Coase’s Conception of Production Factor Costs (and the Coasean Challenge)

Here I want to lay out Coase’s conception of production factor costs as articulated in The Problem of Social Cost.  Coase’s conception of production factor costs has very significant implications for what might be called the “Coasean Challenge”–a challenge which in my view has been all but ignored by Chicago Law and Economics.  We start with the Coasean Challenge and then show how Coase’s conception of production factor costs greatly amplifies the difficulties of that challenge.

The Coasean Challenge

In The Problem of Social Cost, Coase deals with the “harmful effects” that result from conflicting resource use (e.g. cattle ranching and farming).  In his article, Coase identified the then-dominant “Pigouvian” approach, as follows:   First, the harm from resource conflict is identified as an “externality” (Coase did not use the term for good reason) and second some sort of government regulation (a tax, a liability rule, etc.) is imposed.

Coase was highly critical of this approach.  He argued that harmful effects can be addressed in a number of ways–not simply, government regulation, but by the market or internally by the firm.  In The Problem of Social Cost, Coase deftly showed that at least sometimes, government regulation would be less desirable economically, then doing nothing and letting the market and the firms fashion their own arrangements.

It is clear both in terms of Coase’s general orientation and the tenor of The Problem of Social Cost that Coase was trying to correct what he perceived to be an overly enthusiastic endorsement of government regulation by economists. As he put it: “All solutions have costs and there is no reason to suppose that government regulation is called for simply because the problem is not well handled by the market or the firm.” (Coase pp. 18–19.)   Right.  But Coase was a scrupulous thinker and thus he recognized that, on some occasions, regulation might be preferable. In a passage which could not possibly be quoted enough (and probably ought to be committed to memory) Coase wrote:

There is no reason why, on occasion, such governmental administrative regulation should not lead to an improvement in economic efficiency. It is my belief that economists, and policy-makers generally, have tended to over-estimate the advantages which come from governmental regulation. But this belief, even if justified, does not do more than suggest that government regulation should be curtailed. It does not tell us where the boundary line should be drawn. This, it seems to me, has to come from a detailed investigation of the actual results of handling the problem in different ways.(Coase pp. 18-19 ).

This brings us within reach of the Coasean Challenge.   This challenge is simple enough to elaborate (somewhat harder to resolve).  For Coase, in any situation where there are conflicting resource use problems and thus attendant harmful effects, there are three major solutions available: the firm, the market, and government regulation.

Recall Coase’s rancher/cattle hypothetical. If the cattle are not restrained in some way, they will eat the farmers crop. This is what Coase calls a “harmful effect.”  What to do?  Answer–at  least according to Coase: There are  three systems of coordination available.  (Today we would list more, but never mind).  Here they are:

1.  The Firm: If somehow the rancher and farmers were subsumed in a single firm (merger, buyout, etc.) then the firm’s profit maximization incentive would push toward an efficient solution. If it was more remunerative to allow free-range for the cattle, the firm would do that. If instead, protecting the crops from the cattle were more attractive, the firm would build a fence and do that.   The upshot here is that one solution to a conflicting resource problem is to subsume the two conflicting activities within a single firm.

2. The Market: Another option (not unrelated to the first one) is to allow the market actors (ranchers and farmers) to strike a deal on the market. Coase’s notion of opportunity costs means that each actor has to consider the possible receipts not just from its own respective productive activities, but from each other. Hence, the farmer may increase receipts by curtailing farming in exchange for a payment from the rancher. Or vice versa. If transaction costs are too high, however, and they cannot afford to strike a deal, whatever the law establishes as the baseline or default legal regime (Rancher liability for harm to crops? No liability? Something else?) will remain the final one.

3. Government Regulation: Yet a third option is to use law or government regulation to address the harmful effects problem. The effort is to try to decide what would be the optimal arrangement and impose it through law–taxes, liability rules, mandatory rules, etc.

In the Coasean world, these are the basic options.  Coase at times writes as if these coordination systems were analytically distinct. But one should not make too much of this: His key point is that each has effects upon and is dependent upon the others.   And indeed, it is obvious at this late date that 1) each is always attended and affected by the others and 2) there are a rich panoply of options or mixes of these different coordination system. (Note in this respect that Sunstein’s and Thaler’s “nudges,” Ian Ayres “altering rules” and the ubiquitous sticky/non-sticky defaults are simply some of the currently more popular or at least most visible elaborations of this point.)

And now we can articulate Coase’s Challenge: How are we to choose among the three coordination systems?   Which ones should we tinker (or not tinker) with?    More specifically: Should we leave well enough alone (the do-nothing strategy) and let the market and/or the firms adjust? Should, we instead use the law to tinker with the market (perhaps enable a market to emerge)?   Should we tinker with the law so as to induce the firms to reorganize (i.e. consolidate ranching and farming activities)?  Should we decide that transaction costs are such that there is nothing to expected from changes in the markets or the firms and thus we should impose some tax, liability rule, new property definitions, etc.? Or should we decide to the contrary that even though we cannot expect the market or the firms to reorganize (no matter what we do with the law) we would be better off nonetheless doing nothing?

Coase was keen on making sure we understood this last point (this is the main lesson of his train sparks hypothetical), just because we have a harmful effect and neither the firm nor the market handle it well, this does not mean that we will necessarily be better off with government regulation.  It may be that in terms of economic performance, the best thing to do is to let the harmful effect occur.  This (perhaps surprisingly) brings us to the notion of “production factor cost.”

Coasean Production Factor Costs

In neoclassical economics, a production factor cost is basically the cost of an input in production—usually, conceived as land, capital, and labor. Sometimes economists suggest additional categories (e.g. technology, education, knowledge, entrepreneurship) and then a debate ensues (one I don’t wish to join) about whether these are in fact distinct production factor costs or whether they really are aspects of the original big three (land, capital, and labor). For our purposes, a production factor cost is the costs of inputs in a production enterprise.

Now, the interesting thing is that Coase offers a different take on production factor costs—different at least from most of his fellow economists at the time.  Specifically, Coase recognizes the role that law plays in deciding what is a production factor cost of what?  Economists, he argues, should think of production factor costs less as the costs of physical things and more in terms of legal entitlements.

Take the familiar example of a steel factory emitting smoke that damages nearby commercial activities (e.g. a laundromat). Coase’s point is that if the steel factory is prohibited from emitting smoke by regulation then smoke abatement (or cessation) becomes a production factor cost of producing steel. If by contrast, emitting smoke is allowed with no legal consequence, the smoke damage becomes a cost of any activity potentially damaged by such smoke. In other words, the law (the way it is structured and organized—liability, no liability, tax, regulation, etc.) effectively decides, in many cases what is a cost of what. Coase makes the point very clearly in the concluding sections of The Problem of Social Cost:

A final reason for the failure to develop a theory adequate to handle the problem of harmful effects stems from a faulty concept of a factor of production. This is usually thought of as a physical entity which the businessman acquires and uses (an acre of land, a ton of fertiliser) instead of as a right to perform certain (physical) actions (Coase pp. 43-44).

This moment is huge.   It is huge because it is an affirmation that law plays a crucial role in establishing production factor costs—the kind of costs (identity—e.g. cost of abatement, cost of relocation, cost of…) and their magnitude (dollar amount). Coase, a free market proponent (at least in inclination) is corroborating what many of us who grew up on the Robert Lee Hale–Duncan Kennedy axis of economics believed all along—namely, that law plays a crucial role in establishing the costs of goods (of all kinds).  Law (common law, constitutional law, etc.) is undeniably and intimately involved then in the disbursement of penalties and subsidies (deciding what is a cost of what?) to various activities.

I say penalties and subsidies in the sense that we are socializing the costs of private activities through law and we have no neutral baseline available to tell us across the multitude of existing and potential markets which markets and which activities we should subsidize or penalize how much when.

Now, if we can bring in the Coasean Challenge, as described above, the question arises: in cases of conflicting resource uses, what aspects of the coordination systems should we tinker with—let the firms and the market deal with it? Change the law in some way? Do nothing? Notice that this was a daunting question even before we started thinking about the Coasean conception production factor costs.  Now that we are confronted with Coase’s legalist conception of production factor costs, the challenge has become even more difficult. Why? Because it now looks like when we change the law (or keep it the same) we are unavoidably affecting the size and magnitude of the production factor costs of various private production activities. So how much should we subsidize or penalize them (size) and what costs should we, in fashioning our law, impose on them (magnitude)?   There is even the further question–fodder for a later post: what kind of cost is to be allocated to which coordination system: the firm, the market, the law?  But bracket that for now.

It is perhaps surprising, but Coase has effectively shown that law (common law, constitutional law, etc.) is in effect a socialization of costs.   Such socialization is unavoidable.  Even the most libertarian or laissez-faire regimes are involved in such socialization of costs.

The only question worth arguing after Coase then is how to talk about this socialization of costs.  For that purpose the broad-gauge and deeply cliched disputes about “big government” versus “the free market” or “individual freedom” versus “command and control ” (or even “nudge” versus “mandatory rules”)  are rather crude.    Rather we should face up to much more circumspect, interesting, and important questions on which we might actually make some headway (or at least carry out some useful experiments): which costs and whose costs do we want to socialize when for how long by what means?   This, of course, is an obviously political question (the distributive justice stakes are high)… but my point… is that it is also inexorably an economic question as well and that the failure to confront this question yields not only bad politics, but bad economics.   Coase Minus the Coase Theorem contains the full argument.

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2 Responses to Coase’s Conception of Production Factor Costs (and the Coasean Challenge)

  1. John Carlson says:

    I finally got around to reading your second post on Coase this weekend, and I’ve been thinking about it since. As a CLS-wannabee myself, I’d always thought of Coase as that Chicago-school economist with dreams of a world populated by Ayn-Rand superheroes and defined by zero-transaction-cost bargaining, associations that of course triggered my highly conditioned and patterned insta-responses: What about information imbalances, or the problem of a scattered and weak bargaining partner, to say nothing of the superhero’s incentive to delay, mislead, and buy off politicians and judges? I learned this stuff; they’re good moves. But had I read your two posts back then I could have spared the effort: they don’t even have their Coase right. What a waste.

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