Ronald Coase, Mahabharata, and Behavioral Economics!

There are only a handful of economists with far reaching influence on economy and society. Only a few enjoy respect from wider community outside of their own fraternity. Even a lesser number becomes immortal in their lifetime.

Ronald Coase, a British Economist and University of Chicago Law School Professor was one of them.

In 2013, he died at the age of 102. No, he did not receive the Nobel Prize at the age of 40 or 50 or 60 or 70. He received it at the age of 81 for a piece of work he did at the age of 27 – The Nature of the Firm (1937). The next monumental piece by Coase came in 1960 – The Problem of Social cost. In Nature of the Firm, he introduced the concept of transaction costs explaining the nature and limits of the firm while in Problem of Social cost he has demonstrated why a well defined property rights can help in overcoming the problems of externalities.

He was not an article producing machine. Young scholars in college would have produced more article than Ronald Coase in his lifetime. However, he has fundamental contribution in Economics by way of making ‘Law and Economics’ a mainstream discipline along with Gary Becker, Richard Posner etc. Tons of Article are written on Coase, Coasian framework, Transaction costs. I think there are only a few Nobel laureate in Economics who have achieved such a feat. If you read five of his articles, you will understand Coase and his work. You do not have to read volume after volume to decipher his work.

Noble Committee mentioned the motivation for award as

“for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy."

Coase in his Nobel lecture stated that -

“In my long life I have known some great economists but I have never counted myself among their number nor walked in their company. I have made no innovations in high theory. My contribution to economics has been to urge the inclusion in our analysis of features of the economic system so obvious that, like the postman in G.K. Chesterton’s Father Brown tale, The Invisible Man, they have tended to be overlooked.”

He changed the jurisprudence in civil law litigation. He provided a reason for judicial activism. Ronald Coase and Judge Richard Posner together have advanced the field of law and economics as it became a mainstream discipline now.

Coase is known for Coase Theorem (well, he could not have been known for Alice in Wonderland!). However, he has never used the term Coase Theorem. It is his Chicago Colleague George Stigler who gave it a formal shape. The irony is that Coase never liked the term ‘Coase Theorem’. Washington Post quotes –

“I never liked the Coase Theorem," Coase said on the EconTalk podcast last year. "I don't like it because it's a proposition about a system in which there were no transaction costs. It's a system which couldn't exist. And therefore, it's quite unimaginable."

The reason why Coase did not like the term because he wanted to highlight that the world is not a ‘Zero Transaction Cost’ open field rather the opposite. Unfortunately, it became easier for modeling purpose, so the economists preferred to use the Zero transaction cost assumptions. To model the real world, economists assume many things – most often unrealistic things and at the end of it they use these models to provide policy guidance. No wonder the profession is so closely being scrutinized post the global financial crisis.

What is this Coase Theorem and moreover why do we even talk about it today?

Coase Theorem Says – “Given free bargaining and low transactions costs, voluntary transactions of individuals in the market will allocate property rights to their most highly valued and efficient use. Both parties in a dispute over property rights have an incentive to move to this position. Such allocation occurs automatically without regard to how property rights are initially or legally assigned. Judicial action to allocate them generates a superfluous social cost and is itself a negative externality”.

[or]

“When transactions costs are very low, the efficient solution occurs from free and private bargaining, regardless of how property rights are legally assigned by a court. Under such circumstances, judges cannot expect to alleviate any market failure better than the market itself, which will allocate resources to their most highly valued and efficient use”. [Cobin, 1999]

What does it mean?

Cobin gives a nice example. Let’s go through that with some minor modifications. 

Imagine a rancher’s cattle are destroying the crops of a farmer by crossing the line. Let’s say it is damaging crops of the farmer worth $100 per year. Both know each other so they can easily get into a discussion and fix the problem. Rancher has much more land than the poor farmer.

What could be the solution?

Build a fence. But who would build the fence – the rancher who holds much more land or the farmer with a little amount of land? Both would expect the other person to build the fence as it involves cost.

What are the various options before them?

Farmer – If he builds the fence around his land, it will cost $50 per year. However, it would lower his profits.

Rancher – The cost would be $75 per year since he is having big land area and reduce his profit as well.

Given that $50<$75<100, it makes sense to build a fence as crops worth $100 would be saved.

Question remains - who would now build the fence? Even if the cost is lower for the farmer, why would he spend that money as it is the ranchers cattle that is destroying the crop?

Let’s say both now have gone to the court.

Rule 1: If Court rules that the farmer is responsible since he has left the farm unfenced and in doing so attract the cattle, it will cost $50 to the farmer. Still it would be efficient as the net saving is $50 (since crop loss value is $100).

Rule 2: If the court holds that the rancher is responsible as it is his duty to keep the cattle within his area, then rancher must spend $75 to build the fence around his land. Still it would make sense for the rancher otherwise he would have to pay $100 as crop loss penalty.

Court may now ask them to go for a out of the court settlement among themselves. That is all about arbitration – a quasi-judicial process or they may not involve anyone and do a personal settlement.

So now what sorts of bargaining would happen?

Now the rancher would negotiate with the farmer to save more money:

1. Rancher would prefer to fence around the farmer’s land as it would cost only $50 ($50<$75);
2. Farmer knows about this so he would try to extract a little bit more from the rancher’s savings. Afterall he must sacrifice a bit of his land to do the fencing. He may therefore demand maximum additional money to the extent of $25 (could be $24, $23…);
3. Finally, the rancher may agree to build the fence around the farmers land by spending $50 and pay him a little bit additional money (say $12.50) keeping the additional $12.50 with him.

So, the outcome of this negotiation process is that a fence would be built around the farmer’s land regardless of the court’s ruling on assignment of property rights. A possible market failure situation is averted through the Coase Theorem when the negotiation (transaction costs) costs are zero. Rancher would be happy as he is paying only $62.5 (<$100) and the farmer would be happy as his crop loss worth $100 is saved now with a little more money in his hand.

No matter whatever is the initial allocation of property rights, as I wrote in one of my earlier posts, “as long as both the parties can strike a deal of exchange…If the doctor earns more in a month than the confectioner, he will pay the confectioner to move to another plot and vice versa. Symmetry established through non-coercion.”

This is the beauty of Coasian framework. This is how the mysterious entry of Economics happened in Law and several judgement across the globe is being passed using the economic efficiency concept. Of course, the rule of game changes as soon as the bargaining and negotiation costs become non-trivial!

Ronald Coase’s idea is undoubtedly a supreme contribution!

However, imagine what would have happened had Ronald Coase read – Mahabharata or watched B R Chopra’s TV show in his 20s!

Lord Krishna (the negotiator/freelancer) tried to strike a deal between Pandavas and Kauravs. Mahabharat is nothing but a land dispute in its most mundane form. It would have been registered as a civil case in today’s time. Instead of whole of Hastinapur, Lord Krishna convinced Pandavas to ask for only five villages for the five brothers. Pandavas, therefore, asked for Indraprastha (Delhi), Swarnprastha (Sonipat), Panprastha (Panipat), Vyaghrprastha (Baghpat) and Tilprastha (Tilpat). Negotiation cost was negligible as Lord Krishan was not asking for any fee. Both the parties could have easily struck a deal and the whole Mahabharata war could have been averted!

Duryodhana – the eldest amongst the Kaurava siblings announced that he would not even share land as much as the point of a needle.

The consequence is nothing but a War of disastrous consequences. Why didn’t Coasian framework work?

Come to the Modern times and if you visit any Civil court, you would find – people have left their villages with entire family to come to the city, live there in destitution and fight for their rights over certain pieces of land. You will find there are N-number of cases in Court where the value of the property is abysmal, and the lawyer would have taken even multiple times the price of the property as legal charges.

Why? Why the simple out of the court settlement does not work? Why the village panchayat is not able to resolve such matters peacefully? Why people even waste their entire life fighting over something which has so less material value?

That is the precise questions over which the concept of economic efficiency or the economic doctrine fails. People are not rational human being in the modern conception of rationality in economic science. The axiomatic treatment of rationality is for ease of interpretation of the human being and their nature. It is devoid from the reality.

Land is not a piece of paper – it is a bundle of emotion, ancestry, and rights. People are driven by ego, sentiment, and feelings. People are not a set of equations and it is beyond the capacity of modern computers even to capture those flow of thousand emotions flowing at the same time. While economic efficiency may be an efficient solution to a problem, it works only in limited cases. Else we would not have seen layers of courts and cases being travelled from the local court to supreme court. The sooner we realize the limits of rational thinking and accept the way we are, we will progress in finding solutions.

Is Behavioral economics the beginning?