Coase Theorem-Friedman, Harberger-Smit-Stigler Eric Rasmusen, [e-mail]

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Coase Theorem-Friedman, Harberger-Smit-Stigler
Eric Rasmusen, erasmuse_at_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/rdPnc
  l1.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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Harbergers Method
1. 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
r2qk 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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HarbergersRefinements
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 mills 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. (Friedmans
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
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
Calabresi, Guido Melamed, Douglas, "Property
Rules, Liability Rules and Inalienability One
View of the Cathedral", 85 Harvard Law Review
1089 (1972).
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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 railroads 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)
• 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 theyd have to
  pay the 1,000.)

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Stigleron 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