Ronald Coase: In Memoriam, Part 9

The ninth scholar we discuss in our series, In Memoriam, is yet another Nobel laureate and yet another of my personal heroes, Ronald Coase. Coase was born in 1910 in the UK where he attended the LSE. Coase was, by his own amused admission, a lifelong economist who never studied economics. Of course, he meant that his degree was in commerce and that his economics training was largely autodidactic.

          Ronald Coase YoungRonald Coase Old


Coase initially thought he would become a lawyer or historian. Such predilections might help explain the fact that, despite a career spent in the academe, Coase was doggedly empirical and eschewed the trend in modern economics toward increasing theoretical (i.e. mathematical) sophistication in isolation from the real world and the functioning of real institutions. Coase was truly a prolific thinker and writer—he published his last book, How China Became Capitalist, in 2012 at age 101—and his contributions to the social sciences are too many to be recounted here. I will limit my remarks to the contribution by Coase that began his 80-year career as an institutional economist.

Nature of the Firm

In the 1930’s, as a student and still quite a young man, Coase began struggling with somewhat of a paradox. While many economists were arguing that markets require no top-down coordination, or, to put it another way, that markets worked most efficiently when coordinated in a decentralized fashion by countless individual decision-makers each responding to changes in relative prices of the factors of production, Coase observed that “within a firm, the description does not fit at all.” In effect, real markets operated with a high degree of conscious control over some operations and virtually no conscious control over others:

Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-coordinator, who directs production. It is clear that these are alternative means of coordinating production. Yet, having regard to the fact that if production is regulated by price movements, production could be carried on without any organization at all, well might we ask, why is there any organization? [Download "The Nature of the Firm" (1937) here]

After visiting American factories and businesses, Coase realized several things. First, “there is a cost of using the price mechanism.” These costs are largely the costs associated with finding what the relevant prices are and of organizing exchanges around the fluctuations of those prices. Second, firms form because they are seen as reducing many of these costs, especially when it comes to certain factors of production such as labor. Moreover, market actors must decide whether it is cheaper to make or buy, that is, whether to organize internally or exchange on the market for a factor of production. Thus, how production decisions are made within a market are determined by a comparison of costs which till Coase were not properly taken into account by theoretical economists. These costs, known now as transactions costs, are essential to understanding the nature and function of institutions in various aspects of social and economic life. Thanks to the insight of Coase, multiple disciplines now take account of these costs as well as what they reveal about the human propensity toward institution-building.

Hat’s off to you, Professor Coase!



James M. Buchanan- In Memoriam Scholar Part 8

James McGill Buchanan, Jr. was born on October 3, 1919 and died recently on January 9, 2013. He is this week’s In Memoriam scholar due to his revered work on public choice theory.

Like many top-scholars in our In Memoriam series, Buchanan received his doctorate from the University of Chicago in 1948. He was influenced by the great Frank Knight and Swedish economist Knut Wicksell who studied how government spent money relative to taxpayer wishes. Buchanan founded the Center for Study of Public Choice at the University of Virginia, where he was a long-time professor, before moving to George Mason University. Additionally, he won a Nobel laureate for economics in 1986 and published many books on liberty, democracy, public goods and public debt.


He is most known as the co-founder of public choice theory, alongside Gordon Tullock. Their co-authored book, The Calculus of Consent: Logical Foundations of Constitutional Democracy, explains individual decision-making in the context of the public sector. Some excerpts from Buchanan and Tullock’s book can best explain this constitutional calculus that an individual endures when considering public action:

“The collectivization of an activity will be supported by the utility-maximizing individual when he expects the interdependence costs of this collectively organized activity (interdependence benefits), as he perceives them, to lie below (to lie above) those involved in the private voluntary organization of the activity. Collective organization may, in certain cases, lower expected costs because it removes externalities; in other cases, collective organization may introduce externalities. The costs of interdependence include both external costs and decision-making costs, and it is the sum of these two elements that is decisive in the individual constitutional calculus.” (pg. 50)

The two costs that are explained in the book are:

  1. “Costs that you will endure as a result of the actions of others” (pg. 51)

“An external cost may be said to be imposed on an individual when his net worth is reduced by the behavior of another individual or group and when this reduction in net worth is not specifically recognized by the existing legal structure to be an expropriation of a defensible human or property right. The damaged individual has no recourse; he can neither prevent the action from occurring nor can he claim compensation after it has occurred.”

  1. Decision-making costs which are “the number of individuals who are required to agree before a final political decision is taken for the group” (pg. 51)

“If two or more persons are required to agree on a single decision, time and effort of another sort is introduced—that which is required to secure agreement. Moreover, these costs will increase as the size of the group required to agree increases.”


“The rational individual, at the stage of constitutional choice, confronts a calculus not unlike that which he must face in making his everyday economic choices. By agreeing to more inclusive rules, he is accepting the additional burden of decision-making in exchange for additional protection against adverse decisions. In moving in the opposing direction toward a less inclusive decision-making rule, the individual is trading some of his protection against external costs for a lowered cost of decision-making. “(pg. 57)

Buchanan and Tullock show that individuals face a trade-off when deciding upon collective action. Their book which is written in great detail further explains that not all collective activity should be organized the same way and expands on earlier discussion to include rules of when collective action should be taken. Lastly, half the book discusses welfare economics, voting and taxes in a context that incorporates individual rationality. This was unique at the time, because individual decision-making and individual actions were not explained as fundamental to the collective action problem. Buchanan and Tullock popularized this and essentially, became the “fathers” of public choice theory. Much of Buchanan’s work and Tullock’s work go hand-in-hand and Buchanan’s contributions to public choice and political theory are hard to discuss without mentioning his common co-author Tullock.

In this short video, Friedrich Hayek, a past In Memoriam scholar, and James Buchanan both discuss how economic patterns cannot distinctively be explained by mathematics. At 1:40, Buchanan explains that mathematics can fall short of explaining the entire economic problem and individuals neglect emergent choice. Hayek states we should accept “the impossible”—economists cannot make predictions about everything.

The Punch Bowl Stays: Fed Keeps Interest Rates Low

The Dow Jones closes at a market high today at 17,156.85 after the Federal Reserve met and announced that interest rates will be staying the same.  The reasons for keeping the federal funds target rate in the 0-0.25% range  based on the  FOMC press release are:

  1. The unemployment rate has barely changed and we are under-utilizing labor resources
  2. The housing sector is recovering slowly

While other reasons that they mention seem to support increasing the interest rate:

  1. Household spending and business investment is rising moderately
  2. Inflation is below the Federal Open Market Committee’s long-run goals

However, in the end the Committee felt that to attend maximum employment and price stability maintaining the current interest rate is best. Additionally, the FOMC will buy federal agency mortgage-backed securities at a pace of $5 billion per month (rather than the $10 billion they were buying) and Treasury securities at a pace of $10 billion per month (rather than the $15 billion they were buying). By holding a large amount of long-term securities, the hope is that long-term interest rates will make “financial conditions more accommodating” (i.e. to support mortgage markets). Lastly, the FOMC mentioned that the 0-0.25% federal funds rate will remain even after the asset-buying program dies down, which is set for October.

The video on the bottom of the USAToday article, here, explains why the stock market moves after a Federal Reserve announcement and what has happened over the past four announcements this year. It is a short one minute and thirteen second video, but it is a fantastic way to catch-up with what has been happening with Federal Reserve. Also, here is a neat response after the FOMC announcement from Brad McMillian, the Chief Investment Officer for Commonwealth Financial:


“The Fed is not going to take the punch bowl away. They didn’t want to spook the market.”


Elinor Ostrom: In Memoriam, Part 6

In this week’s edition of In Memoriam—our series in which we honor 10 noteworthy social scientists who have passed away in recent years—I bring you Elinor “Lin” Ostrom. Lin is the only woman on our list and the only woman thus far to win the Nobel Prize for Economics. Her work has also had a great impact on me personally.


Ostrom YoungOstrom Old

Lin received her PhD in Political Science from UCLA in the 1960’s and spent the bulk of her 40-plus year career at Indiana University Bloomington, where she and her husband Vincent Ostrom founded the Workshop in Political Theory and Policy Analysis. There Lin carried out a research program that was focused on addressing real-world problems—from how organizational theory could offer insight into public administration of local police services in the St. Louis metro area, to identifying the institutional requirements for sustainable local management of common pool resources in Indonesia, to the most effective use of development aid in Africa—and she did so not only through an impressive array of social science methodologies, e.g., econometrics, game theory, etc., but with an emphasis on field research which sought to take seriously the capacity of people in local communities to solve their own problems with appropriate help. In the video below, Ostrom summarizes the Tragedy of the Commons and how local communities can devise strategies to avoid depleting common pool resources:

In keeping with the pattern I established in my Amos Tversky and Herbert Simon posts, I will say a little about Lin’s contribution to the rationality debate.  In the development of theoretical models, Lin warned, researchers should remain well-grounded in the world of real humans:

An important challenge facing policy scientists is to develop theories of human organization based on realistic assessment of human capabilities and limitations in dealing with a variety of situations that initially share some or all aspects of a tragedy of the commons. Empirically validated theories of human organization will be essential ingredients of a policy science that can inform decisions about the likely consequences of a multitude of ways of organizing human activities. Theoretical inquiries involve a search for regularities. It involves abstraction from the complexity of field setting, followed by the positing of theoretical variables that underlie observed complexities. Specific models of a theory involve further abstraction and simplification for the purpose of still finer analysis of the logical relationships among variables in a closed system. As a theorist, and sometimes a modeler, I see these efforts at the core of a policy science. One can, however, get trapped in one’s own theoretical web…Confusing a model—such as that of a perfectly competitive market—with the theory of which it is one representation can limit applicability…

Governing the Commons

People are nested in cultural settings with indigenous norms. Any theoretical account which ignores such phenomena has abstracted away too much from how human decisions are made. When it comes to collective action problems, Lin reminded social scientists that top-down planning by elites is not the only way that collective action dilemmas can be resolved and often not the best way. She called on social scientists to look hard at actual communities and discovery how individuals can often voluntarily cooperate to solve their own problems in ways that make sense on the ground:

What is missing from the policy analyst’s toolkit—and from the set of accepted, well-developed theories of human organization—is an adequately specified theory of collective action whereby a group of principals can organize themselves voluntarily to retain the residuals of their own efforts.

Hat’s off to you, Lin Ostrom!



Hayek on Equality

Inequality is one of the hot topics in economics and politics today.  Thomas Piketty’s bookCapital in the Twenty-First Century, has taken the economics field by storm by documenting rising income inequality using national income data across countries and years. Piketty is a French economist who sold over 80,000 copies in France, but has well-surpassed that number in America. His book has been on the NY Times Best Seller list for 19 weeks and counting, which speaks to the fact that people care about this topic. Inequality by other means, such as marriage inequality, continues to be debated in state and federal courts, while racial inequality with police and police force, as exemplified by the incident surrounding Ferguson, Missouri, is a highly contested issue right now.  With such an important focus on inequality in society today, I want to explore Hayek’s point about inequality:


“From the fact that people are very different it follows that, if we treat them equally, the result must be inequality in their actual position, and that the only way to place them in an equal position would be to treat them differently. Equality before the law and material equality are therefore not only different but are in conflict with each other; and we can achieve either one or the other, but not both at the same time” – Friedrich Hayek, The Constitution of Liberty


Marriage and racial inequality with police force is an equality issue before the law, while income inequality is material inequality.  If we treat income inequality as an issue that needs to be fixed by law then the only way to do that is to have unequal laws since people are different. So, we would be fixing income inequality by creating inequality… in the law. With marriage and racial inequality, equality before the law is wanted, but if we treat this problem as one that should be fixed by material equality then we will necessarily create unequal laws to do so. As a society we must choose–equality in law or material equality. What would you choose?

President Obama on “Corporate Deserters”

Burger King is making headlines because it is considering merging with Tim Hortons, a Canadian coffee and donut chain. The motive is to share corporate services with Tim Horton and move the entire headquarters completely to Ontario, Canada to avoid high U.S. corporate taxes. Corporate taxes in the U.S. are 35% and 25.6% in Canada.

President Obama has stated his feelings on “tax inversion” multiple times throughout his re-election campaigns as well as presidency. Recently on July 24 in a speech at a college in Los Angeles, President Obama stated that companies that do cross-border mergers to escape U.S. taxes are “corporate deserters who renounce their citizenship to shield profits”. Later he stated that doing so adds to the tax burden of middle-income families and that companies should exhibit “economic patriotism”. To further sum up his feelings, he stated, “You shouldn’t get to call yourself an American company only when you want a handout from American taxpayers.” In a speech a year earlier, President Obama stated:

“The best way to level the playing field is through tax reform that lowers the corporate tax rate, closes wasteful loopholes, and simplifies the tax code for everybody. But stopping companies from renouncing their citizenship just to get out of paying their fair share of taxes is something that cannot wait. That’s why, in my budget earlier this year, I proposed closing this unpatriotic tax loophole for good.”

Ouch. In the first set of quotes, President Obama feels that corporations who are making the best cost decisions for their companies are “deserters”, while in later quotes he is referencing that many corporations in America do get tax write-offs and benefits (hence “a handout from American taxpayers”).  However, there is nothing “unpatriotic” about choosing to take business elsewhere if it is too costly to run in America.  Is it better for a company to go out of business by having to stay in the original country they incorporated in just to be an “economic patriot”? The tax system should not be driving people out of business. It appears that President Obama, who has been outspoken about tax inversion cannot accurately pinpoint the problem. Yes, the tax system is complicated and should be simplified, but what is “a fair share of taxes” and how is Burger King not going to be paying them? So, long as they are in this country they must pay for taxes according to the tax code and their accountants, you can rest assured, will try and find any tax loopholes if they exist. Is that unfair? The tax code needs fixing, not the companies trying to make more money to create jobs, growth and product.

Moving headquarters or operations to other countries by big brands  may be seen more and more as countries have a much lower corporate tax rate. The Netherlands have a 26% corporate tax rate, United Kingdom has a 21% tax rate and Ireland, 12.5%. The U.S. needs a more competitive corporate tax to incentivize companies to stay in America, rather than name-calling those who choose to make good cost decisions “unpatriotic”.