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Evaluating Coase - Oliver E. Williamon
Evaluating Coase - Oliver E. Williamon
Correspondence
Evaluating Coase
Richard Posner advises that he and I are "ardent admirers" of Ronald
Coase (Fall 1993, pp. 195210, p. 207). Speaking for myself, I would drop the
adjective. Ardent or not, it is strange that two of Coase's professed admirers
should view the Coasian enterprise so differently.
Both in this and in a companion paper that appears in the Journal of
Institutional and Theoretical Economics (March 1993), Posner dwells on Coasian
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otherwise. But why deal with methodology in a forum where the Nobel Prize is
being celebrated if, to repeat, the core contributions reside elsewhere?
Ronald Coase is a seminal thinker and has a timeless message. On my
reading, the essence of Coase is this: 1) push the logic of zero transaction costs
to the limit; 2) study the world of positive transaction costs; 3) because
hypothetical forms of economic organization are operationally irrelevant, and
because all feasible forms of organization are flawed, assess alternative feasible
forms of organization in a comparative institutional way; 4) because the action
resides in the details, study the microanalytics of contract, contracting, and
organization. That is a subtle and powerful combination of ideas and turns out
to be difficult to implement. Although much of it goes against the main
tradition, it has nevertheless made progressive headway in relation to, and
parts have been incorporated within, orthodoxy.
Sherwin Rosen's (1988) remarks about Coase, given at the conference on
"The Nature of the Firm" that was organized to celebrate the 50th anniversary
of Coase's famous 1937 paper, are pertinent to the first of these propositions
(p. 48):
Coase's first lecture reveals a surprising aversion toward mathematics.
Curious, coming from one of the few economists who has a theorem named
after him. In fact, an easy case can be made that Ronald Coase is
responsible for two theorems, a lemma, and, according to some, an
identity. The Coase theorem is at this point well beyond further discussion. The second theorem is the remarkable one on the time-consistent,
subgame perfect equilibrium for a durable goods monopolistthe poor
soul who is forced to either destroy some property or else act as a perfect
competitor because it is impossible to commit now to actions that are nor
credible in the future except when monopoly power remains unexploited. . . . The lemma is not as well known, but should be. It is stated in
some remarkable work with Fowler in 1935, the first known attempt to fit
an intertemporal arbitrage condition, an Euler equation, to real data.
Coase and Fowler were dubious about the rationality of cobweb
theory. . . . The work is instantly recognized today as a version of the
rational expectations hypothesis and acknowledged as such by Muth in his
important paper on the subject.
But whereas both of the theorems as well as the lemma are applications of
Coase's First Law, push the fiction of zero transaction cost reasoning to the
limit, the central message of Coase resides in the Second Law: study the world
of positive transaction costs.
How could Posner have gotten it so wrong? Possibly the "insouciance" with
which Coase "appears to regard one of his most signal achievements"the new
"law and economics movement of the past quarter century" (p. 203)is a
contributing factor.
Correspondence
203
204
References
Coase, Ronald H., "The Nature of the
Firm," Economica N.S., 1936, 4, 386405.
Coase, Ronald H., "The Problem of Social
Cost," Journal of Law and Economics, October
1960, 3, 144.
Coase, Ronald H., "The Regulated Industries: Discussion," American Economic Review,
14349.
Coase, Ronald H., The Firm, the Market, and
1988a.
Coase, Ronald H., "Nature of the Firm:
Origin, Meaning, Influence," Journal of Law,
Economics, and Organization, Spring 1988b, 4,
147.
Coase, Ronald H., "The Institutional Structural of Production," American Economic Review, September 1991, 83, 71319.
Posner, Richard A., "Law and Economics
Meets the New Institutional Economics," Journal of Institutional and Theoretical Economics,
4862.
Williamson, Oliver E., "Calculativeness,
Trust, and Economic Organization," Journal
of Law and Economics, April 1993, 36.
Correspondence
205
would have to be dated, with the price level on the appropriate date attached.
This is simply impossible. Consequently, when inflation subsided, many corporations discovered that they had been bankrupt.
Consumers face problems, too. Ordinarily, when people shop they use a
data bank stored in their memory to assess the prices they are asked to pay. But
when prices change continuously, people find themselves in the dark. I remember situations during the inflationary years when people could not decide on
the reasonableness of prices by up to a factor of 10. I remember when products
at the supermarket had four price stickers, each with a different price, attached
to the product one on top of the other. In the end, the cost of constantly
changing the prices became so substantial that retailers abandoned price
stickers altogether. Instead, a code sticker was attached to each product, and
the cash register was programmed daily to associated prices with codes. The
upshot was that shoppers had no idea of the price of anything they pulled off
the shelves, until reaching the checkout counter. This makes the task of
executing a household budget rather difficult.
The governmental budget process was rendered useless for similar reasons. How is it possible to calculate the real rate of government spending when
inflation proceeds at 0.5 percent (1984) or even 0.3 percent (1983) per day? The
cabinet resorted to debating the budget in dollar terms, although the accountant general at the Ministry of Finance had to continue to write checks and
keep records in shekels. This made communication between plan and execution virtually impossible. Revisions made long after the fact revealed that
estimates of the budget deficit measured as a share of GDP were off by 5
percentage points and more, which is not far from chaos.
Another category of stress concerns the financial structure of business
firms. When nominal interest payments are deductible for business tax purposes and, dividends are not, and since inflation causes nominal interest rates
to rise, the advantage of debt over equity increases with inflation. Consequently, companies were being robbed of their equity to a dangerous degree, as
owners substituted debt for equity.
Indexation of loans is usually regarded as shoring up the financial system
against the vagaries of inflation. For the borrower, however, it is little help.
Consider an investor who plans a project that takes two years to construct, and
wants to secure an appropriate line of credit. Because of inflation, the amounts
that will have to be spent can only be guessed. The alternative of indexing the
line of credit to the actual cost of the project simply does not exist, because of
moral hazard. If the project runs out of money, it will be the investor's task to
convince the creditor that the excessive costs were caused by inflation, and not
simple cost overruns. The added risk that the investor has to shoulder in this
situation may well be an important reason for the decline in investment
observed under prolonged periods of inflation (Plessner and Shalit, 1986).
Even in an indexed environment, inflation causes problems with savings,
too. The most salient symptom is the tendency of households to accumulate
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assets in the form of real estate, on the supposition that this form of wealth is
better shielded from inflation. In fact, the added demand for apartments as a
form of investment actually did cause their prices to inflate more rapidly.
During 1979, for example, housing prices increased by 159 percent, while the
consumer price index rose by 111 percent. This misallocation of resources was
evident from the considerable number of empty apartments that people maintained as a hedge against inflation.
Indexation cannot completely protect government contracts, either. Suppose that the government contracted on July 10, 1983, to purchase defense
components in the amount of IS10 million. On that day, the last known price
index was the one for the month of May, published on June 15. It stood at
986.5, and served as the indexation basis for the contract. Suppose next that
delivery was made on October 10 and that the payment agreement called for a
30-day term. On pay day, November 9, the last known price index was the one
for September, published on October 15. It stood at 1268.3. So the government
paid IS12,856,563.61 (that is, multiply the contracted amount by the ratio
1268.3/986.5). Then on November 15, the price index for October was published, and turned out to be 1535.5. Hence, in terms of the May purchasing
power, the supplier received only 82.6 percent of the contracted amount. Of
course, one can attempt to remedy this situation by using estimates of expected
inflation, or supplemental payments, but these approaches bring costs and
uncertainties of their own.
Problems in the financial sector are not fully solved by indexation, either.
Price index numbers are published only once a month. But balances in
corporate line-of-credit accounts change daily. Since daily inflation rates are not
known (and probably cannot be known), indexation provides only partial
protection. Even at rates of inflation that are far from qualifying as hyperinflation, the losses from inaccurate indexation may wipe out the entire interest
income of the bank or could double the interest rate for the firm, depending on
whether the balance increases or decreases over the month.
The indexation of tax brackets can prevent fiscal drag for individuals, but
it has no relevance to corporate taxation. On the one hand, some corporations
were paying taxes on nominal paper profits, when they were actually making
losses. However, profitable corporations usually did not pay anywhere near
what they should have paid in real terms, since a good portion of corporate
taxes is paid only after financial reports are out, and that delay robs the tax of
much of its real content. Three commissions, consisting of the best tax minds in
Israel, struggled to create a tax code which could deal with these problems. But
their Law for Taxation Under Inflation, adopted in 1983, was so complex that
it had to be practically abandoned.
A dramatic demonstration of the failure of an indexed tax code occurred
when inflation leaped from 191 percent in 1983 to 445 percent in 1984and
real corporate taxes fell by 55 percent compared to 1983. This was a major
factor in the increase of the budget deficit, from 6.3 percent of GNP in 1983 to
Correspondence
207
Reference
Yakir Plessner, and Haim Shalit, "Inflation, the Level of Investment and Interest
Rates," European Economic Review, December
208
understand the philosophy of this, by far the greatest of all the Scotch
thinkers, both works must be taken together, and considered as one; since
they are in reality, the two divisions of a single subject. In the Moral
Sentiments, he investigates the sympathetic part of human nature; in the
Wealth of Nations, he investigates its selfish part. And as all of us are
sympathetic as well as selfish; in other words, as all of us look without as
well as within, and as this classification is a primary and exhaustive
division of our motives to action, it is evident that if Adam Smith had
completely accomplished his vast design, he would at once have raised the
study of human nature to a science, leaving nothing for subsequent
inquirers except to ascertain the minor springs of affairs, all of which
would find their place in this general scheme, and be deemed subordinate
to it.
In subsequent treatment of Smith, Buckle (1970, p. 259) writes: "A short
view of these two works will . . . enable us to perceive that each is supplementary
to the other; so that, in order to understand either, it is necessary to understand both."
Interestingly, the American economist Henry George, in The Science of
Political Economy referenced Buckle's work on Smith and used it to buttress his
own view of the well springs of economic action, which relied not on selfishness
but on a primary postulate that "all men seek to gratify their desires, whatever
those desires may be, with the least exertion." This postulate George (1932,
pp. 7278) argued "is no more affected by the selfishness or unselfishness of
our desires than is the law of gravitation. It is simply a fact."
Evensky deserves every credit for raising an old, but terribly neglected
topic. The story always need retelling and Evensky tells it to us properly. Good
for him!
Lamar B. Jones
Louisiana State University
Baton Rouge, Louisiana
References
Buckle, Henry Thomas, On Scotland and the
Scotch Intellect. Chicago: The University of
Chicago Press, 1970.
Correspondence
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