S. Cheung*
Sixtyyears have
lapsed since Ronald Coase published “The Problem of Social Cost,”
(fn1)and I am delighted to see Steven G. Medema’s piece entitled
“The Coase Theoremat Sixty.” (fn2)
This paper runs 125pages
in fine prints, citing a total of 856 references.
A
mind-boggling endeavor, and it reminds meof what George Stigler
said of Piero Sraffa’s work on David Ricardo: “Here is atask that
needs not be performed again.” (fn3)
Medemaaside,
however, there are some errors in circulation on the dates of
events,and there are some facts distorted by rumors.
As
myself an old man now, once befriended by Coase and his associates,
Ido possess first-hand information on how the wonderful ideas of
Coase cameabout.
In doing so I should also pointout a major
fallacy in the Coase Theorem.
Not meant to belittle that
theorem, of course. The Coase Theorem will godown in history as
certainly as Say’s Law.
The term“Coase
Theorem” was coined by George J. Stigler.
He told me in
person his view that the CoaseTheorem was the single most important
idea in 20th centuryeconomics.
It would be difficult to
arguewith George on this: he was the leading historian of economic
thought of thatentire century.
Section I:
The
Legendary Debate of the Century
First about dates. “The Problem of SocialCost” appeared in
the 1960 issue of the
Journal of Law and
Economics,but that issue did not appear until the early summer
of 1961.
On the other hand, the Coase Theorem did notappear
in that “social cost” paper—in my view, the so-called
“InvariantTheorem” attributed to the 1960 “social cost” paper is
not a theorem.
Rather, the theorem was first enunciated
in1959, in a more beautiful paper by Coase on “The Federal
CommunicationsCommission
.” (fn4) In that 1959 piece there is
one sentence that says: “Thedelineation of rights is an essential
prelude to market transactions.”
This statement is the
Coase Theorem in itscomplete form.
Theintroduction of
transaction costs in the following 1960 piece, thoughimportant,
only supports the working of the theorem stated in 1959.
However, as will be seen later in this paper,it is in the
introduction of transaction costs that Coase committed a
seriouserror.
There wereconsiderable confusions
on the exact issue which led to the legendary debate inAaron
Director’s home in the spring of 1960.
What is known for
certain is that when the FCC paper was submitted toAaron Director
at the University of Chicago, a galaxy of stars at Chicagoopposed
to a key point Coase made. Exactly what that point was, is a
question somefuture historians of economic thought would want to
know.
Coase told me it had something to do with aparking
lot.
His strongest critic atthat time, Reuben Kessel, also
told me it was about a parking lot.
Reuben passed away in
1975, and now I findtwo places in the FCC paper where the phrase
“parking lot” is mentioned.
I put both of them below for
the readers toconsider.
On page 14of the FCC paper, Coase
wrote:
If one person could use a piece of land for growing
a crop,
and then another person could come along and build a
house
on the land used for the crop, and then another
could come
along, tear down the house, and use the space as a
parking lot,
it would no doubt be accurate to describe the
resulting situation
as chaos.
But it would be wrongto blame this
on private enterprise
and the competitive system.
Aprivate-enterprise system cannot
function properly unless property rights are created
in resources,
and, when this is done, someone wishing to use a
resource has to
pay the owner to obtain it.
Chaosdisappears;
and so does the
government except that a legal system to
define property rights
and to arbitrate disputes is, of course,
necessary.
But there is
certainly no need for the
kind of regulation which we now find
in the American radio and
television industry.
Then onpage 25:
It is clear that, if
signals are transmitted simultaneously on a given
frequency by several
people,the signals would interfere with each
other and would make
reception of the messages transmitted by
any one person
difficult if not impossible.
The use of a piece of
land simultaneously
for growingwheat and as a parking lot would
produce similar
results.
As wehave seen in an earlier section, the
way this situation
is avoided is to create property rights (rights, that
is, to
exclusive use) in land.
The creation of similar rights in
the use
of
frequencies would enable the problem to be solved in the same
way in the
radio industry.
We today would not see anything
wrong with thearguments in the two paragraphs above, but in 1959
the understanding of thesocial cost issue was
relatively weak even at Chicago: they were still onthe level with
Pigou. (fn5) It was on the issue of the radio frequencyinterference
and the parking lot interference
that Aaron Director urged
Coase, who was then at the University ofVirginia, to come to
Chicago to clarify his position.
Coase responded that he
would not give a lecturebut would be glad to discuss the issue with
a selected group of economists.
Thediscussion that turned out to be
a heated debate is legendary, and no doubtwill be recorded in the
future history of economic thought.
There now exist a
number of different versionsof that debate, including one of over
100
participants.
Myversion must be accurate, because among the
10 participants
I was acquainted with eight of them.
The ten participants
were Martin Bailey,Milton Friedman, Arnold Harberger, Reuben
Kessel, Gregg Lewis, John McGee,
Lloyd Mints, George Stigler, Ronald Coase, and AaronDirector.
Afterdinner, in
Aaron’s home, Ronald opened with the question: when a
factorypollutes the residents nearby, should this factory be held
liable for thedamage?
Or should the residents pay
thefactory owner to reduce the pollution?
The proper answer,
as we know it today, is that on efficiency grounds itdoes not
matter, so long as the right to pollute or not to pollute is
clearlydelineated so that the market will work its magic.
McGee toldme that during the debate
Harberger was moving furniture around in Director’shouse to form a
fence to check the movements of the cattle, yet Al did notrecall
himself doing so.
There wererumors that the Coase Theorem
was first stated by Milton Friedman, who waspresent in that
legendary debate, and not by Coase himself.
Yet when I
pressed Milton on that rumor, hedenied the glory, saying it all
belongs to Coase.
Coase, however, told me that after more
thantwo hours of debate, he was a bit doubtful of his own thinking,
although hestill believed he was right: it was the thirty minutes
of Friedman summarizingthe main points of his arguments in that
evening, with such great clarity, thathe knew he was home free.
Stigler’sversion supports Coase’s version. He told me that
after more than two hours ofdebate the issue was undecided. Milton
stood up and opened fire, and thebullets hit everybody except
Coase.
Harry Johnson, who was in London at that time, sent a
cable to theEconomics Department at Chicago the next day, saying
that he heard anEnglishman has discovered a new continent again.
Reuben Kessel, who had been the strongestopponent to
Coase’s argument, told me in 1972 that we would have to go all
theway back to Adam Smith to find an economist of Coase’s
level.
Afterthis legendary
debate and as the participants were leaving Director’s home,McGee
recalled, they were mumbling to each other that they had just
witnessedintellectual history.
Aaron Director,who was
editor of the
Journal of Law and Economics at
that time, told metwo matters of interest.
First, Coase
toldme he was rushing to submit the manuscript to Aaron because the
deadline ofsubmission was already passed, so he wrote and submitted
the 1960 paper sectionby section.
But Aaron told me he
could notcare less when would Coase complete that paper:
his
journal could wait for years if needed be.
Second, knowing
the
Journal of Law and Economicspaid authors at that
time, I asked Aaron how much his journal paid Coase forthat 1960
piece, he replied that the University of Chicago regulated the
feespaid to authors by the page, otherwise he would give Coase all
the money at hisdisposal.
Knowing Aaron, my guess isthat he
would not mind closing his precious journal down after Coase’s
1960paper.
I must takepride to add here that
Aaron liked my works!
In the spring of 1969 I presented my
paper on the choice of contracts inStigler’s workshop.
A
day later I alonewas having lunch at the Quadrangle Club at
Chicago, I saw Aaron walking slowlytowards me.
I politely
stood up, and Aaronsaid, “The paper you presented yesterday is the
best I have read in severalyears.”
Then he turned and
walkedaway.
I was still standing, and tearscame down from
my eyes.
And when aftersome 12 yeas of research I finally
published “The Contractual Nature of theFirm” (fn6) in 1983, Aaron
had someone brought me a simple message: After Steve’spaper, the
quarrel on what a firm is exists no more.
Section II:
The Unfortunate Neglect of
Frank Knight
It is unfortunate that in Coase’s
1959 paperon the FCC and his 1960 paper on social cost, no
reference is made on amagnificent 1924 paper, entitled “Some
Fallacis in the Interpretation of SocialCost,” written by Frank
Knight. (fn7) Knight made exactly the same point in 1924as Coase
did in 1959 and 1960.
Coasewent to the University of Chicago
in 1931, from London on a travellingscholarship, and audited
Knight’s lectures.
He must be familiar with Knight’s classic
work.
Knight’s1924 paper
rebuts Pigou’s work on social cost. (fn8) He took issue on
Pigou’sfamous example of two roads.
Two roads,both going
from Town A to Town B, one road is narrow but well-paved, and
theother is broad but poorly surfaced. Pigou argued that the
congestion of cars willoccur on the good road, with the drivers
slowing each other down, hence asocial cost problem exists, and
this problem could be resolved if a tax isimposed on the use of the
good road, while those using the broad but poor road,though with
more cars but still with no congestion, are not harmed.
Hence a tax imposed by the government for theuse of the good road
will reduce the divergence between private and socialcosts.
Thefollowing
comment by Knight on this two-road example is profoundly
brilliant,which in my view is a Coase Theorem of the 1924 version.
Knightwrote:
Professor Pigou’slogic in regard to the
roads is, as logic,
quiteunexceptionable.
It weakness
is onefrequently
met with in economictheorizing, namely that
the
assumptions divergein essential respects
from the facts
of real economicsituations.
The
most essential featureof
competitive conditions isreversed, the
feature namely, of
the privateownership of the factors practically
significant
for production.
If the roads are assumed to
be subject to
private appropriationand exploitation, precisely the
ideal
situation whichwould be established by the
imaginary tax
will be broughtabout through the operation of
ordinary
economic motives.
Yes, thisis the
1924 version of the Coase Theorem, 36 years before what was
enunciated by R.H. Coase.
To
myknowledge, Pigou never replied to Knight’s challenge, except his
famoustwo-road example was deleted in the later edition of
The Economics ofWelfare.
It
isimportant--very important-- to note that by “assumptions” Frank
Knight meantthe constraints assumed!
And this is
thespotlight guiding literally all my own research.
I was
delighted that in an earlier write-upof Frank Knight in
Wikipedia, my name was one among five
economistsinfluenced by Knight, but then was disappointed that in a
later version onKnight, the names were changed.
I wish to note that in December 1968, in Bob Mundell’slavish
cocktail party, I had the honor of meeting Knight and told him in
personhow much I adored him and learned from his 1924 paper.
He looked at me for a long moment, and said,“That was a
long time ago!”
Section III:
OceanFishery and the Dissipation of Rent
Another unfortunate
omission of Knight’spathbreaking work of 1924 is found in yet
another important paper, the one onocean fishery as a common
property resource.
This beautiful piece, written by H. Scott
Gordon in 1954, made noreference to Knight, but the geometric
diagrams Gordon used were essentially Knight’sdiagrams, as tilted
mirror images and relabeling the axes. (fn 9) What Knightdrew to
describe Pigou’s two roads now becomes two fishing grounds in
Gordon’spaper.
Theimportant--very
important--conclusions in Gordon’s insightful work is that theocean
rent that may be captured in fishing is absorbed into the cost of
fishinglabor and therefore is dissipated under competition, because
the ocean fishingground is not privately owned.
To
myknowledge, the term “dissipation of rent,” which I use often, was
first coinedby Gordon.
In my view, the frequent useof this
concept of rent dissipation is one distinguishing feature of what
laterbecame known as the Washington School of Economics. (fn
10)
However,Gordon’s
analysis of the dissipation of rent in ocean fishery is flawed.
As I pointed out in my 1970 paper on thestructure of a
contract, the complete dissipation of rent in ocean fisheryrequires
the number of competing fishing boats be approaching infinity.
I reached this interesting result byextending Cournot’s
duopoly analysis while allowing free entry with homogeneousfishing
inputs. That is, even if the ocean is under common ownership so
that nocompeting fishing boat has the right to exclude other
entrants, some ocean rentwill be captured by each fishing-boat
owner so long as the number of fishingboats is in some way
restrained.
This ismy explanation why unions of various
types are so commonly observed in oceanfishery!
In fact, my
analysis says thatthe more restrictive it is on the number of
fishing boats, the more the oceanrent will be captured by each of
the boat owners.
Section IV:
A Key Error in the Coase Theorem
Let menow turn to
what in my view is a serious error in the Coase Theorem.
I
take issue with a key statement he made atthe beginning of Section
IV of his 1960 paper, when he stated his analysis isbased on “the
pricing system is assumed to work smoothly (that is,costlessly).”
This is the notedassumption of zero transaction cost and
the functioning of the market.
However, as pointed out in
my work
WillChina Go Capitalist?,
published
in1982 (fn 11), I wrote that if transaction costs were truly zero
there would beno market:
If all transactioncosts, broadly defined, were
truly zero,
it would have to beaccepted that consumer
preferences
would be revealed withoutcost.
Auctioneers
and monitors
would provide freeall the services of gathering and
collating
information; workersand other factors of production
would
be directed freelyto produce in perfect accord
with
consumer preferences;and each consumer would
receive
goods and servicesin conformity with his
preferences.
The
total income received byeach worker (consumer),
as
determined costlesslyby an arbitrator, would equal
his
marginal productivityplus a share of the rents of all
resources
according to any of a numberof criteria costlessly agreed
upon.
In other words,production and consumption activities can
in
principle be carriedout without a market, to produce the
same
result as thoughcostless markets were in operation.
This viewis
important, and Kenneth Arrow immediately agreed with me when he
read it.
Coase also agreed with me a littlelater.
However, the full implications ofthis view took me nearly 25 years
to obtain.
Section V:
TheTheorem of Transaction Costs Substitution
The greatpuzzle is that there are
in fact markets in the real world, and by our dailyobservations
there are numerous types of transaction costs associated with
thesemarkets.
If all transaction costs weretruly zero there
would be no market, then it makes no sense to say that marketsexist
because of the presence of transaction costs.
Why do
markets exist after all?
Myjourney to solve
this major puzzle involved several steps.
First, different
types of transaction costsoften cannot be logically separated, as a
toll collector at the entrance of ahighway performs both the
functions of collecting tolls and policing againstintruders.
Second, under thisinseparable rule and pushing this rule to
the limit, transaction costs mustinclude all those costs that
cannot be conceived to exist in a one-person orRobinson Crusoe
economy. On this point George Stigler agreed, and it was
laterelaborated in my paper entitled “The Transaction Costs
Paradigm”. (fn12)
Third,the
dissipation of rent is a cost, and because this dissipation can
only be theresult of competition, it cannot be conceived to exist
in a one-maneconomy.
Therefore, rent dissipation
istransaction cost.
For example, if theprice of a product
is restricted by control to below the market price,customers would
have to stand in line for, say, half an hour for a purchase,the
value of standing time must be added to the price of the product to
thebuyer to obtain its true value.
Hencethe value of the
product reduced is a dissipation of rent.
Fourth—and this the
key--
of the numerous criteria that may be used todetermine
winners or losers under competition in society, only the market
priceentails no dissipation of rent. This isbecause in a
free market one has to produce something before he can offer
toexchange for something else.
Theratio of that
exchange is the market price, and because one has to
producesomething to participate in this competition game, there is
no dissipation ofrent.
Hencecomes a
beautiful “Theorem of Transaction Costs Substitution”:
In
order toreduce rent dissipation under competition in a society, all
the transaction costsincurred in the market—lawyers, bankers,
policemen, middlemen, etc.— are meantto support the use of the one
single criterion of determining winners whichentails no rent
dissipation, namely, the market price! In other words,
the transaction costsincurred in the market are meant to substitute
or reduce the dissipation ofrent—another type of transaction
costs—which must arise when the market price isnot used.
The ideathat the
market price is the
only criterion of
determining winners andlosers that entails no dissipation of rent
was known to me when I was agraduate student, and an elaborate
theoretic treatment of the subject is seenin my piece on price
control, published in 1974. (fn 13) However, putting otherelements
together to obtain the above Theorem of Transaction Costs
Substitutiontook a long time.
There are numerousother
important implications associated with this theorem, because the
choiceamong different contracts necessarily entails transaction
costs substitution(fn 14).
However, if confined to
thesubstitution between the costs of using the market price and the
dissipation ofrent, the theorem is relatively simple and straight
forward.
In my view, this latter substitution is atthe core
of the theorem of transaction costs substitution which I
propoundhere.
In
1979, when China was just talking aboutopening up, I published an
article in the Chinese language, bearing the title “OneThousand
Rules, Ten Thousand Rules, in Economics There is Only One Rule.”
(fn 15)This piece forcefully argues that of the numerous rules that
may be used toallocate resources under competition, nearly all
entail rent dissipation.
All except one—the market
price—which entailsno rent dissipation.
Some friends toldme
that that article was widely circulated in Beijing, leading to
complaintsthat the government turned to charge prices for
everything.
It was not easyfor me to convince
my Beijing friends, however, that private property rightsare
essential for the emergence of markets and the use of market
prices.
It is at this critical point that Coase’sidea of
clear delineation of rights works magic. The Chinese culture
isallergic to the word “private”, but clear delineation of rights
they were eagerto accept.
This is the central
contributionof Coase’s works on the economic transformation of
China.
It isinteresting to note here that
in my 1981 pamphlet bearing the title
WillChina Go
Capitalist?, which correctly predicted that China will reform
tobecome a market economy, the underlying elements of an implicit
theoreticstructure is essentially the same as the Theorem of
Transaction CostsSubstitution which I discuss here.
Ittook
more than 30 years to put the elements together to form an
integratedtheorem.
Section VI:
Episodes toRemember
Inclosing, I would like to
recall a fond memory in my last meeting with Coase.
It was in December,1990 when Ronald was awarded theNobel Prize.
Because that was the 90thanniversary of that prize, all the
living Nobel laureates were invited toStockholm for a massive
gathering.
Mywife and I were also invited to attend this
gathering.
The reason is that in the evening before
thePrize was awarded, there was a dinner party for all Nobel
laureates ineconomics, and I as the only non-winner was asked to
give a talk at thatdinner, on behalf of Coase, because Ronald had
to rest to prepare for theexcitement coming the next day.
Two economistsgave talks during that dinner party, Kenneth Arrow
and I myself.
Ronald, Marian,Milton, Rose, my
wife and myself were together for several days.
Two days
before the award ceremony, Ronalddelivered his Nobel Lecture.
During thatlecture, my wife and I were arranged to sit next
to Rose and Milton.
It was a huge hall, filled with people,
and athunderous standing applause sounded when Ronald was slowly
walking down theaisle towards the podium.
We all stoodup,
and Milton was standing next to me.
I whispered to Milton:
“Do you think this guy deserve this prize?”
He replied:”
You mean Ronald? He should havewon it a long time ago!”
Ronald hada deep feeling for China
ever since he was a boy, but had never visitedChina.
In
2013, a few months beforeRonald passed away, he was to travel to
China to see me.
Everything was arranged.
His
expired passport was renewed, and my wifereserved a hotel suite
with a nice view for him and his helper.
He was to join us
in Shanghai on October 1,the beginning of a ten-day holiday. I had
arranged a team of doctors to standby just in case medical
assistance was needed.
I had also alerted several
universities in that region for Ronald tovisit.
I wanted
Ronald to know howunique a hero he was in the eyes of millions of
Chinese youths.
China owed this man for his ideas, and
Iwanted Ronald to see the gratitude with his own eyes.
But It wasnot to be.
Ronald
passed away onSeptember 2, 2013, at the age of 102.
Footnote References
*Professoremeritus,
University of Hong Kong. The ideas contained in this paper are
takenfrom Section IV, Chapter 2, Book V of a five-volume treatise
entitled
EconomicExplanation, written in the Chinese
language.
In the
preparation of this paper I
was assisted by Shihan Shen, Yan Zhou, NingWang, and Gary
Shiu.
1.
Coase, Ronald.
1960.
The Problem of Social Costs,” Volume 3, October,
Journal of Law andEconomics, pp. 1 – 44.
2.
Medema,Steven.
Forthcoming, “Coase Theorem atSixty”,
Journal of Economic
Literature.
3.
Stigler, George.1953. “Sraffa’s
Ricardo,” Volume 43, September,
American Economic
Review,pp. 586-599.
4.
Coase, Ronald.
1959.
“The Federal CommunicationsCommission
,” Volume 2, October,
Journal of Law and Economics, pp. 1-40.
5.
Pigou, Arthur.
1920.
TheEconomics of Welfare.
London:Macmillan.
6.
Journal of Law
andEconomics, Vol. 26, April 1983, pp.1-26.
7.
Knight, Frank.
1924.
“Some Fallacies in the Interpretationof Social Cost,” Volume 38
Number 4, August,
Quarterly Journal of Economics,pp.
582-606.
8.
See Footnote 5.
9.
Gordon, H. Scott,“The Economic
Theory of a Common Property Resource: The Fishery,”
Journal ofPolitical Economy, (April, 1954).
10.
The existence of a
unique Washington School ofEconomics is likely first mentioned by
Douglas North in his
Institutions,Institutional Change
and Economic Performance, published in 1990 by theCambridge
University Press.
On page 27of the book, he wrote in a
footnote that “[t]he transaction cost approach isconsistent only in
its agreement on the importance of transaction costs; it isfar from
unified in other aspects.
Theapproach developed here might
most appropriately be characterized as theUniversity of Washington
approach, originated by Steven Cheung .”
Robert
Higgs, who was once on the faculty atUniversity of Washington,
wrote in 1991 that “I call this proposition, which isa more
sophisticated variant of the modernization hypothesis, the theory
of theWashington School.
Its prime proponentis Douglas
North…North draws on theoretical work on measurement and
transactioncosts by Steven N.S. Cheung (formerly University of
Washington) and YoramBarzel (still there).”
See Robert
Higgs,1991, “Eighteen Problematic Propositions in the Analysis of
the Growth ofGovernment,” Volume 5, Number 1 and 2,
The
Review of Austrian Economics,pp. 3-40.
Commenting on my role in thefounding of the Washington School,
Deirdre McCloskey at the University ofIllinois at Chicago said back
in 2017 that, “[h]is main legacy was persuadingDouglas North at
Washington to take property rights seriously in economichistory.
No Cheung, no North.”
The quote is from “
Responses to an Inquiryon S. N. S. Cheung’s Economics after a
Conference on the Matter in Shenzhen,China, November 2017”. It
could accessed via the following link:
http://deirdremccloskey.org/docs/pdf/McCloskey_CheungianEconomics.pdf
11.
Cheung, Steven.1981.
Will China Go Capitalist? AnEconomic Analysis of Property
Rights and Institutional Change.
London: Institute of
Economic Affairs.
12.
S. N. S. Cheung, “The
Transaction Costs Paradigm,”
Economic Inquiry,
October 1998. This is the only work of mine which Milton Friedman
gavedetailed comments, word by word, line by line, and rendered the
verdict that Ialone occupy a position in this paradigm.
13.
See S. N. S. Cheung, “A
Theory of PriceControl,” Volume 17, April 1974,
Journal
of Law and Economics, pp.53-71.
14.
SeeS.N.S.Cheung,
“Transaction Costs, Risk Aversion, and the Choice of
ContractualArrangements,” Volume 12, April 1969,
Journal
of Law and Economics,pp,23-42.
15.
Thepiece is written in
Chinese, “
千規律，萬規律，經濟規律僅一條”
(One Tousand Rules, Ten TousandRules, in
Economics There is Only One
Rule), originally published in October1979
in the
Hong Kong Economic
Journal Monthly, Volume
3,Number 7.
