Introductory economics is often criticized for providing an overly idealized version of the world. The price system functions perfectly, markets are competitive, and information is freely available. A well known result from microeconomics, the First Welfare Theorem, says that under certain assumptions, a competitive equilibrium is Pareto efficient. Government intervention in the market cannot make anybody better off without making somebody else worse off. Critics of neoclassical economics point out that the conditions under which this result holds are incredibly unrealistic. As soon as those assumptions are relaxed, the door opens for government to improve upon the market.
The classic example of these kinds of “market failure” are externalities like pollution where the total cost to society is more than the private cost faced by the producer. Our modern treatment of such problems in introductory classes is essentially unchanged from Pigou’s analysis of the problem almost 100 years ago in The Economics of Welfare. He outlined a simple solution to the problem of externalities. If producers impose costs (like pollution or noise) on others through their production activities, we can simply tax them to force them to internalize the social cost of their actions. Unlike standard taxes that introduce inefficiencies to a market economy, these “Pigovian taxes” actually improve efficiency.
Much of economics tends to follow a similar pattern. We begin with the perfect world, the benchmark economy of full information and a perfectly competitive economy. We then show that relaxing some of these assumptions, putting in asymmetric information, or monopoly power, or externalities, can mess up this perfect benchmark. Finally, we outline how government can solve these problems. The left loves to complain about how we too often stop at step 1 (especially in intro courses) and forget about all the problems of markets that government really needs to fix.
I also take issue with this kind of economics, but for a different reason. To understand my view, we need to take a look at an incredibly famous, but sometimes misunderstood paper, called “The Problem of Social Cost” by Ronald Coase.
Coase begins his paper by responding to Pigou. He shows, in several numerical examples, that Pigovian taxes or other government solutions are entirely unnecessary if the price system functions costlessly. This argument has been summarized in what is now known as “The Coase Theorem.” Private actors will always find the most efficient solution as long as transaction costs are not too high. Although perhaps unintuitive at first, Coase’s intuition is actually quite simple. If bargaining is costless, there is no reason why private agents wouldn’t be able to work out a solution that is beneficial for everyone. I recommend reading the article for many numerical examples of how this kind of bargaining could work to produce an outcome just as good as that produced by the Pigovian solution.
Unfortunately, most discussions of Coase tend to stop there. Supporters of free markets use Coase to argue against any form of government intervention. Detractors respond that of course transaction costs are not zero and therefore Pigovian solutions are still needed. Both sides miss Coase’s broader point. As Deirdre McCloskey puts it, “Something like a dozen people in the world understand that the “Coase” theorem is not the Coase theorem…One of this select few is Ronald Coase himself so I expect we blessed few are right.”
Here’s what I think is a better “Coase theorem” (from Coase’s paper): “All solutions have costs and there is no reason to suppose that government regulation is called for simply because the problem is not well handled by the market or the firm. Satisfactory views on policy can only come from a patient study of how, in practice, the market, firms and governments handle the problem of harmful effects”
Coase’s use of a world without transaction costs was not an attempt to make a statement about the real world, but rather to demonstrate the emptiness of doing analysis in a world without transaction costs. His article serves a deeper purpose than simply a criticism of Pigou’s treatment of externalities. It more importantly acts as a response to what Coase called “blackboard economics.” He thought the exercise of comparing “a state of laissez-faire and some kind of ideal world” to be entirely pointless. Economics without some consideration of the set of institutions, of the laws and the legal system that govern agents actions, is just an analysis of some imaginary world that will never exist. He wanted to bring economics back to reality.
For Coase, “a better approach would seem to be to start our analysis with a situation approximating that which actually exists, to examine the effects
of a proposed policy change and to attempt to decide whether the new situation would be, in total, better or worse than the original one. In this way, conclusions for policy would have some relevance to the actual situation.”
Shifting lines on a blackboard makes for nice undergraduate exercises. It is less useful for real policy analysis. Coase’s approach is less elegant. Blackboard economics gives nice simple answers to a wide range of policy questions. Unfortunately those answers don’t always tell us much about the much more complicated questions of the real world.
Coase’s argument against blackboard economics is essentially the same as Hayek’s criticisms of economic analysis. If we assume away all the hard stuff like who sets prices and who possesses knowledge of relevant economic information then of course we can come up with solutions to all sorts of economic problems. But those answers only hold in a world that looks nothing like our own and more importantly in a world where those policy choices are completely unnecessary in the first place. To get any kind of policy answers that our actually relevant for the world we actually live in, we occasionally need to ask these much harder questions about institutions and the economic environment in which economic actions take place.