Josh Barro wrote a somewhat controversial op-ed in the NYT attempting to apply the Coase theorem to the negotiation between passengers on a plane about whether or not to recline their seats. Economist Greg Mankiw and political theorist Jim Johnson each posted a short reaction to the paper. See if you can spot the difference in tone. First, here’s Mankiw:
And here’s Johnson:
I wonder what Steve Medema would say.
A (Budding) Sociologist's Commonplace Book 
Arjun Narayan
/ August 28, 2014I feel like Josh Barro completely missed the point about the Coase Theorem.
Coase’s theorem on the surface says:
1. Absent transaction costs,
2. two parties will be able to reach the “socially efficient” solution
3. regardless of the initial allocation of property rights.
Some folks (and in this particular case, Josh Barro, and by endorsement, Mankiw) make the mistake of thinking that this means that government needs to get out completely, since “the market” will reach the efficient allocation. But that’s not what Coase said at all!
Coase instead fully acknowledged the fact that statement [1] is not true in reality: transaction costs matter all the time, and negotiation is not cheap (has Barro ever tried to hire a lawyer?).
Instead, Coase’s point was that given this framework, we can see that there is an overwhelming preference for one particular solution, which would be realized in an ideal world where negotiation is free. Thus, government should try and allocate the initial property rights such that it would eliminate the need for spending the transaction costs that may prohibit society from reaching efficient solutions. If you will permit me some abuse of mathematical notation, it’s an elaborate proof by contradiction, and most people miss that the initial “assume transaction costs are zero” is not meant to represent reality, it’s step one in a contradiction proof.
EconTalk’s Russ Roberts makes this point in an interview with Robert Frank quite clearly:
Frank: … Either way we would get the cheapest solution, which is the one we want. So, I think people seized on that example to say, Oh, look; here’s an externality and people can resolve it efficiently all by themselves. It doesn’t matter whether the government has a noise regulation; we can do quite nicely without that.
Russ: If you come to that conclusion, it means you didn’t read the rest of the article.
Frank: That’s right.
Russ: So, carry on.
Frank: So, Coase was very clear in his piece, and if you read the broader context of his earlier work it’s even more clear, that he did not believe that in general people could reach easy solutions through private negotiation about such problems. His very first work conducted when he was a young man on a visit to the United States from England was a detailed study of why we have firms in the first place. Why don’t we just do everything through individual contracts in the spot market? It’s because all the contracts you’d have to write would be so cumbersome to negotiate that it’s just much cheaper to have a firm organize them all internally and then give you a final product that you can buy. So he saw that negotiation was very impractical much of the time. And he sought to understand institutions, laws, social norms, all manner of institutional arrangements as attempts to economize on negotiation costs, making negotiation unnecessary.
Source: http://www.econtalk.org/archives/2014/02/robert_frank_on_2.html
I think this problem comes up often in Economics. You see the same thing with Modigliani-Miller, and people using it to say that we shouldn’t care about leverage ratios, etc. But that’s just false. To recap, the Modigliani-Miller theorem says that:
1) Absent agency costs, asymmetric information, and taxation,
2) The capital structure of a firm does not matter. I.E. investors should be indifferent to debt vs equity funding as long as it’s transparent.
But empirically what we observe is that capital structures of firms DO matter! And even absent the tax advantages of debt, highly levered firms do exhibit different behavior from firms that have no debt. You’re not supposed to take away from Modigliani-Miller that capital structure is irrelevant. You’re supposed to take it as proof that agency costs and asymmetric information are highly important things that significantly affect firms.
scritic
/ September 1, 2014Wow, I think this KneeDefender business is a nice case-study for introducing undergraduates to STS. Far better than Latour’s speedbumps, which are useful as far as they go, but which we’re so used to, that it’s hard to show different people arguing about them. Not so here. Everyone has an argument about who has the property rights! And someone even invokes Ronald Coase! Excellent.
But Dan, I have a question. I read Barro’s article and I have to say I don’t quite understand him. For now I’ll take him at his word about Coase (your points in this blog-post notwithstanding; I’m not an expert on Coase). Coase, he thinks, says that “it doesn’t matter very much who is initially given a property right; so long as you clearly define it and transaction costs are low, people will trade the right so that it ends up in the hands of whoever values it most.”
And then he spends the rest of his article arguing that indeed, the right to recline must be allocated to the person who is sitting, and indeed, this person must be privileged over the one who demands more legroom (this person is tall and is already privileged, etc.). If the initial allocation of rights was not important at all, why bother making this argument? After all, however you allocate the rights, it is going to end up in the hands of whoever values it the most. Which is all good.
So perhaps, while Barro might have stated Coase’s point wrongly (one that perhaps fits in with his free-market ideology), his whole article is written in the spirit of Coase’s *true* point (at least according to the Steve Medema piece you linked to). That transaction costs are always positive, and often high, and therefore the allocation of property rights is very, very important. And that in this case, the right to recline must be allocated to the person who is seated in the chair, rather than to the person who sits behind him.
What do you think?
Dan Hirschman
/ September 1, 2014In retrospect, the wildest part of Barro’s argument, to me, is the bit where he claims that no one has tried to transact with him (“in hundreds of flights I have taken, I have rarely had anyone complain to me about my seat recline, and nobody has ever offered me money, or anything else of value, in exchange for sitting upright.”) and yet somehow doesn’t see that as evidence that transaction costs are high! The lack of liquidity in a market is a classic case of market failure – somehow negotiation costs are high or information is asymmetric or something. Does he imagine that no one ever wanted him to not recline? Etc.
Also, I think he errs here in assuming that property rights are clearly assigned (pretty clearly false since there is unresolved dispute about it!). But because he think that such rights are *already* clearly assigned, he’s not really calling for a change (or at least, I don’t think he thinks he is). What he’s saying is, property rights are clear, transaction costs are low, so just pay me if you don’t want me to recline and it’s all good, yay for Coase.
scritic
/ September 1, 2014The transaction costs in this case being (with some creative license) the act of paying the person in front of you (or behind you) not to recline (or to recline). Really, what world does Josh Barro live in? “If sitting behind my reclined seat was such misery, if recliners like me are “monsters,” as Mark Hemingway of The Weekly Standard puts it, why is nobody willing to pay me to stop?” Please. That said, I would pay (ha!) to watch someone perform a breaching experiment like that.