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Blackboard Economics and the Coase Theorem

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.

7 thoughts on “Blackboard Economics and the Coase Theorem”

  1. Dear Christopher,  I always enjoy reading your Pretense Papers.  There are two things I would like you to consider: 1) Should not an essential question in economic policy decisions be, “Who or what organization is best suited to solve this?”   The left always says it is government, but I would say the government rarely solves it best, or most efficiently. 2)What is your opinion on “Pascal’s Wager” and where does God fit into our lives?


    Keep up the good work.



    1. Thanks for reading! Glad you get some value out of it.

      1) Yes this is exactly the question that needs to be asked. Identifying a “market failure” is not the same as justifying a government solution.

      2) Pascal’s wager is tricky. I tend to think that even if it is logically correct, it is impossible to make yourself believe something you don’t just because you want the reward. So it’s a great argument for people that already believe to keep believing, but doesn’t do much to convince a skeptic. But even beyond that there’s a lot of problems with the argument. This page gives a good discussion:

  2. You say that Coase’s approach is less elegant. Is there a single exemplary paper in the literature that takes the Coasian approach to answering policy questions? Would be curious to read that.

    Also, I have always thought that there is a deep incoherence in the Coase Theorem which has to do with tenuous semantic differences between government and market. One could imagine how, starting from the state of nature, people would form non-governmental organizations to administer Coasian agreements in a highly decentralized manner. For example, neighborhood committees to enforce neighborhood covenants. Two things lead to government. First, people seek the ability to make binding contracts, which requires a legal authority. Second, they seek to minimize redundancies across different organizations, which requires centralization (for example, if every neighborhood covenant bans pollution, it could lower transaction costs to empower a central authority to measure and tax all pollution).

    Is it possible that government is the market’s chosen solution? To prove that this is the case, would the market need to continuously signal its support? Or is it possible that the market choose’s government as a way to pre-commit to virtuous choices that are impossible, or expensive, for the market to uphold ex-post? It bears some similarities to Social Contract theory, I guess.

    1. I’m not sure a single paper exemplifies the Coasian approach, but I would say most things by Alchian and Demsetz tend to fit the Coasian style of economics. Buchanan is also very Coasian. In general anything that deals with institutions rather than just taking the market structure as given would fall into this category I think. Here’s a kind of nice summary of the differences between Coase and the rest of the Chicago school:

      On your other point I don’t think that’s an incoherence, I think that’s exactly the kind of question Coase considered interesting. What is the best institutional environment to solve economic problems? His theory of the firm is essentially what you are saying. People came together and realized that transaction costs were too high for everyone to coordinate production activities so they developed some institution (the firm) to reduce those costs.

      I’ve thought a lot about your last question especially as it relates to Hayek’s idea of spontaneous order. If government was simply the natural evolution of people trying to solve problems that require collective action, is it really a market intervention at all? It is definitely possible that government is the best way to solve certain problems. The issue is in deciding which ones and who gets to decide which ones. If 51% of people believe government can solve some kind of problem, is it justifiable for them to force the rest to follow their chosen policy?

      Buchanan, for example, would say that the only justifiable actions would be ones everybody (or at least a very strong super majority) agrees to. When one side believes very strongly about one issue, they should make concessions on other issues to those that don’t care as much to form some package of laws that everybody would prefer to the current set of laws. I’ve only read a bit of Buchanan, and he has a whole book on this so I don’t want to pretend to be an expert, but I would say that this kind of thinking is exactly what Coase desired from the economics profession.


  3. Interesting response, but you have left unanswered the difficult question! What constitutes evidence that the market chooses a particular institution? Does it require continuous approval? If so, then this rules out many potentially powerful institutional structures which enable commitment, by forcing people to do things that they no longer want to do.

    A particularly powerful subset of these are those in which one can make commitments on behalf of one’s own children or grandchildren, etc. At which point things become quite murky.

    1. You’re right and that’s because I don’t really have a good answer! I think continuous approval is for sure too strong. Even simple contracts only work because they force people to commit. If people could back out of a contract at any time it wouldn’t be very effective.

      I suppose one check on an institution would be whether there is any market force constraining its policies. For example, if a firm follows some unpopular policies and people stop buying its product it will eventually die. A homeowner’s community that has bad policies will not be able to attract people to move in. You could argue that elections serve the same purpose as a profit and loss system and in that sense government is also market constrained, but it seems like there is some distinction there. I’ll have to think more about this.

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