Addendum on Coase [Again- Apologies in Advance!]

A friend here in New York wrote to me to say he “didn’t get” the import of my comment yesterday about Coase. This is my fault. Let me take a quick – I promise – stab at clarification because his befuddlement strikes right at the heart of why regular people find economics so baffling.

Recall that I use Coase’s 1937 article as my starting point. For the record, Coase won a Nobel prize for his later work and not for his comments about the existence of firms.

In that 1937 article Coase posed the question: “why do firms exist?”.

Now, to my friend, and no doubt to most of you, this is just a silly question. It is obvious after all why firms exist: they are places where we cooperate to produce stuff. And the complexity of production requires big organizations with capital and expertise to get the job done.

Right?

Well no. Not if you are an orthodox economist. And this is where orthodox economics and reality part ways. Coase was trying to inject reality by asking his question and was soundly ignored for his effort.

The problem is this: having spent the better part of a hundred years constructing a wonderland in which markets perform miracles and are indisputably the best possible way of organizing economic activity – including production – there is no way to fit the real world thing we call a firm anywhere into free market economics. No way. However real they may be. However obvious it is to you. However many people they may employ. However important they may appear. In orthodox economics, especially as it existed back in 1937, firms do not exist.

More to the point they cannot exist.

This is because markets are held to be so efficient and superior that the emergence of a cooperative form of activity, e.g a firm, would be crushed before it took root. It is a question of theory in defiance of reality.

This may seem arcane and irrelevant to you, but I beg to differ. We are assaulted daily about the effectiveness of markets as economic organizing machines. They, we are told, are wizards. Nothing can compare with “the market”. Especially not the evil alternative known as “central planning” which we usually conflate with government. No. We are lectured by dozens of Nobel prize winning economists that the market should be set free to decide resource allocations, income distributions, what gets produced, who wins and who loses. After all the market cannot be surpassed in effectiveness in such matters. So relentless is this repetition that the superiority of markets has entered the central narrative of American life. Pick up some of our most popular economics textbooks and you will be told that America is wealthy because it adheres to a free market form of economic policy. Business is retrofitted into this narrative for sure. But not into the underlying theory.

In other words there is a massive disconnect between the story we are told, and the theory on which that narrative rests. We are misled.

It was in the context of that deeper theory that Coase asked: then why do firms, manifestly a form of central planning, exist?

If orthodox theory is correct there should be no firms, at least as we know them. Their very existence is an indictment in the real world of a hundred and fifty years of theorizing.

Which is why to this day the subject called the “theory of the firm” hardly ever gets onto the curriculum in school.

In response to Coase economists basically carried on as if he never asked the question, and it is only much more recently that people have taken up the challenge. And even then, in my opinion, they attempt to elide the real challenge.

This entire discussion goes to show the huge gulf between orthodox economic theory and the real world. I hope it highlights why we should all be extremely skeptical of the notion of the hidden hand. That markets do certain things is obvious. That firms exist is equally obvious. But to orthodox economists intent on defending the extreme vision they have of free markets – and I mean extreme – firms are a huge, and very unwanted, elephant in the room.

So to sum up: Coase’s simple little question plunges a dagger right into the heart of orthodoxy’s most revered conclusion. Free markets are not always efficient. They do not always have good outcomes. This is obvious to us all, but is a plague on orthodox theory. It undermines the claim that deregulation will lead to a healthier economy. It suggests we need a more balanced approach to policy. It tells us that a mixed economy, where some things are centrally organized and others left to the market is probably a better solution than leaving everything to the market. It implies we should all rid ourselves of the notion that unfettered capitalism is always preferable to any alternative. And so on.

By asking his question Coase was pulling on a string that if pulled a little more would have unravelled a century’s worth of work. He chose not to pull again.

Had he, economics would have been improved immeasurably and people like my friend would not be befuddled by the derisory way in which orthodox economics treats business.

So, no, my friend didn’t miss anything. On the contrary it is economics that misses something. That something being reality.

Does that make it more clear?

And I apologize for repeating myself. Economists, even rotten ones like myself, can be truly obscure sometimes.