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Journal of Economic Perspectives

Volume 8 Num ber 2–Spring 199 4— Pages 201–209

Correspondence

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Evaluating Coase

Richard Posner advises that he and I are "ardent admirers" of Ronald

Coase (Fall 1993, pp. 195–210, p. 207). Speaking for

myself

I would drop the

adjective. Ardent or not, it is strange that two of Coase's professed admirers

should view the Coasian enterprise so differently.

Both in this and in a companion paper that appears in the Journal of

Institutional and Theoretical Econom ics

(M arch 1993) , Posner dwel ls on C oasian

methodology. Is that really where the central contributions of Coase reside?

As anyone who knows Coase in the original will recognize, Posner has

written a brief in which the core contributions figure negligibly. Not everyone,

however, knows Coase in the original. Readers of "Ronald Coase and Method-

ology" who are unfamiliar with Coase could easily conclude: why bother? That

would be unfortunate if, as I contend, the core Coasian contributions are

distinctive and important.

Let me state at the outset, however, that I share some of Posner's puzzle-

ment over Coase's views on methodology. Coase's earlier neglect—which he

takes steps to rectify in his Nobel Prize Lecture (Coase, 1992)—of the need to

formalize his arguments is one example. Also, I agree with Posner

(pp. 206–209) that economics is distinguished more by its approach than by its

subject matter (see for example, Williamson, 1993), whereas Coase holds



202 Journal of Economic Perspectives

otherwise. But why deal wi th methodology in a forum where the Nobel Pr ize i s

being celebrated i f , to repeat , the core cont r ibut ions res ide el sewhere?

Ron ald Coase i s a seminal th inke r an d ha s a timeless message. On my

re ad ing , the essence of Coase is this: 1) pu sh the logic of zer o t ransa ct ion costs

to the l imit ; 2) study the world of posi t ive t ransact ion costs; 3) because

hypothe t ical forms of econo mic organiza t ion are operat ional ly i r relevant , a nd

bec aus e all feasible forms of org aniz at ion ar e f lawed, assess al ternat iv e feasible

forms of organizat ion in a comparat ive ins t i tu t ional way; 4) because the act ion

res ides in the detai l s , s tudy the microanaly t ics of cont ract , cont ract ing , and

organ izat ion . Th at i s a subt le an d powerful c om binat ion of ideas an d tur ns out

to be diff icul t to implement . Although much of i t goes against the main

t radi t ion , i t has never theless made progress ive headway in relat ion to , and

par t s have been inco rpora t ed wi th in , o r thodoxy .

Sherwin Rosen 's (1988) remarks about Coase, g iven at the conference on

"T he Na tu re o f t he F i rm " tha t was o rgan ized t o ce l eb ra t e t he 50 th ann iver sary

of Coase 's famous 1937 paper , are per t inent to the f i rs t of these proposi t ions

(p .

48) :

Coase 's f i r s t l ecture reveals a surpr i s ing avers ion toward mathemat ics .

Cur ious , coming f rom one of the few economists who has a theorem n a m e d

after him. In fact , an easy case can be made that Ronald Coase is

responsib le for two theorems, a lemma, and, according to some, an

ident i ty . T h e Coase the ore m is a t th i s poin t well beyo nd fu r ther d iscus-

s ion . The second theorem is the remarkable one on the t ime-consis tent ,

subgame per fec t equ i l i b r ium fo r a du rab l e goods monopo l i s t—the poor

soul who i s forced to ei ther dest roy some proper ty or e l se act as a perfect

compet i tor because i t i s impossib le to commit now to act ions that are nor

cred ib l e i n t he fu tu re excep t when monopo ly power r emains unex-

ploi te d. . . . T h e le m m a is no t as well kn ow n, bu t sho uld b e. I t is stated in

som e rem ark able w ork wi th Fowler in 1935, the f i rs t known a t tem pt to fi t

an i n t e r t empora l a rb i t r age cond i t i on , an Eu le r equa t ion , t o r ea l da t a .

Coase and Fowler were dubious about the rat ional i ty of cobweb

the ory . . . . T h e wo rk is instant ly rec ogn ized today as a version of t he

rat ional expectat ions hypothesis and acknowledged as such by Muth in h is

impor t an t paper on t he sub j ec t .

But whereas both of the theorems as wel l as the lemma are appl icat ions of

Coase's First Law, push the f ict ion of zero t ransact ion cost reasoning to the

l imi t , the cent ral message of Coase res ides in the Second Law: s tudy the wor ld

of posi t ive t ransact ion costs.

How could Posner have got ten i t so wrong? Possib ly the " insouciance" wi th

which Coase "ap pea r s t o r egard one o f h is mos t si gna l ach i eve me n t s"— the new

" law and economics movemen t o f t he pas t quar t e r cen tu ry" (p . 203)—is a

cont r ibut ing factor .



Correspondence 203

To be sure, Coase's Nobel Prize lecture on "The Institutional Structure of

Production" gives much greater weight to his 1935 article ("The Nature of the

Firm," which inspired the new institutional economics) than to his 1960 article

("The Problem of Social Cost," to which the new law and economics relates).

Although Posner (1993a) would reverse those priorities, that merely helps to

explain Posner. The object is to explain Coase.

What I find especially important about Coase's Nobel Prize Lecture is that

it dispels, once and for all, any confusion over his core message. According to

Coase, "the important contribution of [the 1937] article is the explicit introduc-

tion of transaction costs into economic analysis" and his ambition is to see that

transaction cost arguments are brought to bear broadly and systematically

throughout economics (Coase, 1992, p. 716).

That ambition is repeated in Coase's treatment of his 1960 article, which is

introduced as follows (Coase, 1992a, p. 717): "I now turn to the other article

cited by the Swedish Academy, "The Problem of Social Cost," published some

thirty years ago. I will not say much about its influence on legal scholarship,

which as been immense, but will mainly consider its influence on economics,

which has not been immense, although I believe that in time it will be."

The novelty of the 1960 article is that it used the fiction of zero transaction

costs to examine property rights, but this fiction was meant to be used as a

"stepping stone on the way to an analysis of an economy with positive transac-

tion costs" (Coase, 1992, p. 717). Accordingly, the crucial lessen of the 1960

article is the same as that of the 1937 article: "let us study the world of positive

transaction costs" (p. 717).

Posner contends that the key to understanding Coase "lies in his English-

ness"

(p. 204). Maybe, but I have always found it more illuminating to

understand an artist from his canvas than from ascribing an intellectual ances-

try. The key to understanding Coase is to read his seminal articles. Interested

readers are therefore encouraged to examine "The Nature of the Firm" (1937),

"T he Problem of Social Cost" (1960), and "Ind ustrial Organization: A Proposal

for Research" (1972a), to which his Nobel Prize Lecture (1992) provides

perspective.

Those who wish to continue should read "The Regulated Industries:

Discussion" (1964), "Durability and Monopoly" (1972b), his autobiographical

lectures on "The Nature of the Firm: Origin, Meaning, Influence" (1988b), and

his collection of essays The Firm the Market and the Law (1988a).

The Royal Swedish Academy plainly focussed not on methodology but on

the core contributions in awarding the 1991 Nobel Prize in Economics.

Oliver E. Williamson

University of California

Berkeley, California

1

1

An ear ly draf t of this com m ent w as writ ten w hile I was the Jack N. Pr i tzker Dist ingu ished Visit ing

Professor a t Northwestern Universi ty Law School.



204 Journal of Econom ic Perspectives

References

Coase, Ronald H., "The Nature of the

Firm," Economica N.S., 1936, 4, 386–405.

Coase, Ronald H.,

"The Problem of Social

Cost," Journal of Law and Economics, Oc tobe r

1960, 3, 1–44.

Coase, Ronald H., "The Regulated Indus-

tries: Discussion, American Economic Review ,

May 1964, 54 , 194–97.

Coase, Ronald H., "Industrial Organiza-

tion: A Proposal for Research." In Fuchs, V. R.,

ed., Policy Issues and Research Opportunities in

Industrial Organization. New York: National

Bureau of Economic Research, 1972a, 59–73.

Coase, Ronald H.,

"Durability and Monop-

oly," Journal of Law and Economics, 1972b, 15 ,

143–49.

Coase, Ronald H., The Firm the Market and

the Law. Chicago: University of Chicago Press,

1988a.

Coase, Ronald H.,

"Nature of the Firm:

Origin, Meaning, Influence,"

Journal of Law

Economics and Organization, Spring 1988b, 4,

1–47.

Coase, Ronald H.,

"The Institutional Struc-

tural of Production," American Economic Re-

view

, September 1991,

83

, 713–19.

Posner, Richard A., "Law and Economics

Meets the New Institutional Economics," Jour-

nal of Institutional and Theoretical Economics ,

March 1993a, 14 9, 73–87.

Rosen, Sherwin, "Transaction Costs and

In te rna l Labor Marke ts ," Journal of Law Eco-

nomics and Organization, Spr ing 1988, 4 ,

48–62.

Williamson, Oliver E.,

"Calculativeness,

Trust, and Economic Organization,"

Journal

of Law and Economics, April 1993, 36 .

On the Costs of Inflation: Israel's Example

Don Patinkin gave his account of the Israeli stabilization plan of 1985 in a

recent issue of this Journal (Spring 1993, pp. 103–128). Part of his comment

was devoted to the cost of inflation, which occurred despite the fact that Israel

practiced the most comprehensive system of indexation of any country. Besides

noting "the feeling of malaise that beset us from the constant changes in

prices," Patinkin mentions various inflationary costs. One is the "shoe-leather"

cost associated with the increased activity of the public in the financial markets,

in an attempt to minimize inflationary erosion. A second cost is connected to

the first: as the public demand for financial services increases, so does employ-

ment in these services. In Israel, it grew from 5.2 percent of total employment

in 1970, to 9.5 percent in 1984. Another cost identified by Patinkin is the

increased corporate effort devoted to managing cash flow and finances gener-

ally. He also mentions how inflation reduces the information content of relative

prices, and how it can affect both tax receipts and government spending.

From my vantage point as deputy governor of the Bank of Israel during

the most awful years of inflation, I had an excellent view of its costs. For those

who have not had to live through such an experience, some concrete elabora-

tions may help bring the costs of inflation to life.

Inflation destroys the measuring rod of the economy. When inflation

proceeds at, say, 400 percent annually, the average monthly rate is over 14

percent. A dollar received for sales at the end of the month is worth about 13

cents less than a dollar spent for productive inputs at the beginning of the

month. In this setting, to convey the correct information, all cash transactions

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Correspondence 205

would have to be dated, with the price level on the appropriate date attached.

This is simply impossible. Consequently, when inflation subsided, many corpo-

rations discovered that they had been bankrupt.

Consumers face problems, too. Ordinarily, when people shop they use a

data bank stored in their memory to assess the prices they are asked to pay. But

when prices change continuously, people find themselves in the dark. I rem em -

ber situations during the inflationary years when people could not decide on

the reasonableness of prices by up to a factor of 10. I remember when products

at the supermarket had four price stickers, each with a different price, attached

to the product one on top of the other. In the end, the cost of constantly

changing the prices became so substantial that retailers abandoned price

stickers altogether. Instead, a code sticker was attached to each product, and

the cash register was programmed daily to associated prices with codes. The

upshot was that shoppers had no idea of the price of anything they pulled off

the shelves, until reaching the checkout counter. This makes the task of

executing a household budget rather difficult.

The governmental budget process was rendered useless for similar rea-

sons.

How is it possible to calculate the real rate of government spending when

inflation proceeds at 0.5 percent (1984) or even 0.3 percent (1983)

per day

? The

cabinet resorted to debating the budget in dollar terms, although the accoun-

tant general at the Ministry of Finance had to continue to write checks and

keep records in shekels. This made communication between plan and execu-

tion virtually impossible. Revisions made long after the fact revealed that

estimates of the budget deficit measured as a share of GDP were off by 5

percentage points and more, which is not far from chaos.

Another category of stress concerns the financial structure of business

firms. When nominal interest payments are deductible for business tax pur-

poses and, dividends are not, and since inflation causes nominal interest rates

to rise, the advantage of debt over equity increases with inflation. Conse-

quently, companies were being robbed of their equity to a dang erous degre e, as

owners substituted debt for equity.

Indexation of loans is usually regarded as shoring up the financial system

against the vagaries of inflation. For the borrower, however, it is little help.

Consider an investor who plans a project that takes two years to construct, and

wants to secure an appropriate line of credit. Because of inflation, the amounts

that will have to be spent can only be guessed. The alternative of indexing the

line of credit to the actual cost of the project simply does not exist, because of

moral hazard. If the project runs out of money, it will be the investor's task to

convince the creditor that the excessive costs were caused by inflation, and not

simple cost overruns. The added risk that the investor has to shoulder in this

situation may well be an important reason for the decline in investment

observed under prolonged periods of inflation (Plessner and Shalit, 1986).

Even in an indexed environment, inflation causes problems with savings,

too.

The most salient symptom is the tendency of households to accumulate




assets in the form of real estate, on the supposition that this form of wealth is

better shielded from inflation. In fact, the added demand for apartments as a

form of investment actually did cause their prices to inflate more rapidly.

During 1979, for example, housing prices increased by 159 percent, while the

consumer price index rose by 111 percent. This misallocation of resources was

evident from the considerable number of empty apartments that people main-

tained as a hedge against inflation.

Indexation cannot completely protect government contracts, either. Sup-

pose that the government contracted on July 10, 1983, to purchase defense

components in the amount of IS10 million. On that day, the last known price

index was the one for the month of May, published on June 15. It stood at

986.5,

and served as the indexation basis for the contract. Suppose next that

delivery was made on October 10 and that the payment agreement called for a

30-day term. On pay day, November 9, the last known price index was the one

for September, published on October 15. It stood at 1268.3. So the government

paid IS12,856,563.61 (that is, multiply the contracted amount by the ratio

126 8.3/98 6.5). The n on N ovemb er 15, the price index for October was pub -

lished, and turned out to be 1535.5. Hence, in terms of the May purchasing

power, the supplier received only 82.6 percent of the contracted amount. Of

course, one can attempt to remedy this situation by using estimates of expected

inflation, or supplemental payments, but these approaches bring costs and

uncertainties of their own.

Problems in the financial sector are not fully solved by indexation, either.

Price index numbers are published only once a month. But balances in

corporate line-of-credit accounts change daily. Since daily inflation rates are not

known (and probably cannot be known), indexation provides only partial

protection. Even at rates of inflation that are far from qualifying as hyperinfla-

tion, the losses from inaccurate indexation may wipe out the entire interest

income of the bank or could double the interest rate for the firm, depending on

whether the balance increases or decreases over the month.

The indexation of tax brackets can prevent fiscal drag for individuals, but

it has no relevance to corporate taxation. On the one hand, some corporations

were paying taxes on nominal paper profits, when they were actually making

losses. However, profitable corporations usually did not pay anywhere near

what they should have paid in real terms, since a good portion of corporate

taxes is paid only after financial reports are out, and that delay robs the tax of

much of its real content. T hre e com missions, consisting of the best tax mind s in

Israel, struggled to create a tax code which could deal with these prob lems. B ut

their Law for Taxation U nde r Inflation, ado pted in 1983, was so complex that

it had to be practically abandoned.

A dram atic dem onstration of the failure of an index ed tax code occurred

when inflation leaped from 191 percent in 1983 to 445 percent in 1984—and

real corpo rate taxes fell by 55 perce nt com pared to 1983. This was a major

factor in the increase of the budget deficit, from 6.3 percent of GNP in 1983 to



Correspondence 207

14.4 percent of GNP in 1984. The mirror-image of this development occurred

after the stabilization of 1985, when the budget deficit was transformed into a

surplus of 0.3 percent of GNP. This was facilitated more by increased revenues

than by reduced spending. Despite the fact that tax rates did not change,

revenues increased by an amount equal to 9.4 percent of GNP, while non-

interest spending declined by 8.4 percent of GNP, and interest payments rose

by 3.2 percent of GNP. Clearly, at high rates of inflation, part of the govern-

ment's deficit may be the effect of inflation, rather than its cause.

I doubt that I have been able to track down all the areas in which inflation

makes its bite felt. But the above provides at least a partial list of some

important instances.

Yakir Plessner

Center for Study of Public Choice at George Mason University

Fairfax, VA

and the Hebrew University of Jerusalem

Reference

Yakir Plessner, and Haim Shalit,

"Infla-

tion, the Level of Investment and Interest

Rates," European Economic Review

, December

1986, 30 , 1169–87.

Ethics and the Invisible Hand

Jerry Evensky's "Ethics and the Invisible Hand" (Spring 1992, pp. 197–205)

is a pleasant reading, and certainly one that offers useful perspective to

economists who have been trained primarily at the blackboard. However,

Evensky's work was done years ago, in the writings of the remarkable English

historian Henry Thomas Buckle (1821–1862). Buckle's great work was The

History

of

ivilization

in England , which app ear ed first in 1857 to great acclaim.

As subsequent editions of the original work were published they were divided

into three volumes. For matters at hand it is the five chapters that became the

v o l u m e On Scotland and the Scotch Intellect that are of in teres t .

Following a discussion of Francis Hutcheson, Buckle (1970, p. 255) writes:

The next great attempt to study the actions of men scientifically, and to

generalize the principles of their conduct without the intervention of

supernatural ideas, was made by Adam Smith, who, in 1759 published




his Theory of Moral Sentiments, and in 1776 his Wealth of Nations. T o

understand the philosophy of this, by far the greatest of all the Scotch

thinkers, both works must be taken together, a nd considered as one; since

they are in reality, the two divisions of a single subject. In the

Moral

Sentiments, he investigates the sympathetic part of human nature; in the

Wealth of Nations, he investigates its selfish pa rt. And as all of us ar e

sympathetic as well as selfish; in other words, as all of us look without as

well as within, and as this classification is a primary and exhaustive

division of our motives to action, it is evident that if Adam Smith had

completely accomplished his vast design, he would at once have raised the

study of human nature to a science, leaving nothing for subsequent

inquirers except to ascertain the minor springs of affairs, all of which

would find their place in this general scheme, and be deemed subordinate

to it.

In subsequent treatment of Smith, Buckle (1970, p. 259) writes: "A short

view of these two works will . . . enable us to perceive that each is supp lem entary

to the other; so that, in order to understand either, it is necessary to under-

stand both."

Interestingly, the American economist Henry George, in

The Science of

Political Economy

referenced Buckle's work on Smith and used it to buttress his

own view of the well springs of economic action, which relied not on selfishness

but on a primary postulate that "all men seek to gratify their desires, whatever

those desires may be, with the least exertion." This postulate George (1932,

pp. 72–78) argued "is no more affected by the selfishness or unselfishness of

our desires than is the law of gravitation. It is simply a fact."

Evensky deserves every credit for raising an old, but terribly neglected

topic.

The story always need retelling and Evensky tells it to us properly. Good

for him

Lamar B. Jones

Louisiana State University

Baton Rouge, Louisiana

References

Buckle , Henry Thomas , On Scotland and the

Scotch Intellect. Chicago: The Universi ty of

Chicago Press, 1970.

George, Henry ,

The Science of Political Econ-

omy.

London: The Henry George Foundation,

1932.

More Etiquette Tips for Young Economists

Having spent a year abroad, I only recently saw Daniel Hamermesh's

article (Winter 1992, pp. 169–179). It is a mine of useful information for young



Correspondence 209

economists embarking on a career. I would, however, like to add a small

remark to his section on preparing articles for publication.

Ham erme sh discourages autho rs from am ending articles at the galley-proof

stage, noting that "mo st journ als threaten dire consequences for any changes,

and some actually charge you for changes." This is good advice, but there is

another important reason for not making changes at this stage (or a fortiori at

any later stage in the p rodu ction process). Even if the jou rn al consents to a

change an d agrees not to charge the au thor (m any journ als are quite reason-

able about this), the risk of an error by the printer is significantly greater at this

point. Presumably the reason is that there is only limited checking of what the

printer has done, and this checking is carried out by people who may not

understand what they are reading.

It is extremely unp leasan t to pick up a jou rn al in which one's article

appears only to find that a late change has been rendered incorrectly. (The

unpleasantness is heightened by the fact that authors tend to have an unusual

and perhaps unnatural affection for their own work.) This is an experience best

avoided by anybody, but particularly by a young author.

Oliver Hart

Harvard University

Cam bridge, Massachusetts

evaluating coase - oliver e. williamon

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