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Coase Theorem-Friedman, Harberger-

Smit-Stigler

Eric Rasmusen, erasmuse@Indiana.edu

G604, History of Thought, policy , 23 March 2006

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• Classics: Public Policy     George J. Stigler (1971) "The Theory of Economic Regulation" The Bell Journal of Economics and Management Science, 2(1): 3-21 (Spring 1971)     David Friedman, Law's Order, chapters 4 and 5, pages 36-62, on the Coase Theorem and Calabresi and Melamed. (See http://www.daviddfriedman.com/laws_order. )    Arnold C. Harberger (1954) "Monopoly and Resource Allocation," The American Economic Review, Papers and Proceedings of the Sixty-sixth Annual Meeting of the American Economic Association, 44(2): 77-87 (May 1954)     I have posted my lecture notes and powerpoint slides on Stigler, Coase-Friedman, and Harberger.     Adam Smith, The Wealth of Nations (1776) "Of the Causes of Improvement in the productive Powers of Labour, and of the Order according to which its Produce is naturally distributed among the different Ranks of the People," Book I, chapters 1-3. (skip the intro and chapters 4 and on).

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Adam SmithThe Wealth of Nations

• The policy of some nations has given extraordinary encouragement to the industry of the country; that of others to the industry of towns. Scarce any nation has dealt equally and impartially with every sort of industry.

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The Division of Labor• … is commonly supposed to be carried furthest in some

very trifling [industries];

• not perhaps that it really is carried further in them than in others of more importance: but in those trifling manufactures which are destined to supply the small wants of but a small number of people, the whole number of workmen must necessarily be small; and those employed in every different branch of the work can often be collected into the same workhouse, and placed at once under the view of the spectator.

• In those great manufactures, on the contrary, which are destined to supply the great wants of the great body of the people, every different branch of the work employs so great a number of workmen, that it is impossible to collect them all into the same workhouse.

• We can seldom see more, at one time, than those employed in one single branch.

• Though in such manufactures, therefore, the work may really be divided into a much greater number of parts, than in those of a more trifling nature, the division is not near so obvious, and has accordingly been much less observed.

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Pin Making

One man: 1-20/day

Ten men: 48,000/day

Leonard Read, "I, Pencil," The Freeman (December 1958). http://www.econlib.org/library/Essays/rdPncl1.html.

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Advantage• The corn of Poland, in the same degree of

goodness, is as cheap as that of France, notwithstanding the superior opulence and improvement of the latter country.

• The corn of France is, in the corn provinces, fully as good, and in most years nearly about the same price with the corn of England, …

• The corn-lands of England, however, are better cultivated than those of France, and the corn-lands of France are said to be much better cultivated than those of Poland.

• But though the poor country, notwithstanding the inferiority of its cultivation, can, in some measure, rival the rich in the cheapness and goodness of its corn, it can pretend to no such competition in its manufactures; at least if those manufactures suit the soil, climate, and situation of the rich country.

• Absolute vs. comparative advantage (Ricardo, rent)

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A man commonly saunters a little in turning his hand from one sort of employment to another. When he first begins the new work he is seldom very keen and hearty; his mind, as they say, does not go to it, and for some time he rather trifles than applies to good purpose.

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Innovation

• A great part of the machines made use of in those manufactures in which labour is most subdivided, were originally the inventions of common workmen, who, being each of them employed in some very simple operation, naturally turned their thoughts towards finding out easier and readier methods of performing it.

• (the steam engine boy)

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Harberger Triangle article,

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Harberger’s Method1. Get return on capital in mfgr. industries, and sales (q)

2. Calculate deviations from average profit as a percentage of sales. Call this r.

3. Assume the elasticity of demand, k, for each industry equals 1.

3. Calculate .5 r^2qk for each industry.

4. Add them up.

5. Multiply 2.2 since we just looked at a fraction of manuf. industries.

5. The result: about .1% of national income.

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Harberger’sRefinements

1. What if there are increasing costs in industries?

2. Equity capital is measured to include the value of patents, which capitalizes monopoly profits. So it is greater than the amount of real capital supplied, and monopoly profits might look too low.

3. Sample selection bias. These industries have an average profit of 10.4%, while for manufaturign as a whole it was 8%.

4. Aggregation. This smooths out differences in profit rates across products.

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Some Big Problems

1. Why include the low-profit industries?

2. Why use return on capital instead of return on equity? Bondholders do not get monopoly profit.

3. What if all industries are monopolized, and profit rates are all equal? His method would show zero loss.

4. What about labor monopolies? (unions, restrictive entry of the kind Stigler discusses)

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Another Approach

Suppose ALL of the return to equity is monopoly profit. What is the welfare loss?

US Mfgr corporations had profit of 245 billion dollars in 1998. Sales were 4,591 billion. So the profit rate on sales was .053. And the triangle loss was .5 (.053)(.053) (4591) = 6.5 billion dollars. GDP was 8790 billion dollars, so the loss is .07% of GDP.

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Refinement: Fewer monopoly industries

Suppose ALL of the return to equity is monopoly profit. What is the welfare loss?

US Mfgr corporations had profit of 245 billion dollars in 1998. Sales were 4,591 billion. So the profit rate on sales was .053.

Suppose a quarter of firms are monopolies, with profits of 20%, and 3/4 are not, with profits of 0% of sales. Then the triangle loss is .5 (.20)(.20) (.25) (4591) = 23.0 billion dollars.

What if prices were double what they should be, in every industry? Then the approximation involved gets bad, but we can compute . 5(1) (1) 4591 = 2296, and the loss is 26% of GDP.

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• Coase, Ronald.The Problem of Social Cost, 3 Journal of Law and Economics 1-44 (1960).

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Coase Theorem Example

A steel mill’s pollution reduces resort profit by $200,000 unless $100,000 is paid to control pollution.

There is a real externality of $200,000. The Pigouvian tax would be to charge the steel mill $200,000 if it pollutes. It would then choose to control the pollution instead.

Coase insight: Suppose the resort could switch to timber, earning $50,000 less. Then the Pigouvian tax is inefficient.

Or, just let the steel mill and the resort negotiate with each other. If the “property right”– who has the legal right to decide pollution– is clear, the outcome will be efficient.

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The Coase Theorem

“If transaction costs are zero, then any initial allocation of property rights leads to an efficient outcome. “ (Friedman’s statement)

What is interesting is to figure out the implications of transaction costs. A function of law is to minimize transaction costs.

http://www.daviddfriedman.com/laws_order/

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Property and Liability Rules

Calabresi, Guido & Melamed, Douglas, "Property Rules, Liability Rules and Inalienability: One View of the Cathedral", 85 Harvard Law Review 1089 (1972).

If you are protected by a property rule, you can go to court and get an injunction to stop someone from doing X. (court of common law). Good if transactions are cheap.

Examples: Patent infringement, someone building a house on your land, someone stealing your car.

If you are protected by a liability rule, you can go to court and get damages from someone who has done X. (court of equity) Good if courts are cheap.

Examples: tort suits for personal injury, damages for breach of contract

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The Train Sparks Example A railroad chooses whether to install a spark arrester at cost $1000 or not. 100 farmers each choose whether to plant clover or wheat. Clover does not burn, but yields $800 less in revenue. Wheat burns, for a loss of $400.

Possible Rules (who decides? who pays?):

1. Railroad property right. The railroad can throw sparks if it so desires.

2. Farmer property right. Any one farmer can stop the railroad from throwing sparks.

3. Farmer liability right. The railroad can throw sparks if it pays the farmers for any damage that results.

4. Railroad liability right. Any one farmer can stop the railroad from throwing sparks, but he must pay the railroad’s cost of installing a spark arrester.

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Train Sparks II

A railroad chooses whether to install a spark arrester at cost $1000 or not. 100 farmers each choose whether to plant clover or wheat. Clover does not burn, but yields $800 less in revenue. Wheat burns, for a loss of $400.

Possible Rules (no contracts enforced)

1. Railroad property right. Farmers plant wheat and it burns. $400 cost.

2. Farmer property right. RR installs spark arrester. $1,000 cost.

3. Farmer liability right. Farmers plant wheat and it burns. $400 cost. The RR pays $400 to the farmer.

4. Railroad liability right. Farmers plant wheat and it burns. $400 cost. (The farmers could insist on the spark arrester, but they’d have to pay the $1,000.)

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Stigler—on regulation, Bell Journal,

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Stigler: What does Government Supply?

Answer: The power to coerce. Violence.

1. Direct subsidy (US airlines before 1968, universities)

2. Entry restrictions (US airlines before 1975, tariffs)

3. Suppression of substitute goods (margarine, plastic pipes)

4. Price-fixing (interest rate regulation, advertising restrictions)

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A blank slide for writing on

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A link to the course website

http://www.rasmusen.org/g604/0.g604.htm