Hard Coase, Soft Coase

Over the course of this semester, I have been working on two research projects which parallel each other very closely.  Both look at water market exchanges (ie, people who buy and sell water), one from a Coasian perspective (ie, how changes in legislation affect markets), and the other from an Ostrom/Ellickson perspective (ie, how social norms and mores affect markets).  Both these papers are being finished up and I will post links to them here, but there is an interesting connection between the two: both forms of bargaining are “bargaining under the shadow of the law.”

“Bargaining under the shadow of the law” typically refers to working within a framework established by a court (eg, how a court determines property rights).  This is the “hard Coase” theorem.  However, “law” need not apply to just courts; indeed, it does not.  There are general rules, or laws, that develop “[From] our continual observations upon the conduct of others,” to help us “form to ourselves certain general rules concerning what is fit and proper either to be done or to be avoided,” (Adam Smith, The Theory of Moral Sentiments, Section III, Chapter IV, Paragraph 9).  These rules are the social norms and customs, what the Romans called mos, or “a guiding rule of life” (see On Duty by Cicero, translated by Benjamin Newton, specifically Newton’s glossary at the end of the book).  These rules, customs, laws govern our behavior and our interactions just as much as legislation does (perhaps even more so) since we face not jail or prison if we violate these rules, but censure, disapprobation, and demerit from our fellow man; extreme cases could result in isolation from the community, a terrible punishment, indeed, given that man is a social creature.  It is these rules, this law, that I refer to as “soft Coase.”

In both the hard Coase and the soft Coase situations, Coase’s arguments about bargaining hold generally true: changes in the law affect how we behave and interact with one another.  This, in turn, affects how we address externalities and other economic behavior.

The Coase/Ostrom/Ellickson look at collective behavior, sprinkled liberally with Alchian/Demsetz insight and Tulluck/Buchanan public choice theory, is an important way of exploring the market process.

The Problem with Optimal

In economics, the concept of “optimal” is often used: optimal taxation, optimal pollution, optimal consumption, etc.  Optimal, in an economic sense, just means marginal benefit equals marginal cost.  For individual actors, such a definition and usage makes sense.  However, problems arise when trying to generalize optimality over collective units.

With optimality, it is important to remember a key characteristic about benefits and costs: they are subjective.  All value, whether a benefit or a cost, is subjective.  Therefore, an individual can optimize his behavior by aligning his subjective marginal benefits and subjective marginal costs.  But this is not true with collective action.  When analyzing collective action, the point of view of the analyzing person comes into play.  Collective agencies cannot have subjective feelings about things, they cannot optimize; the one who does the analysis optimizes based on his/her subjective values.

Therefore, it doesn’t make sense to talk about the optimization of collective units in the same way it does to talk about the optimization of individual units.  Concepts like “optimal tariffs,” “optimal taxation,” etc., lose their meaning when we start considering subjective costs.  It comes down very heavily to the subjectivity of the person who is doing the calculating, what he/she believes the costs/benefits are.  When that individual is responsible (ie, they pay the cost if they are incorrect) for the results of their actions (eg, the owner of a firm), then such subjectivity is not an issue; they are properly incentivized to make sure their subjective understanding aligns with their collective goal.  When the person is not responsible (eg, government agents), then such optimization becomes…problematic.

The Hayek Memorial Pathway

The picture above is what I like to call the Hayek Memorial Pathway located on GMU’s Fairfax campus.  This pathway is the result of thousands of students deciding to go the shortest path rather than the long paved path.  In other words, this path is a spontaneous order; the result of human action but no one person planned such a path.

Surprise!

At Cafe Hayek, Don Boudreaux has a blog post discussing the rather frequent argument used by some protectionists who object to foreigners owning American assets.  Don writes:

One of the facts that I pointed out [in Don’s recent debate with Ian Fletcher] is that a U.S. trade deficit is good for the U.S. insofar as such a deficit means that capital is flowing into the U.S. and creates new businesses (or bolsters existing businesses).  Think, for example, of BMW’s factory in Greer, South Carolina, or of any of the many Ikea stores across the United States.

In reply, Fletcher agreed that such investment is productive, and even that it’s beneficial for Americans.  “However,” he replied (and here I quote from memory), “it would be even better if those assets were owned by Americans.”

…

The core error in Fletcher’s reply is the assumption that the productive assets that are brought into being by foreign investment would exist in the absence of foreign investment.  Fletcher assumes, for example, that the successful Ikea store in Dale City, Virginia, would exist in the absence of Ikea’s decision to build and operate a store there.  Fletcher assumes, in other words, that the ownership of an asset is economically distinct from the creation of an asset.  But this assumption is plainly mistaken.  Nothing prevented Americans from building a large furniture (or other kind of) store on that very location before Ikea built its store there – nothing, that is, other than the failure of any Americans to have the vision or the willingness to do so.  Ikea’s entrepreneurial vision and willingness to take the risk of building a store in Dale City added tothe capital stock in America (and in the world).

To build upon Don’s point:

People like Fletcher treat assets and resources as if they are mana from Heaven, that these factories and stores and the like just fall to the Earth, waiting to be claimed by whoever walks by.  But goods and services are brought into existence and traded through human action. It’s man, not God, that transforms and produces. God just gave us the faculties to do so.

However, there is also a crucial element of what Israel Kirzner called “surprise” needed.  That is, being aware when an opportunity presents itself.  Allow me to explain via metaphor:

Two shoe salesmen land in a foreign country. Both notice no one in this country wears shoes. The first calls back to headquarters: “I’m headed home. There are no sales opportunities here. No one wears shoes!” The second calls back to headquarters: “Send me more people. There are lots of sales opportunities here. No one wears shoes!”

The point of this story is that entrepreneurial activity includes “surprise,” that is: being aware of an opportunity that presents itself even when not actively searching for it.  One of the salesmen, the one who thought no opportunity existed, had no such element of surprise.  The other did.

There’s no reason to assume that if Ikea hadn’t shown up, someone else would have. This isn’t a “search cost” thing (ie, other people did not simply look hard enough and Ikea just looked harder/longer), but rather an entrepreneurial surprise thing. Ikea spotted an opportunity and invested. It’s probable no one else would have spotted (or, at least spotted at the same time) this opportunity.

But let’s say more. Let’s say that some American firm did spot the same opportunity at the same time and were competing against Ikea for the same resources (land, labor, etc). Would it be safe to say that the community would be better off if the assets were owned by the American firm rather than Ikea? Not necessarily. Given that Ikea won the bidding war, that probably means Ikea had a higher value on the resources than the other firm. This, in turn, means that Ikea can likely produce more value out of the resource, which means providing value to the consumers of furniture. By being more efficient (that is, using fewer inputs to achieve the same or greater outputs), Ikea produces more value for the community than the other firm that lost the bid.

Economic growth occurs through the mechanisms of discovery and surprise (a la Kirzner) and resources going to their most valued uses.  We cannot take for granted either one of these processes.

What I’ve Been Reading

The following is a short list of some of the non-technical books I have been reading over the past few months:

–The Theory of Moral Sentiments (Adam Smith): A classic of classical liberal philosophy

–The Man and the Statesman (Frederic Bastiat): The collected correspondence and several articles by the noted French economist and statesman

–The Firm, the Market, and the Law (Ronald Coase): A collection of the famous essays and notes/responses by Coase on their receptions and interpretations

–The Calculus of Consent (James Buchanan & Gordon Tullock): The foundations of public choice theory

–Human Action (Ludwig von Mises): A classic work on economics and human interaction

–Free Market Environmentalism (Donald Leal and Terry Anderson): Exploring environmental issues through the eyes of price theory

–Governing the Commons (Elinor Ostrom): How people come together to solve commons problems

–Order without Law (Robert Ellickson): A similar story to Ostrom: how people come together to deal with externalities without the state

–De Officiis (Cicero, translated by Benjamin Newton): a classic of moral philosophy

 

Optimal Tariffs Are Not Optimal

The other day, I had a brief discussion on optimal tariffs.  I wanted to expand a little on that topic.  Warning: what follows is somewhat wonky.

Optimal Tariffs and Blackboard Economics

Don Boudreaux favorably quotes Doug Irwin over at Cafe Hayek.  Below is a slightly edited comment I left:

What Iriwn, like Hayek and Coase before him, points out I think is just brilliant: the scarcityists’ arguments are one long exercise in begging the question. They’re assuming they have the very knowledge they’re trying to show they can acquire. Yes, if one just happened to know the complete set of preferences and demand curves for all people in the nation, then one could create an optimal tariff or policy for that given moment in time. But it’s in getting that knowledge where the trick lies.

Note that the key word here is “knowledge,” not “information.” You don’t need data points to feed into a machine, but precise observations about the nature and time and place of each individual, observations the individual himself does not necessarily know. Collecting these necessary observations are impossible.

But there is another thing to keep in mind: Bastiat. Let’s grant the scarcityist’s assumptions and say we can set an optimal tariff policy. Such a policy is optimal in name only; it’s optimal only through incomplete accounting. It’s optimal only from the point of view of the country levying the tariff. But economics is not about only looking at one person in one time period (the seen). We must look at all people over all time periods (the unseen). An optimal tariff in the US may temporarily raise US net welfare, but at the same time, the world as a whole is made worse off. A poorer world means fewer buyers of US products and fewer sellers of goods to the US (exacerbated by the tariff). A poorer world also means increased instability, and likely more war. Both these effects will rebound on the US, leading to a poorer US as well over time. In short, even if we grant the assumptions of the scarcityists, the outcome from tariffs, when explored across all people in all time periods, is still negative.