Coase, Transaction Costs, and Environmental Entreprenureship

Today’s Quote of the Day comes from pages 7-8 of Ronald Coase’s 1988 book The Firm, the Market, and the Law [emphasis added]:

Markets are institutions that exist to facilitate exchange, that is, they exist in order to reduce the cost of carrying out exchange transactions.  In an economic theory that assumes transaction costs are nonexistant, markets have no function to perform and it seems perfectly reasonable to develop the theory of exchange by an elaborate analysis of individuals exchanging nuts for apples on the edge of a forest or some similar fanciful example.

Many readers of Coase (including economists!) misunderstand him.  This is evident in the improperly named Coase Theorem (it’s improper in that it’s not a theorem).  In fact, Coase is so often misunderstood, he felt compelled to write the book this quote is from to clarify his point!  Coase is often understood to say that, absent transaction costs (or sufficiently low transaction costs), externality issues (eg pollution, noise, etc) can be solved by an allocation of property rights and, regardless of their initial allocation, will result in a Pareto-efficient outcome.  This is correct, but only a partial understanding of Coase.

Much of Coase’s work (and work that spun off from him, such as with Armin Alchian, Harold Demsetz, Gordon Tullock, and many others including my own) focus on the role of the market in addressing externality issues.  Detractors from Coase argue that his insights, that markets for externalities can exist only if there are no/low transaction costs, are not applicable to the “real world,” since transaction costs abound and, therefore, government intervention is necessary.  But this argument represents a misreading of Coase.  In a purely ideal world, there would be no transaction costs, but then no market would be necessary.  As Coase says in the above quote, it is in the world of transaction costs that the market is most useful!  The existence of transaction costs gives rise to firms and other means of human collaboration, which in turn reduce transaction costs, and increase the market exchange of individuals (see The Nature of the Firm (1937) for a more in-depth conversation on this point).

Expanding the idea of markets, firms, and transaction costs to environmental issues, we see the rise of “enviropreneurs” (to use the phrasing of PERC), that is people who seek out and find ways to mitigate these transaction costs in order to achieve desired environmental ends; in short, a market process of environmental concerns (for a detailed look at many different kinds of enviropreneurs, see Free Market Environmentalism for the Next Generation, especially Chapter 9).  The fact transaction costs exist is not a detriment to free market environmentalism, like the detractors of Coase argue, but rather what allows it to come about!

Like Coase (and Buchanan and many others) before me, I realize the market is not a panacea.  There may be conditions for government to get involved (namely where involvement by the firm or an individual are too costly).  But the work of Coase (and Alchian and Demsetz and Buchanan and Tullock and Anderson and many others) show us that the mere existence of an externality and transaction costs is not enough to justify intervention.

Economics as a Positive Science

Following a natural disaster, one can count on two things in the opinion pages and blogosphere: economists of all stripes decrying price-gouging legislation in a disaster and proponents calling economists immoral for questioning such legislation.

The conversation/disagreement between these two is a microcosm of a much larger discussion: the difference between the normative (subjective) and the positive (objective).

Economics is a positive science.  It deals with what is, not what ought to be.  When economists argue that price ceilings (like price-gouging legislation) cause shortages, that is a positive claim: it is a claim of what is.  This claim can be empirically tested, but it does not reflect the moral positions or suppositions of the economist.  In fact, the claim carries with it no moral implications whatsoever.  The claim price-gouging legislation causes shortages carries with it no more or less moral weight than the claim the sky is blue.

Conversely, morality is a normative science.  It deals with what ought to be, not what is.  When moralists argue that raising prices during a disaster is immoral, that is a normative claim: it is a claim of what ought (not) to be.  This claim cannot be empirically tested (although it can be tested to see if it falls into various moral criteria).  It reflects the belief structure of the person making the claim.  The claim raising prices during a disaster is bad carries with it no more or less empirical weight than the claim the sky is blue is good.

Allow me to elaborate, lest I give the mistaken impression that normative and positive sciences are opposed.  Normative and positive are not opposed; in fact, they compliment each other quite well.  Normative can prevent positive from becoming abusive (think, for example, our modern sensibilities against eugenic human breeding [normative] despite knowing certain traits are genetic [positive]).  But positive can also keep normative from being “pie in the sky,” by explaining how the world is.  For example, normative claims like “one should not kill his neighbor,” are all well and good, but the positive claim that “murder happens,” is important to know, too.  Knowing the two together brings us to the conclusion that police are needed for the few who do break the law.

To apply this reasoning to disasters, knowing price-gouging legislation makes the logistical system worse is important to know, as it can help inform better forms of aid and legislation.

In short, answering a positive claim with a normative claim will get us nowhere, but the two must be given, and understood, concurrently.

Price Gouging Legislation Means Fewer Resources for Search & Rescue

Police, like any resource, is scarce: there simply is not enough to satisfy every want and need.

Because of this simple fact, anti-price-gouging legislation has two perverse effects on a disaster.  The first, and the one economists tend to focus on, is what I discussed the other day, namely that price controls create shortages.  The other, as the title of this post would suggest, is even more of an immediate threat to life and limb.

If police resources are diverted toward price-gouging enforcement, then that means there are fewer police resources for search and rescue operations!  A cop who has to spend his time making sure merchants don’t charge too much is not spending his time looking for people, or preventing looting, or distributing goods.

Just your daily reminder: scarcity is a thing

A Smithian Look at Price-Gouging

As Hurricane Harvey hits Houston, Texas has invoked its price-gouging legislation, preventing prices from rising to meet the new levels of supply and demand.  As usual, lots of ink has been spilled by economists denouncing this legislation (for example, see here, here, and here).  On a recent post, Mark Perry asks: “It’s really not that complicated is it, to understand the adverse consequences of anti-price-gouging laws?”

Part of the issue is the price theory arguments against price-gouging are not complicated, but they are subtle.

I think the other issue is people take the positive analysis of economics and try to impute normative analysis onto it. That prices rise when demand rises/supply falls is neither good nor bad. It just is. Just like the sun rising in the East and setting in the West is neither good nor bad. It just is.

However, people will take this positive and try to make it normative. It is “bad” prices rise and people profit off of the suffering of others. Or it is “good” prices rise and lure in profit-seeking individuals and that increases supply.

These normative imputations get problematic because it is trying to answer a different question than the one originally posted. The question is not “how should people act when disaster strikes” (the normative) but rather “how to allocate needed resources to disaster areas” (the positive). Giving a normative answer to a positive question is neither helpful or insightful.

This is not to say that there is no room for the normative. I think that is an important aspect. Should people raise prices during disasters? Should there be discounts for those in absolute need? I think the answers to these two question is “yes.” I think Adam Smith’s “impartial spectator”  would be pleased to see prices rise in order to attract more goods/services to where they are needed, but also to see prices not rise (a discount) to those in absolute need. Indeed, the impartial spectator may frown if prices are “gouged” for those in the most need.

But does the disapproval of the impartial spectator, (“The heart of every impartial spectator rejects all fellow-feeling with the selfishness of his [the price-gouger’s, in this case] motives,” to use Smith’s words [The Theory of Moral Sentiments, page 78.3]), necessarily imply the need to anti-gouging laws? I’d argue “no.” Punitive legislation, Smith (and I) argue exists to serve justice:

“Resentment seems to have been given us by nature for defense, and for defense only.  It is the safeguard of justice and the security of innocence.  It prompts us to beat off the mischief which is attempted to be done to us, and to retaliate that which is already done; that the offender may be made to repent of his injustice, and that others, through fear of the like punishment, may be terrified from being guilty of the like offense.  It must be reserved therefore for these purposes, nor can the spectator ever go along with it when it is exerted for any other.  But the mere want of the beneficent virtues, though it may disappoint us of the good which might reasonably be expected, neither does, nor attempts to do, any mischief from which we may have occasion to defend ourselves (page 79.4).”

And the violation of justice is injury, that is: “it does real and positive hurt to some particular persons, from motives which are naturally disapproved of (page 79.5).” Since the price-gouger’s actions do no real and positive harm or a person, he cannot be punished: “To oblige him by force [ie, by legislation] to perform what in gratitude he ought to perform, and what every impartial spectator would approve of him performing, would, if possible, be still more improper than his neglecting him to perform it (page 78.3-79.3).”*

In short, the anti-gouging legislation both cause economic problems by creating shortages of much-needed supplies when they are already extremely scarce, but also invoke an injustice upon the society by punishing people, by inflicting harm on people, when no real and positive harm has been done.

*Nota bene: This conversation here revolves around price-gouging in general.  We could carve out all kinds of exceptions here that would allow for punitive legislation, but we are discussing the general case, not specifics.

Models, Monopsony, and Minimum Wage

At Cafe Hayek, Don Boudreaux has an excellent post on models and their usefulness in economics.  Don’s gist is as follows:

Anyone can devise a model to show almost anything.  And economics is filled with widely referenced models that are useless (or worse than useless).  The Keynesian Cross comes to mind.  So, too, the textbook model of so-called “perfect competition” (which, in addition to being a model in which almost everything resembling real-world competition is either squeezed out or appears as a monopolizing (!) tactic, isn’t even logically coherent – for in the model no room exists for any agent actually to change prices).

The value of an economic model is found in its ability to make the world more understandable.  Devising a model is no evidence that the named concepts in the model have anything in reality to correspond to them, or that the model is a useful analytical tool.

I have made similar points in the past, noting that the results from models are, well, model-dependent.

In short, the mere fact that a model can show that some preferred policy will increase/decrease economic efficiency doesn’t mean said model is of any analytical use.  Sure, the minimum wage in a monopsony may improve the situation, but that information does us no good if the market is not a monopsony.

But let’s build upon this idea.  Let’s assume, for the sake of argument, that a given market where a minimum wage is considered is indeed a monopsony.  As such, it is theoretically possible that minimum wage would be beneficial, that we would not see, over a given price range, a decline in employment.  The poor economist stops here.  He might even advocate for minimum wage at this point.  But, as Bastiat reminds us, the economist looks for not just the seen effects (ie, what the model says), but the unseen effects, too.  The good economist is prompted now to ask “is minimum wage the most cost-effective solution to the problem we are trying to address (in this case, low wages for workers)?”  Minimum wage may be an option here, but it may not be the most beneficial option!  There may be other options, other institutional arrangements, other agreements that can be reached that will create a better outcome!

Gordon Tullock and James Buchanan drive this point home in their 1962 book The Calculus of Consent.  The following is from page 61 of the Liberty Fund Edition of the book (original emphasis):

The most important implication that emerges from the [analytical] approach taken here [in this chapter] is the following: The existance of external effects of private behavior is neither a necessary nor a sufficient condition for an activity to be placed in the realm of collective choice.

While Tullock and Buchanan are discussing externalities here, we can easily generalize their comment to any form of collective action including minimum wage or other methods used to “improve” monopsonies:  The existence of a monopsony market resulting from private behavior is neither a necessary nor sufficient condition for a minimum wage to be imposed.  The burden of proof requires the good economist to demonstrate that any proposed solution is the best of all available options.  Otherwise, the result of the market process, even if less-than-ideal, may be the best choice.

It is easy to play around with models, and any given model may have any number of policy implications.  But the mere fact the model suggests Policy A would work doesn’t necessarily mean that Policy A is the best choice.  If the costs of imposing A are high, then it may likely end up being a net loss!

 

Unintended Consequences of Protectionism: The Jones Act and Highway Congestion

In 1920, the US government passed the Jones Act, an act requiring all sea shipping between US ports be done on ships that were built, crewed, flagged, and owned by Americans.  The act is a clearly protectionist measure designed to protect domestic shipping from foreign competition (although there is also a national defense argument for it).  The idea is that a cheaper foreign shipping company could not undercut US shippers on domestic trade routes.  If I were to ship something via ocean from Miami to Boston, I’d have to do it on US built, crewed, flagged, and owned ships.

The Jones Act, to the extent it is binding, raises the cost of ocean shipping in the US (if this were not the case, say it were already cheaper to ship on US ships than foreign ones, then the Jones Act would not be binding).  When the relative price of something rises, it encourages the use of substitutes.  The main substitutes for domestic shipping are trucking and railroad (and air to a lesser extent).  With the rise of ocean shipping costs from the Jones Act, transporters would turn to trucking and rail.  Furthermore, since trucks take up a lot of room on the highways and freeways, it is likely the marginal increase in trucking from the Jones Act increases congestion on the highways.  In short, the unintentional result of the Jones Act is to increase traffic congestion (and, potentially, traffic accidents as well).

Some interesting thoughts for further research:

  1. Do trucking and rail companies lobby in support of the Jones Act (bootlegger and Baptist)?
  2. Has the Jones Act had a measurable impact on the level of traffic (this is an empirical question that would be extremely hard to answer because of the age of the Act)?

Immigration and Institutions: A Response to Jonny Anomaly

Writing at Quillette, Dr. Jonny Anomaly (yes, that’s his real name) discusses immigration, institutions, and why some immigration restrictions may be necessary.  It’s an interesting article, although I find his rationale for immigration restrictions rather weak.

Dr. Anomaly writes:

For one thing, the social norms and political institutions that promote prosperity are often quite fragile, as evidenced by recent events in Turkey, and the failure of constitutional democracy to take hold in Iraq after American attempts to replace dictatorship and tribalism with a secular liberal order.

I disagree with his interpretation of the evidence here.  The two examples he provides are where a liberal order was forced upon the area, rather than developed naturally.  Institutions, when imposed, do tend to be fragile.  This is seen in the work of many great developmental economists work (for example, see Doing Bad by Doing Good by Chris Coyne or The Tyranny of Experts by William Easterly).  However, where liberal institutions develop naturally, they tend to be highly robust.  The United States is an excellent example where despite many shocks to the system over the approximately 250 years of our existence, we remain a highly liberal country.  Shocks have included invasion, mass immigration (by both intelligent and less intelligent people), famine, drought, civil war, terrorism, etc.  The US is not ideally liberal, and there have been missteps, but the whole thing hasn’t collapsed the way it would have if institutions were inherently fragile.

He goes on to say:

Many supporters of open borders fail to distinguish between different qualities of immigrants. They assume that if a high level of immigration has benefitted some countries in particular eras, such as the United States, Canada, and Australia in the 19th and 20th centuries, then it is simply the quantity of migrants, rather than the composition of migrants, that caused prosperity in these nations. But this is a fallacious inference that depends on the assumption that all people are just as likely to promote the welfare of a country regardless of their values, skills, or traits.

In his recent book, Garrett Jones argues that a nation’s wealth and welfare depend crucially on the qualities of its citizens, including IQ, conscientiousness, and the ability to delay gratification. These personality traits are heritable, are (according to Jones) positively correlated with prosperity, and (according to criminologists) negatively correlated with crime.

The problem with this argument is that it doesn’t appear, at least prima facie, to be correct.  The mass immigration of the 19th and 20th Centuries was not of high-skilled immigrants.  Rather the opposite, really: they tended to be the dregs of European society.  And yet, America prospered.  Those who attempted to turn America toward Socialist institutions were not uneducated immigrants, but rather highly educated native WASPs.

This is not to discount the importance of intelligence in economic activity; quite the opposite.  But rather, an economy is made up of all kinds of goods: high quality, low quality and everything in between.  A dynamic economy allows all resources to find a niche, including labor.

There’s more I could say on this article, and maybe I will down the line, but I want to finish off with this: the evidence on immigration’s impact on the economy is far from crystal clear.  There are copious amounts of evidence pointing in both directions.  Given this ambiguity, I argue a liberal society demands that freedom is preserved and that the action which would restrict freedom (in this case, restricting freedom of commerce of the citizens of the society) must be shunned until evidence beyond a reasonable doubt is presented.

 

Everyday Economics: Bioshock Edition

On my recent trek between Virginia and Massachusetts (and back), I listened to an audio version of the book Bioshock: Rapture by John Shirley (If you’re looking for something light to take your mind off of things, this is a good book).  The book details the rise and fall of Rapture, a massive underwater city built by Andrew Ryan (a not so subtle jab at Ayn Rand) to escape the “parasitic” governments of the world and build a society dedicated to freedom and free markets.  While the initial goal of Rapture may have been freedom and free markets, as the novel (and the video game that the novel is based on) details, Rapture becomes a totalitarian police state with an extremely wealthy (and often sadistic) upper class, and extremely poor low class, and no one in between.  Some see Bioshock as a refutation of Randian philosophy, however, I will not address that here as I am no expert in Ayn Rand (for an excellent discussion, see The Value of Art in Bioshock: Ayn Rand, Emotion, and Choice by Jason Rose).  I’ll leave that to people far smarter than I.  Rather, I want to address the economic situation of Rapture and discuss, briefly, how that contributed to the downfall.

A few quick disclaimers before I begin:

  1. As far as I know, Bioshock: Rapture is not canonical.  However, it is the only detailed source I can find thus far on the days of Rapture that take place before the video game (which is canon) so I will operate on the assumption that my source material is canonical knowing full well everything I write here could become completely worthless insofar as discussing canonical information (the lessons gleaned from this book are still important, however).
  2. Nothing in this essay should be taken as implying the rise or fall of Rapture is purely economic.  There are many other factors involved (social, political, medical, psychological, etc).  I skip or gloss over these not because I think they are unimportant (quite the opposite, really), but because I simply lack the expertise to discuss them with any confidence.
  3. I will be avoiding using direct quotes in this version of this essay.  The reason for this is simple: I have the audio book, not the book itself.  I can’t easily do verbatim quotes and attribute them to proper pages for citations.  Therefore, the reader should be aware that I am doing this partly out of memory (although I did scribble some notes) and further the reader should assume that whenever I describe what’s happening in Rapture, that is a reference to the work of Mr. Shirley.  The only original material will be my analysis.  Any inaccuracies, either to details or analysis, belong to me and me alone.

The short version of what follows: Rapture cannot be classified in any meaningful sense as a “free market.” It suffers from several deficiencies that prevent us from labeling Rapture as a free market: lack of property rights, lack of free trade (autarky), lack of labor mobility (autarky in the labor market), rejection of altruism, widespread and institutionalized fraud (this issue is speculative based off of interviews with characters within the book but not substantiated by details), and censorship (indirect at first, but more direct later).  In Andrew Ryan’s Rapture, “free market” and “laissez-faire” were not much more than dishonored buzzwords.  It can best be described, in the words of James Buchanan, as “moral anarchy,” (see Moral Science and Moral Order, especially page 190 and Limits of Liberty, especially Chapter 7).  These factors, coupled with other psychological, social, and other factors, lead to the decline, civil war, and eventual fall of Rapture.  Continue reading

Mistakes to Avoid When Discussing Health Care

Noah Smith has an interesting piece on health care at Bloomberg.  The piece is worth a read, although there are some head-scratchers in there.  Smith’s big conclusion is this:

In other words, don’t believe the argument that the cost difference between the U.S. and other countries is the inevitable price of a more innovative health-care system. Americans really are being greatly overcharged for their care. For whatever reason, health seems to be one industry where government does things more cheaply than the private sector.

There’s a problem with this conclusion, namely that it uses biased data to support the claim.  Health care is cheaper in other countries because the price system is rigged: universal health care keeps prices down by refusing to let them rise.  So, one cannot compare prices in a system where prices are allowed to fluctuate vs one where prices are determined by government diktat.

Prices are a signal.  They provide us valuable information about the relative scarcity of commodities.  When prices are allowed to adjust, they provide accurate information.  When they are not, they provide poor information, and lead to worse outcomes.

It is also important to note that monetary costs are not the only costs involved.  They are one cost, sure, but there are many other kinds of costs: wait times, quality, quantity supplied in general, that sort of thing.  Monetary prices can/will adjust for these different factors (for example, a luxury higher quality car may sell for more than a lower quality car), but if prices cannot adjust, these other costs will rise; there ain’t no such thing as a free lunch, after all.

Let’s take, for example, Canada.  In the US, monetary costs for doctor visits may be higher, but in Canada, wait times are much longer (in the US, it’s approximately 24 days to see a doctor.  In Canada, it’s 20 weeks).  This is a real cost.  Quality of care is another cost.  In Britain, for example, you’re about 45% more likely to die in a hospital than the US.  This is a real cost.

It’s admirable to want to compare costs and benefits among two systems like Smith does, but he makes two major mistakes when doing so: 1) he compares price signals from a relatively free market to price signals that are artificially low, thus biasing his estimate (this is a point Bob Higgs has made repeatedly when discussing GDP), and 2) does not do a full accounting of the costs.  Smith may be right that health care is an area where government can provide cheaper than the private sector, but the evidence he puts forth for his claim is weak.