorem with enthusiasm. Of course, in all in making one’s argument it’s quite a right to simplify but this has to be done sensibly. In discussing the trajectory of a bullet fired from a rifle it’s no doubt reasonable to neglect the effect of gravity, but to make the assumption that gravity did not operate (40:07) anywhere would mean that you don’t have a bullet, a rifle or indeed anything else. And that’s what tended to happen in the whole discussion of the Coase theorem.  People didn’t say, “Oh, we’re neglecting the effect of transaction costs in this particular transaction.” They said: “In a world of zero transaction costs”, which is, as I say, a world that couldn’t exist. Looking back, it might have been better if in my FCC article I hadn’t been influenced by my courses in law at LSE, and had not discussed Sturges (41:00) against Bridgman. I could have confined myself to what I said about a newly discovered cave. Whether a newly discovered cave belongs to the man who discovered it, the man on whose land the entrance is located, or the man who the first of the surface under which a cave is situated, is no doubt dependent on the law of property. But the law merely determines the person with whom it is necessary to make a contract to obtain the use of the cave. Whether the cave is used for storing bank records, as a natural gas reservoir or for growing (41:39) mushrooms depends on not on the law of property but on whether the bank, the natural gas corporation or the mushrooms concerned will pay the most in order to be able to use the cave. This approach makes the same point as does the analysis of Sturges against Bridgman but does not involve the kind of argument about that case which so upset the Chicago economists. On the other hand, this change of approach would have meant that there was no meeting at Aaron Director’s house nor any article on the problem of social costs and very probably no new subject (42:21) of law and economics. Furthermore, since as has been plausibly argued, it was the problem of social costs that drew attention to the nature of the firm, there would have been no Nobel prize in economics for me, and the only bright spot, no Coase lecture. But God moves in a mysterious way his wonders to perform. And law and economics did emerge and has flourished propelled by Richard Posner’s economic analysis of law. Many lawyers have learned enough economics to make significant contributions to law and economics. The value of using economic (43:10) concepts – opportunity costs, elasticity of demand, and so on – to aid in the elucidation of legal problems is clear. This work has a solid footing and will continue and develop. The same cannot be said in my view of another part of law and economics. The effect of the legal system on the functioning of the economic system. Although it is generally agreed that without a well-functioning legal system you cannot have an efficient economic system. One reason for this lack of interest is that economics has become a theory (43:54) driven subject. And the need to carry out the massive empirical work required if you ought to do this is not accepted by economists. And is certainly not done. But that’s a bad reason why the effect of the legal system on the functioning of the economic system has not being carried out. But there’s also a good reason.

It is relatively easy for a non-economist to learn the economic concepts. It is very hard for a non-lawyer to learn how the legal system operates with its doctrines and terminology. I suggest (44:42) therefore, that the study of how the legal system affects the economic system is a task that professors of law should undertake. Not all of them, of course, some of them. I don’t think this is a diversion from their main task of training the young. Lawyers in business – and there are many of them – are deal makers. They make it possible for certain transactions to be carried out. Although it may not always seem like this to the client, they reduce transaction costs. I suggest the research projects be undertaken with the aid (45:28) of students into how this contracting process actually operates. Some years ago professor Kisch, then of this Law School, undertook with the aid of students a study of the regulation of taxi cabs in Chicago. The result was an excellent study which was published in the Journal of law and economics. The students proved to be superb investigators. They use some rather unorthodox methods for discovering what went on including talking to the secretaries. I think much more of this work utilizing the creativity and energy of the young could (46:19) be done. It would be good training for work for many of them many of them undertake, and the rest of us will benefit from a vastly improved law and economics.



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Sanjeev Sabhlok

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