Equilibrium in Ronald Coase's Method

 



 

August 17, 1998

Abstract

 

            The aim of this paper is to describe the critical role that the concept of equilibrium played in Ronald Coase's two revolutionary papers on the firm and on social cost. He introduced his paper on the firm with a concept of equilibrium in which individuals were assumed to adjust instantaneously to changes via the price mechanism. He attributed this concept to A. Salter but Salter’s concept can be traced further to J. B. Clark, who provided a methodological foundation for understanding its role in economic analysis. Later in history, the equilibrium was employed in rational expectations theory. Coase’s paper expanded the Salter model to include adjustments to changes by means of firms. His paper on social cost expanded it further to include direct government regulations, rights to control actions that have external effects, and legislation.

 


Outline

 

1.The Nature of the Firm

            a.The Clark Equilibrium

            b.The Salter Equilibrium

            c.The Coase Equilibrium

            d.Arnold Plant's Use of the Salter Equilibrium

2.The Problem of Social Cost

3.Property Rights and Rights to Control Actions

4.Conclusion


 

Equilibrium in Ronald Coase's Method

 

             Ronald Coase's seminal papers have had an enormous influence on applied economics. Although the number of his written pages is small compared with other Nobel Prize winners, subsequent writers applied the ideas contained in his fundamental papers. By doing so, they have largely succeeded in transforming the fields of law and economics, study of organizations, institutional economics, and economic history. Given this fact, one might expect that economists would have carefully examined Coase’s method of constructing theory and compared it with that of earlier economists in order to help them understand why it has yielded so much fruit. Yet surprisingly little has been written on this subject.

            The aim of this paper is to show the crucial role that the concept of equilibrium played in this method. Coase did not use the term “equilibrium.” It is evident, however, that he introduced his innovations into economic theory by conceiving of an “economic system that is automatic, elastic and responsive” (Coase 1988: 34). Footnote Such an image corresponds to what we today call a rational expectations equilibrium.

            The argument that equilibrium played a crucial role does not imply that Coase ever assumed that a real economic system is “in equilibrium,” whatever meaning we might attach to this term. It means only that the image of the economic system which he used to differentiate his theory from that of other writers was an equilibrium image. Given this fact, we can best understand his innovations by recognizing the role that equilibrium played.

            To understand why this is the proper course, one only needs to realize the critical role that choice played in Coase’s analysis. In his major papers at least, Coase always assumed that economic actors were choosers. Yet neither the choice of a single individual nor the choices of many interacting individuals can be comprehended without conceiving of a beginning point before choices are made and an endpoint afterwards. It is common in economics to express these beginning points and endpoints by using the term “equilibrium.” That Coase apparently tried to avoid the use of this term in no way compromises the argument that the concept of equilibrium played a crucial role in his method. All that it demonstrates is that Coase himself did not have a complete understanding of this role.

            Coase used the equilibrium concept for two purposes: (1) to show how to extend the notion of cost beyond that of production cost to the costs of using the market mechanism and (2) to introduce a new means of understanding and evaluating public policy, broadly defined, toward external effects, in light his revised definition of a factor of production as a right to control an action. This paper traces the development of the equilibrium concept through his two major papers, taking account of his later discussions of those papers. Part one shows how he used the concept in his paper on the firm. Part two shows how he expanded this use in his social cost paper. Part 3 discusses related literature. Part 4 presents a brief conclusion. 

 

 

1. The Nature of the Firm

 

            Coase introduces the equilibrium concept in his 1937 paper by referring to Sir Arthur Salter's model of the economic system. In this system, "supply is adjusted to demand, by a process that is automatic, elastic and responsive"(Coase 1988: 34).

 

The Clark Equilibrium

             To fully understand this idea, it is wise to begin with a simpler concept of equilibrium that was used by John B. Clark. This is the so-called static state or static equilibrium (Clark 1899: 189-192). In describing this state, Clark writes:

We want to know everything that happens in consequence of organization. We want to keep out of our minds what further happens by reason of changes that are all the while going on in society...We must bring before our minds all that happens in consequence of mere organization, and nothing that happens in consequence of change, growth, and progress in the organization...[L]abor and capital do not flow from group to group...[T]here is no change in the comparative sizes of the subgroups.

 

What is the cause of [capital and labor’s] stationary condition? [T]hey have no inducement to move. [A] unit of labor...can gain nothing from moving, and it stays where it is...Perfect mobility on the part of economic agents, without any movement, is characteristic of the static state...

 

A static society, then, is a no-profit state; and it is a state of uniform productivity for labor and of uniform productivity of capital. These conditions...tell us clearly why labor does not go from [A to B] or elsewhere. The inducement to move labor or capital in one direction equals the inducement to move it in any other direction (ibid.: 189-91).

 

            Ludwig von Mises elucidated the static state further. He pointed out that the static state

is a fictitious system in which the market prices of all goods and services coincide with the final prices...The same market transactions are repeated again and again...The plain state of rest is disarranged again and again, but it is instantly reestablished at the previous level...The essence of this imaginary construction is the elimination of the lapse of time and of the perpetual change in the market phenomena (Mises 1966: 247).

 

In the static state, we imagine that the same production, buying and selling, consumption and saving, and production behavior in factor and final goods markets, is repeated again and again. There is no change. There also is no time, although time is represented by the hypothetical, repeated behavior. And there is no profit incentive. Let us call this the Clark equilibrium. Footnote

 

The Salter Equilibrium

            This paper uses the term Salter equilibrium to refer to the model of the economic system that Coase attributes to that writer. In describing it, Coase quotes D. H. Robertson:

The normal economic system works itself. For its current operation it is under no central control, it needs no central survey. Over the whole range of human activity and human need, supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive (Coase 1988: 34; Robertson 1928: 85).



Coase goes on to say that “[a]n economist thinks of the economic system being co-ordinated by the price mechanism...[although] this does not mean that there is no planning by individuals” (ibid.).

            Let us compare this to the static state. As Mises (quoted above) points out there are prices in the static state. However, there is no price mechanism to signal changes. Indeed a price mechanism is unnecessary since there is no change. From this point of view, it differs from the Salter system described by Coase. Footnote In Coase’s view, Salter was referring to a situation in which prices are continuously guiding the owners of the factors of production. Referring to F. A. Hayek (1933: 130), he characterizes the Salter system not as “an organization but as organism”(Coase 1988: 34). The guidance function of prices is conspicuously absent from the static system.

            The Salter equilibrium and the Clark equilibrium are related in the following way. The Clark equilibrium allows us to describe the fundamental elements of the Salter equilibrium in the simplest way. All the factors of production and goods are “fully organized.” The Salter equilibrium is an “active organism” in which owners of the factors of production are continually yet instantaneously adjusting, via the system of markets and prices, to changes and perhaps also causing some changes. Yet they are also always fully adjusted.

            To try to get a better handle on this, imagine an initial state of the Clark equilibrium. Now consider a change in demand or cost which, if it was not immediately adjusted to, would lead to a situation in which supply was not adjusted to demand in all markets. Now assume that the changes are instantaneously identified and adjusted to by all suppliers and demanders. In today's age of computers, we could imagine a computer program that would closely simulate such simultaneous adjustment. The Salter equilibrium is a Clark equilibrium that is continuously being disarranged by changes in demand and/or supply yet is instantly reestablished in light of the changes. Footnote

 

The Coase Equilibrium

            Referring to the Salter equilibrium, Coase remarks that it is not only an "incomplete" image of the economic system, it does not help to describe what happens "within a firm" at all. A workman within the firm does not automatically adjust to a change in demand. Instead, he follows the orders of his boss (ibid.: 35). By noting this difference, Coase makes the Salter equilibrium the embarkation point, so to speak, for his investigation of the employer-employee relationship.

            Coase's next step is to introduce the entrepreneur as the embodiment of all the organization or coordination that occurs outside of the Salter equilibrium. In other words, he conceives of two kinds of coordination: (1) that which occurs according to the Salter equilibrium and (2) that which he associates with the concept of the entrepreneur in Alfred Marshall, J. B. Clark, Frank Knight, and D. H. Robertson (ibid.). He proposes to explore this concept from the perspective of the relationship that forms between the employer and employee.

            His exploration begins with a new conception of an economic system. This is a Salter equilibrium in which there "is a cost of using the price mechanism." In other words, he retains the assumption of instantaneous adjustment but adds a cost -- and, correspondingly, an alternative in individuals’ choice sets. Actually, he adds two different types of price-mechanism-use costs. These are (1) "costs of discovering what the relevant prices are" and (2) "costs of negotiating and concluding a separate contract for each exchange transaction" (ibid.: 38).

            Let us call the equilibrium that includes these additional costs (and choice options) the Coase equilibrium. It is an economy in which there is automatic and instantaneous adjustment to change, as in the case of the Salter equilibrium. Yet there are additional costs of making transactions for which the Salter equilibrium does not account. The presence of transactions costs may correspond to an incentive to form a firm. A coordinating entrepreneur may recognize that he can avoid the costs, or at least some of them, by making a contract with employees and other factor owners in which the latter agree to shift their resources from one project or location or type to another, at the employer’s request, without requiring a new contract. In other words, the contract between the coordinating entrepreneur and employee (or other resource owner) specifies that the worker follow the orders of the entrepreneur, within limits (Coase 1988s: 39). The coordinating entrepreneur acquires legal rights to the use of the factors of production that enable him to arrange production by means of an administrative decision (Coase 1991: 66).

            Coase elaborates on this equilibrium in his 1991 review of his earlier paper by pointing out that a more complete conception of the firm would recognize the contractual nature of the firm -- i.e., that the administrator of the firm, or entrepreneur, makes contracts not only with the factors of production but also with the buyers of its products (ibid.: 64-7). He also writes that the firm’s relationships, in reality, include inter-firm transactions.

            In the Salter equilibrium, the instantaneous adjustment implicitly involves a negotiation of contracts to act in particular ways; in the Coase equilibrium, it also involves employers giving orders to employees. Footnote Moreover, the ways in which individuals act is expanded to include inter-firm and firm-consumer transactions. In both equilibria, changes in demands and costs are being continuously adjusted to. But in the Coase equilibrium, this includes changes in the costs of using the price-mechanism. For example, changes in the costs of making inter-firm and firm-consumer transactions will lead to adjustments. In the former case, the result may be a movement toward or away from vertical or horizontal integration (ibid.: 66-7).

 

Arnold Plant’s Use of the Salter Equilibrium

            Before going on to show how Coase used this equilibrium concept in his social cost paper, it is worth noting a related use of the Salter equilibrium by Coase’s teacher Arnold Plant, who Coase cites in his paper (Coase 1988: 34). Like Coase, Plant remarked that Salter’s “account of our system is incomplete” (Plant 1932: 51). But he saw Salter’s account in a different light and conceived of its being incomplete in a different way.

            He began by writing that the Salter image is useful because it demonstrates consumer sovereignty. Commenting on an extended version of the same Salter passage quoted by Coase, he writes that “[t]he controlling employer in the productive system is the community of consumers. The business man is simply one of the many faithful servants” (ibid.: 52). Next, he cites several reasons why he believes the Salter image is incomplete. First, it fails to recognize that consumers experiment and speculate (ibid.). Second, “business men are not, and never have been, content to remain entirely submissive to consumers’ choice” (ibid. 53). Examples of aggressive business actions are the use of persuasion in marketing, product standardization and simplification, the introduction of new patterns and devices, technological advance, cutting prices, giving rebates, offering consumers shares of profits, giving coupons in cigarette packets, full-line forcing, exclusive dealing, and mass advertising aimed at driving out competitors.

            Like Coase, Plant felt that the Salter equilibrium disregarded some opportunities that were available and used by everyday business people. Also like Coase, Plant used the Salter equilibrium as a stepping stone, or benchmark, to launch his discussion about real choice. Footnote

 

 

2. The Problem of Social Cost

 

            Recall that the Coase equilibrium is simply the Salter equilibrium with some firms that have arisen due to assumption that, in light of the costs of using the price mechanism, organization by means of firms is superior, under some circumstances, to organization by means of the price mechanism. In the “social cost” paper, Coase expanded this image by introducing organization by means of government intervention. He describes two forms: (1) administrative regulation and (2) the delimitation of rights. Regarding regulation, he writes:

Instead of instituting a legal system of rights which can be modified by transactions on the market, the government may impose regulations which state what people must or must not do and which have to be obeyed...The government is able, if it wishes, to avoid the market altogether, which a firm can never do...[Although] direct governmental regulation will not necessarily give better results than leaving the problem to be solved by the market or the firm...there is no reason why, on occasion, such governmental administrative regulation should not lead to an improvement in economic efficiency (Coase 1988: 117-8).



Regarding the delimitation of rights, he identifies two ways in which governments accomplish this: (a) through “statutory enactments” and (b) through the “courts, in cases relating to nuisance” (ibid.: 132).

            We see from these statements a broader vision of what I have called the Coase equilibrium than was evident in his paper on the firm. It is one that includes government action in the form of the regulation and the delimitation of rights, the latter occurring through law-making and decisions under common law. We can call this the expanded Coase equilibrium. It includes the institution of government in the form of a clearly delineated set of regulations, common law, and statutory rights. Footnote He used this equilibrium to assess the realism of economists’ statutory recommendations for dealing with external effects. Footnote

 

 

3. Related Literature

 

The Coase Equilibrium in Relation to Other Uses

            The equilibrium concept has been used in a number of ways in economics. Three uses stand out. The first, which is the most popular in mainstream professional economics, is as a model of an economy. Such a model can be used as a basis for organizing statistical data and for econometric testing of statistical hypotheses. The second is as a norm, or optimum of economic interaction, with respect to which images of non-normative, non-optimum economic interaction can be defined. Normative images, or models, can the be used as a basis for describing observed economic interaction and/or for evaluating it. The descriptive images that are derived from a normative equilibrium differ from econometric models in that the latter are always intended as an intermediary step toward the ultimate goal of testing hypothesis by using numerical data. The former have no such goal in mind. Their aim is explanation. The third is as an endpoint consisting of a complex structure of interrelated prices and quantities of factors of production and consumer goods. This image opens the door to the study of the market process, which is regarded as the set of actions that would, if there was no change in the data, tend toward the equilibrium. Footnote

            Coase’s equilibrium comes closest to this second use. He is not interested in the normative image to evaluate interaction. Indeed he cautions against this (Coase 1960 [1988]: 141-2). Instead, he uses normative images as descriptive tools. The story of Coase’s use of the equilibrium concept is basically a story about the normative images he constructs for descriptive purposes. One might legitimately raise the question of what Coase aims to describe. An easy answer is: a more realistic economic system. However, in light of his criticism of the approach to hypothesis-testing that he associates with Friedman’s positive methodology, it would seem more correct to say that he uses the equilibrium models to describe his own more realistic theory. For his criticism of the positivist, hypothesis-testing methodology ends with the statement that, if one uses it, “[w]ork could certainly continue, but no new theories would emerge” (Coase 1982 [1994]: 24). There is a subtle, yet seemingly important, difference between (1) testing hypotheses about whether this or that depiction corresponds with reality and (2) inventing theories, or models, of reality that are more accurate. Friedman was concerned with the former; Coase aimed to accomplish the latter.

            The remarks in this paper seems broadly consistent with Gibbard and Varian’s discussion of equilibrium. They describe two uses of economic models by economic theorists, “aside from the large scale econometric models programmed on computers”: descriptive and ideal. Within the class of descriptive models are (1) econometric models (photographs), (2) realistic models (realistic drawings), and (3) caricatures (1978: 665). They write that economists apply descriptive models econometrically and casually (ibid.: 672). It seems that the use of what in this paper are called normative equilibrium images and their non-optimum derivatives for descriptive purposes would fit into their category of casual descriptions. They write that “[t]he goal of casual application is to explain aspects of the world that can be noticed or conjectured without explicit techniques of measurement ”(ibid.).

 

The Zerbe-Medema Interpretation

            Richard Zerbe and Steven Medema present an interpretation of Coase’s work that focuses on Coase’s self-proclaimed belief that he was following Alfred Marshall’s eclectic approach to economic problems. They expand this into an argument, which they intimate corresponds to that of Coase, that economics should begin with the phenomena that one aims to understand, then construct theory (by which they mean a hypothesis) about the “cause” of the phenomena, and then test, in the Popperian sense, whether the theory explains the phenomena (Zerbe and Medema: 1997: 221). In this author’s opinion, this is a correct representation of Coase but only insofar as one recognizes that Coase’s theories are all based on the assumption of choice. In other words, his explanations of the causes of phenomena are explanations based on the assumption that the phenomena have resulted from individual choices. Thus it would be wrong to suggest, as Zerbe and Medema do, that Coase would subscribe to the belief that economics could be “set on the right track by empirical psychologists” (ibid.: 212). It is precisely the fact that Coase assumes that economic subjects are choosers that he needs the equilibrium model to represent his assumptions about their interrelated choices. It would be similarly wrong to claim that Coase emphasizes the behavior of individuals and institutions, if by this one implies a denial of that fact that Coase’s unique contribution to economics is his explanation of interaction and institutions in terms of a theory, or logic, of choice.

 

Blackboard Economics

            A reader of an earlier version of this paper criticized it by pointing out Coase’s aversion to so-called blackboard economics. He reasoned that since blackboard economics means equilibrium economics and since Coase appears to have avoided using the term “equilibrium” in his discussions, this paper’s representation of his theories in terms of equilibrium must be inconsistent with Coase’s method. However, the Salter equilibrium described above is not blackboard economics. The view of a coordinated economic system that this equilibrium enables one to attain cannot be presented on a blackboard. The misconception to the contrary appears due to the fact that most economists learn about equilibrium on the blackboard. This, in turn, arises from the professional desire to model economic interaction mathematically. However, if we follow Coase in regarding the Salter equilibrium as a means of organizing one’s image of a coordinated economic system, the association between equilibrium and the blackboard vanishes.


4. Conclusion

 

            On the basis of the discussion here, it appears that Coase used the equilibrium concept to refer to an economic system that contained change as well as instantaneous adjustments to change. In the Salter formulation, which was Coase’s starting point, all adjustments take place through the market mechanism. They are adjustments by individuals making pricing and output decisions. Coase added to this by recognizing that adjustments take place in three additional ways: (1) in firms, (2) in government regulation and (3) in the delimitation of rights. The rights that exist at any given time make up part of the institutional structure within which the market mechanism and firms make adjustments. Indeed, the firm is an institution itself for which writers of regulations and delimiters of rights ought to account if they wish to attain their goals. Market adjustments, adjustments in the firm, government regulations, and the delimitation of rights all interact in the adjustment process of the expanded Coase equilibrium. The precise nature of this relationship has been explored by Coase himself and in the literature. This paper has mainly focused on the equilibrium framework within which the interaction is assumed to take place.



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