17 November 2015

The Tragedy of the Commons keeps Ronald Coase relevant

By Len Shackleton

Nobel-Prize-winning economist Ronald Coase died in 2013 at the grand age of 102. The two contributions for which he is best-remembered – his 1937 analysis of the significance of transactions costs for the genesis of firms, and his 1960 focus on the role of property rights in understanding externality problems – were written a very long time ago. His non-mathematical treatment of these issues seemed old-fashioned then, and is apparently even more so today. Yet Coase’s approach continues to prove amazingly fecund.

In a new book from the IEA, authors find that Coase’s work was way ahead of its time and that it continues to point the way forward for policy-makers.

For instance, take Coase’s insights about supposed ‘external costs’ of economic activity. Textbooks generally see these as purely negative: on the contrary, Coase argues, it all depends on your viewpoint. Pollution, for example, carries benefits to those who produce and consume the goods produced by a ‘polluting’ process. These benefits need to be recognised, and reflected in policy which should build on property rights and negotiation rather than administrative diktat.

In today’s context this acts as a necessary warning to those who pursue reductions in carbon emissions regardless of costs. By emphasising the possibilities of bargaining between affected parties rather than laying down arbitrary government regulations, it also  points the way to possible resolution of land-planning issues which hold back housing and infrastructure development.

Coase was scornful of what he called ‘blackboard economics’, making policy on the basis of abstract theorising rather than careful empirical research. In a famous paper about lighthouses – held up by Paul Samuelson as an example of a ‘pure’ public good which the private sector could not provide because of its characteristics of ‘non-rivalness’ and ‘non-excludability’  – he showed that these important aids to navigation were in fact provided by private initiative in Britain. This observation led to the development of the theory of ‘club goods’ by James Buchanan, and showed that the necessary role of the state is much smaller than many politicians believe.

One area where the state has over-reached itself is financial regulation. In the 19th century, club-based regulation helped to maintain a stable financial environment without government intervention. The stock exchange was a paradigmatic case. A Coasean-style analysis of the past success of self-regulation can draw out lessons for today.

In the late 1950s Coase wrote an historical examination of the Federal Communications Commission in the United States which concluded that its regulation of the radio frequency spectrum was fundamentally misconceived. Alone at the time, he argued for the auction of spectrum rather than its allocation for free as a result of a political process. He was regarded as batty: but nowadays his position is the new orthodoxy.

One fascinating area covered in the book is the application of Coase’s analysis to the new ‘sharing’  economy, encompassing innovations such as Uber and AirBnB, which is the centre of much speculation and controversy at the moment. The fundamental feature of such disruptive entrepreneurial activity is the use of new communications technology to reduce transactions costs. This enables people to share goods and services, and to build the trust necessary to share them, to an extent unknown in the past. The possibilities of mutually beneficial ‘trades’ are hugely enhanced, with all sorts of implications for future patterns of production and employment.

It is foolish to pretend that Coase had any special insight into the future of our economies and societies. Nevertheless, his emphasis on the fundamental forces driving economic activity in his own time is likely to continue to provide inspiration for economists for many years to come.

Len Shackleton is a Research Fellow at the Institute of Economic Affairs