Economists Misunderstand What They Teach

4 minute read

A popular theorem within economics comes from Ronald Coase, an economist who won the Nobel for his analysis of the firm and revitalization of institutional analysis. The Coase Theorem, as vocalized by George Stigler, suggests that so long as transaction costs are low or non-existent and property rights are clearly defined, the initial endowment in market transactions should not matter. In other words, markets will naturally internalize any externality created by transactions and provide the optimal outcome.

What economics sort-of-kind-of is (not really), Source: Gustavo Rodriguez

As a student of new institutional economics, that statement really gets me excited! Why? Because Coase's work shows how institutions matter and their effect on how market transactions occur. However, that point does not make it across for most undergrad students, and sadly, many professional economists as well. After a lecture at the KFP conference, I talked with Dr. Wenzel, an institutional and Austrian economist of Flagler College, and Mr. Marcoux, a business ethics professor at the University of Creighton, about how institutional analysis remains ignored by many economists, and, consequentially, how the lesson of the Coase Theorem is extremely misunderstood.

Dr. Wenzel called the Coase Theorem a 'silver bullet' for many pro-market advocates who do not fully understand the nature of Coase's work. While the Coase theorem shows how markets can perform efficiently, Coase's argument focused on how this efficiency only occurs under very special and rare circumstances. The reason why markets do not operate optimally is because of the transaction costs under different institutions. Laws, norms, legal agencies, and people themselves all add to the transaction costs of market exchanges, which violates a fundamental premise of the Coase Theorem. Making matters worse, property rights have historically been in public ownership and/or extremely inefficient, violating the second part of the Coase Theorem.

An example can be found in an analysis of waterways. Because there exists no clear boundary between one user's ownership and the next, many users can lay claim to the water system making it difficult to assign responsibility over a segment of the river (poorly defined property rights). Individuals may try to litigate over pollution expenses, but the more individuals fighting over water rights, the more difficult and convoluted the process becomes (high transaction costs). This entire scenario provides a real life example of how markets often fail to exhibit clearly defined property rights and low transaction costs.

This reality means that both fundamental parts of the Coase theorem are violated on a normal basis, and that markets will actually behave sub-optimally. The greatest contribution of the Coase Theorem comes from the realization that we do not see these idealized property rights and non-existent transaction costs. Coase meant this to show how important institutions are for ensuring efficient markets and to explain economic phenomenon seen in the market, but even economists like Stigler and Samuelson, each Nobel laureates in economics, truly failed to appreciate his contribution. Institutions themselves are what determine how property rights are defined and defended, along with the various norms that dictate market behavior. Some institutions, like a free market, are better than others, such as pastures in feudal England, and result in more optimal outcomes.

The late Ronald Coase, economist extraordinaire, Source:

Mr. Marcoux pointed to a very good paper by Deidre McCloskey, a Chicagoan economist, outlining the current misunderstanding of Coase in academia. In her article, "The So-Called Coase Theorem", she has this to say:

Coase's actual point, the core of a Coasean economics, was to note what happens in the many important cases in which transaction costs cannot be neglected. If the situation does have high transaction costs, then it does matter where the liability for pollution is placed. In Consequence, as Coase has stressed throughout his career, the economist's preference for a simple, blackboard solution, taxing the party that "causes" the pollution (as Pigou and Samuelson suggest), is no longer defensible. [emphasis by author]

The Coase Theorem is not really a theorem at all, and to paraphrase McCloskey, the concept was already captured by Adam Smith himself and several other prominent economists. Even Coase agreed with this, and he actively discouraged the attachment of his name to the theorem! What Coase was trying to communicate was that the theoretical, 'blackboard' economics being taught by ivory tower academics did not match the real world. Neoclassical economics had completely neglected the institutional frameworks through which society and individuals operate. And despite his 50+ years of teaching, it seems that Coase still failed to reach out to the majority of academic economists. Policies and models are still based on the fanciful idea that transaction costs do not affect the patterns and transactions of society, that plain cut theory can explain away problems based in reality, and that economists can perfectly encapsulate the world in their recommendations.

Despite his 'failure' to express the complexities of institutions to all of economics, Coase's efforts did not go in vain. New institutional economics has become a thriving force within the academic community and more economists are wising up to the reality of how institutions influence human action. The discussion I had with Mr. Marcoux and Mr. Wenzel only makes me more sure of this.