05 Jul 2013

Eduardo Araral (L), Vice Dean (Research) and Associate Professor, the LKY School, with Ronald Coase, Nobel laureate.

Ronald Coase recently passed away at the age of 102. I have had the privilege of knowing him personally as an alumni and faculty of the Coase Institute and as a visiting fellow at the George Stigler Center on Political Economy at the University of Chicago in 2006 and 2007 respectively. On both occasions, I have had the privilege of having lunch with him during which time he gave me several pieces of advice. First, he said, “Look around you. There’s gold everywhere.” Second, he said, “If you want to study a horse, go out in the barn. Don’t be a blackboard economist.” Third, “if you torture the data long enough, it would soon confess.” I have since been passing on these pieces of advice to my PhD students.

Coase received the Nobel Prize in Economics in 1991 “for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.” Coase’s two big ideas – the nature of the firm and the problem of social cost – have significant implications for public policy.

First, Coase showed policy makers that there are alternatives to taxes and regulation in mitigating the problem of social cost. The conventional thinking then was that taxes and regulation should be used in cases of negative externalities. Coase argued that when transaction costs are low, property rights are easily measured and transferable, private bargaining among parties would be a more efficient solution. This idea – the Coase Theorem – led to the emergence of tradable emissions permit as a key policy tool by governments to deal with problems of pollution including global warming.

Second, Coase influenced the way governments thought about how to regulate the use of scarce resources like radio wave spectrum. In the late 1950s, the US Federal Communications Commission would assign radio spectrum for specific purposes for a small fee on a permanent basis. Coase argued that this is not efficient. He suggested that the spectrum should “be treated like any other property to be auctioned off to the highest bidder and allowing the bidder to use it however they chose and even sell or trade it, much like land.” This idea has important implications today for mobile information and communications technology revolution.

Third, Coase helped transform the way people think about law and economics. He argued and showed that judges should be mindful of the efficiency implications of their rulings. Along with his colleagues in Chicago, he reminded regulators about the costs of regulation and their unintended consequences. His work in this area has had significant implications in the development of antitrust regulations.

Fourth, Coase’s ideas on transaction costs and the nature of the firm have important implications in the reform of public bureaucracies. This is especially in the case of developing and emerging economies that have long been under a command and control regime. Long before contracting out of government services became fashionable, Coase had already thought about their efficiency implications. Long before the idea of measuring the costs of doing business and competitiveness became fashionable, Coase and his students such as 2009 Nobel Prize Winner Oliver Williamson were already laying the foundations of the theory of transaction costs.

During one of our luncheon conversations, Coase asked me, “Why does General Electric have 200,000 employees and not 100,000 or 300,000.” I smiled. I said transaction costs. Coase asked, “What kind of transaction?”. I explained that for an industrial giant such as GE, which very much depends on research and development, its size can also be explained by the tragedy of the anti-commons. To produce a hi-tech product, thousands of patents are needed. Alas, these patents are owned by hundreds of owners who have the incentive to hold out, hoping for the highest bid. Therein lies the tragedy. I argued that GE wants to minimise the transaction costs involving the tragedy of the anti-commons. Coase smiled back.

Finally, the Coase Theorem has practical implications in finding creative solutions to the haze problem in Singapore and Indonesia. Many solutions have been put forward and none of them appear to be working. According to the Coasian solution, if Singapore wants to minimise the haze, it can bargain with and buy out the rights of Indonesia (government, farmers, plantation owners) from burning peatlands for palm oil concessions. Peatlands produce half of haze emissions from Sumatra because they burn longer than the slash and burn methods of farmers. Peatlands can be demarcated on the ground and enforcement of the agreement can be jointly monitored with satellites and compensation tied to the extent to which they are not burned down. The problem should not be framed as one between Indonesia and Singapore but rather more broadly as part of efforts to reduce carbon emissions under the on-going REDD+ experiment in Indonesia. In this experiment, Norway compensates Indonesia for avoiding deforestation. The REDD experiment itself has its intellectual origins in the work of Coase on tradable property rights.

In its tribute to Coase, The Economist noted, “The job of clever people is to ask difficult questions. The job of very clever people is to ask deceptively simple questions.” The Economist called him “one of the giants.” And a humble one too. He said his ideas were “commonsensical.”

Eduardo Araral is Assistant Professor at the LKY School. He is also the recipient of 10 international awards and recognitions including the Fulbright PhD scholarship, a US National Science Foundation Grant and fellowship awards from the research centers of three Nobel Prize Winners: Ostrom, Stigler and Coase. His work on the costs and benefits of investments in collective has been cited by the World Bank to justify a US2.36 billion national poverty alleviation programme in the Philippines.