Appreciation of Ronald Coase

Ronald Coase passed away yesterday, four months shy of his 103rd birthday and working right up to the end. An archive search here shows how deeply Coase’s work influences Mike’s and mine, and we are not alone — Coase was one of the most influential economists of the 20th century, an influence made even more striking by the fact that it derives from relatively few publications. Few, but subtle and nuanced, and blockbuster. I cannot think of any aspects of my research that his work has touched, and his method of analyzing and thinking through problems also informs most of my teaching and research, and writing more generally.

Some appreciations of Coase come from Peter Klein, Geoff Manne, Jonathan Adler (on Coase and Ellickson and on Coase and externalities, the second being a must read), Todd Zywicki (making the essential point about the subtlety of Coase’s argument that costs are reciprocal), and Northwestern’s own Kevin Bryan. David Henderson also excerpts a quote of Coase’s that I find particularly inspiring in suggesting how we should engage in economic analysis:

Testable predictions are not all that matters. And realism in our assumptions is needed if our theories are ever to help us understand why the system works the way it does. Realism in assumptions forces us to analyze the world that exists, not some imaginary world that does not.

Given the recent debate around “economath” and the Rosenberg/Curtain NYT commentary about economics not being a science because it fails to generate testable predictions (which is a very narrow and not widely-held definition of science, I think), Coase’s observation is apt — strong assumptions to enable excessive formalism in our theory formation reduce our ability to use our models to understand how the world works, and that’s a tradeoff that we confront constantly.

I honor Coase’s long, richly-lived life, and the important new ways of thinking about and understanding the world that his work has enabled.

UPDATE: Pete Boettke and I were clearly working in parallel, and he posted this excellent observation about Coase’s contributions to new institutional economics and robust political economy at the same time I did. Pete also points to the 1959 FCC paper, which I think is one of Coase’s best and is quite underappreciated for many reasons (and I’ve written about a lot here before, particularly regarding modern spectrum policy).

Public Choice Theory: Skwire’s First Law

Some time last spring, my friend and occasional KP contributor Sarah Skwire formulated on Facebook what’s now dubbed “Skwire’s First Law”, and we’ve been using it, kicking its tires, and discussing it all summer. In a timely manner (given what we’ve learned this summer about widespread, unwarranted government surveillance and the impending likelihood that yet another president will engage in yet another international military action without Congressional authorization), Sarah has formalized and expanded upon Skwire’s First Law in a Bleeding Heart Libertarians post today:

Accidentally invented by me on Facebook a while back, named by my co-blogger Steve Horwitz, and picked up–to my great diversion–by a crew of Facebook friends, Skwire’s law is simply stated thusly:

Politicians are asshats.

I’m driven to write a bit about Skwire’s First Law today because, like every other day, politicians are being asshats. And I want to talk about how Skwire’s law—though simply expressed—is not merely a sigh of exasperation, a political version of “boys will be boys.” It’s a manifesto condensed into three words.

Saying that politicians are asshats means that you acknowledge the deep truths of public choice theory. It means that even if the occasional politician supports a policy you like or gives a speech you admire, you know enough not to turn him or her into a hero. We can debate, as my friends and I have on Facebook, whether asshats become politicians or politicians become asshats. I don’t think that debate much matters, because I think both parts of it are true. Politics is a machine that turns good people and good ideas into bad ones, and turns bad people and bad ideas into worse ones. Politics is a system that attracts not only people who want to help, but people who want to control. And once those people—good or bad, helpful or controlling—are in the system, they use it to further their ends.

Note in particular the last three sentences, and how they encapsulate the essential implications of public choice theory — in our roles as political actors (here let’s focus on individuals as elected representatives and in regulatory agencies, not as voters), individuals prioritize self interest, broadly defined. This is the extension to the political decision realm of the self-interest assumption in our roles as purposive individuals in other decision settings. Many individual politicians are motivated by good intentions (the “public interest”, making the world a better place, “giving back”, bringing resources to his/her community), and some are also motivated by the desire to control and manage the choices of others and how others live their lives. Public choice theory is general enough to accommodate that diversity of motivation and intent.

More insidiously, though, the fact that political power gives politicians coercive power to make decisions about the resources and the choices of others means that even those who have good intentions and good ideas can, do, and often must use control and coercion to satisfy those intentions and attempt to implement those ideas. Thus even well-intentioned politicians use the system of coercion and control to attempt to achieve their ends. And I hope Sarah doesn’t mind my paraphrasing a Facebook comment of hers on this point, because it’s apt: by definition, politics means using the state’s monopoly on force, and being a politician means that you contribute to decisions that will use that force to enshrine your “honest mistakes or infelicitous actions” in a pretty permanent way in the lives of many, many people, including those the politician says s/he wants to help. If that politician is unaware of that likelihood, or doesn’t care, that’s asshattery. It’s also hubris. And it’s pervasive in politics.

Sarah goes on to point out that this outcome is not accidental or a flaw, although some of us may consider it perverse. Here’s where the study of institutions and incentives becomes important — once these individuals become politicians, they are embedded in a set of institutions that shape their incentives. They face the tragedy of the commons in the federal budgeting process, because to bring resources home to their constituents means either decreasing resources somewhere else that doesn’t matter as much to them or increasing government spending in ways that can unsustainably increase government debt (oh, hey, did you know we’re hitting another government debt ceiling in October?). They trade votes and engage in log-rolling to achieve what they style as “compromise”. The incentives are inherent in the institutions, and they are bad incentives that lead to inferior outcomes and to politicians being asshats. Of course there are nuances and degrees of asshattery, especially if you look on an issue-by-issue basis at the questions you find most pressing. But remember the initial formulation: occasional support that aligns with your preferences does not change the fundamental, underlying institutional incentives.

Note that this asshat designation is not a statement about personal character or merit of the individual politician. It’s a statement about the institutionally-driven incentives facing each individual politician regardless of their motivations or intentions. And that’s what makes it such a pithy and damning statement about the pernicious effects of political decision processes, even (or perhaps especially) political decision processes in what is supposed to be a democratic republic. It is the nature of our political institutions that politicians are asshats, and therefore

[t]hey are wasting your time and your money and your energy. They are allying you with people you hate and with causes you despise and with actions you would never condone.

Don’t wait around for them to save you or the things you think are important. Don’t think you’ve found the politician who can fix your world.

Realizing this nature of political institutions opens up the idea that political processes are not necessarily the only or the best way to approach social conflicts and problems. Thinking about alternatives, about experimenting with different approaches, about the impossibility of doing away with all social problems, gives us opportunities to be creative and to enable other approaches to emerge.

“If your toilet’s so smart, how come I can hack it?”

Thus reads the headlines on David Meyer’s Gigaom post on news that the Satis toilet, manufactured by the Japanese firm Lixii, comes with a smartphone app that can be used to control any Satis toilet (see also this BBC news article). You may wonder why a toilet needs an app, which is a valid question; this one allows recording of one’s activity (if you so choose …), remote flushing, remote air freshener spray, and remote bidet operation. Subjective utility being what it is, I’ll consider Lixii as entrepreneurs responding to what they perceive as some undersatisfied preference in the market, which the extent of their subsequent profits will indicate or not …

Although the story is scatologically humorous, Meyer’s closing observation hits upon exactly the same point I made recently in my post about the hackability of home management systems:

Of course, it’s not like someone will be exploiting this vulnerability to prank someone a continent away — Bluetooth is a pretty short-range wireless technology. However, it’s the kind of thing that should be borne in mind by manufacturers who are starting to jazz up previously low-tech appliances with new-fangled connectivity.

Because when it comes to security, as Trustwave SpiderLabs and others have warned, the home is the last place you want to be caught with your pants down.

Bruce Yandle on bootleggers & Baptists

Bruce Yandle’s “bootleggers & Baptists” model of political coalition formation is one of the most useful models in the political economy of regulation (and one that both Mike and I employ frequently, as seen by our many posts using the model).

Here’s a great new Learn Liberty video featuring Bruce himself describing how coalitions of seemingly-unlikely interests can form to enact particular regulations. He describes the original formulation, and then applies it to environmental regulation.


Why vertically integrate?

Lest ye think that I am not a fan of vertical integration, given how firm I am in my arguments for the dis-integration of the vertically-integrated, regulated electric utility, I recommend this post from Seth Goldin about reasons why firms vertically integrate. In large part it’s a concise summary of Klein, Crawford, & Alchian (1978), one of the seminal papers in transaction cost economics. A good reminder of the extent to which the transactional boundaries of firms depend on the relative cost of pursuing similar transactions in markets, and that all of those costs can change over time and with technological change.

New Chicago mall and Schumpeterian disruptive innovation

Today a new mall is opening in Rosemont, near O’Hare Airport and the Rosemont Convention Center. The Fashion Outlets of Chicago will have a range of familiar factory outlet stores and restaurants, conveniently located near the airport and public transportation (I could even take the el there from KP Chicago HQ!).

So what? According to its developer, Arthur Weiner, this mall breaks a bunch of retail factory outlet rules that were just begging to be broken:

“The rules that this center broke were rules that needed to be broken. They were begging to be broken,” said Arthur Weiner. So, just what’s bonkers about the place? “It’s fully enclosed, two levels — never been done before. It is next to the third largest airport in the world, never been done before anywhere in the world.”

“It’s wrapped around a seven-deck, structured parking garage, never been done before,” he continued. “It is never more than 75 feet from the entrance to a shop, never been done before. You go to an outlying outlet center, you’re walking 700 yards after you park your car.”

That does sound pretty neat, and novel. And there will be baggage concierge service for the airport, and an airport shuttle. Another novel aspect is the partnership with a group called The Arts Initiative, which will install large pieces of public art from Chicago artists in the mall. Thus the space will be part mall, part gallery.

Of course, this rang my Schumpeter bell. Rules broken, new configuration, new location, new set of customer services, new arts partnership. Perennial gale of creative destruction. Bring it, baby.

Course video: Alfred Marshall and the neoclassical synthesis

Here’s the next video from my history of economic thought course, on Alfred Marshall.

Alfred Marshall and the Neoclassical Synthesis from Lynne Kiesling on Vimeo.

Alfred Marshall was one of the most important economists shaping the field as we practice it today. By synthesizing the classical economics focus on production and costs with the new marginal utility theory of value and the concept of subjective utility, Marshall created the neoclassical synthesis. He also formalized elasticity, the theory of the firm, and welfare analysis.

NSA surveillance imperils the Internet as an economic platform

Today’s new revelations from Edward Snowden’s whistleblowing show that the NSA can, and does, use a program that surveils our Internet behavior in a general, blanket way (much in the nature of the “general warrants” that were the whole reason the authors of the Bill of Rights put the Fourth Amendment in there in the first place!).

Make no mistake: this deep and broad US government surveillance diminishes trust not just in the federal government (as if there is any general trust in the federal government any more), but also in Internet companies — communications companies, ISPs, Apple, Google, Yahoo, Amazon, and so on. The economic implications of the deep and broad US government surveillance are profound. How much economic activity on the Internet will leave those companies? Will government surveillance be able to access substitutes for these companies in other countries, if substitutes come into being? Isn’t this going to cause the commercial Internet to shrink?

The federal government may not have intended to stifle the role of the Internet as an economic value-creating commercial platform, but that consequence is almost certain.

UPDATE, 1 August, 3:19 CDT: Welcome readers from reddit, and thanks for the link! Since some commenters wanted more original analysis of this issue than I intended, I’ve recommended a follow-up post that provides deeper evaluation of the potential effects on the Internet as a commercial platform.

Joel Mokyr: Technopessimism is bunk

My department is currently a focal point in the debates over the future of innovation and economic growth. Technopessimist arguments from my colleague Bob Gordon (as profiled in this New York Magazine article from the weekend) join those in Tyler Cowen’s The Great Stagnation to suggest that the increase in living standards and the growth rates experienced over the past 200 years may be anomalous and not repeatable.

In the PBS Newshour Business Desk, my colleague (and former dissertation adviser) Joel Mokyr offers a different, more optimistic perspective. Joel emphasizes the dynamic aspects of new idea generation and the ensuing technological change and its effects on people and societies. Technology is never static, humans and our curiosity and our efforts to strive are never static, and that means that there’s not likely to be an “end of innovation” along the lines of an “end of history”:

Technology has not finished its work; it has barely started. Some lessons from history may show why. For one thing, technological progress has an unusual dynamic: it solves problems, but in doing so it, more often than not, creates new ones as unintended side-effects of the previous breakthroughs, and these in turn have to be solved, and so on. …

As we know more, we can push back against the pushback. And so on. The history of technology is to a large extent the history of unintended consequences. …

What will a future generation think of our technological efforts? During the Middle Ages, nobody knew they were living in the Middle Ages (the term emerged centuries later), and they would have resented a notion that it was an age of unbridled barbarism (it was not). During the early stages of the Industrial Revolution in the 18th century, few had a notion that a new technological dawn was breaking. So it is hard for someone alive today to imagine what future generations will make of our age. But to judge from progress in the past decades, it seems that the Digital Age may become to the Analog Age what the Iron Age was to the Stone Age. It will not last as long, and there is no way of knowing what will come after. But experience suggests that the metaphor of low-hanging fruit is misleading. Technology creates taller and taller ladders, and the higher-hanging fruits are within reach and may be just as juicy.

None of this is guaranteed. Lots of things can go wrong. Human history is always the result of a combination of deep impersonal forces, accidents and contingencies. Unintended consequences, stupidity, fear and selfishness often get in the way of making life better for more and more people. Technology alone cannot provide material progress; it’s just that without it, all the other ways of economic progress soon tend to fizzle out. Technological progress is perhaps not the cure-all for all human ills, but it beats the alternative.

Joel’s essay is well worth reading in its entirety. His argument highlights the decentralized, curiosity-driven process of technological change that does not proceed linearly, but is impossible to quash. These processes contribute to economic well-being in societies with good institutional and cultural contexts that facilitate and reward innovation when it generates value for others.

Disruptive innovation and the regulated utility

Over the weekend the New York Times ran a good story about how rooftop solar and regulatory rules allowing net metering are putting pressure on the regulated distribution utility business model:

The struggle over the California incentives is only the most recent and visible dust-up as many utilities cling to their established business, and its centralized distribution of energy, until they can figure out a new way to make money. …

“Net metering right now is the only way for customers to get value for their rooftop solar systems,” said Adam Browning, executive director of the advocacy group Vote Solar.

Mr. Browning and other proponents say that solar customers deserve fair payment not only for the electricity they transmit but for the value that smaller, more dispersed power generators give to utilities. Making more power closer to where it is used, advocates say, can reduce stress on the grid and make it more reliable, as well as save utilities from having to build and maintain more infrastructure and large, centralized generators.

But utility executives say that when solar customers no longer pay for electricity, they also stop paying for the grid, shifting those costs to other customers. Utilities generally make their profits by making investments in infrastructure and designing customer rates to earn that money back with a guaranteed return, set on average at about 10 percent.

In a nutshell, what’s happening is that environmental and global warming policy initiatives are resulting in government subsidies and tax credits for consumer investments in rooftop solar, especially in states like California. As more consumers install rooftop solar they both make less use of the electricity distribution network to receive electricity and can put the excess power generated from their solar panels onto the distribution grid (called net metering). Under net metering they receive a per-kilowatt-hour payment that ranges between the averaged, regulated retail rate and the wholesale price of electricity at that time, depending on the net metering rules that are in operation in that state. From the regulated utility’s perspective, this move creates a double whammy — it reduces the amount of electricity sold and distributed using the wires network, which reduces revenue and the ability of the utility to charge the customer for use of the wires, but since most of the costs for the network are fixed costs and the utility is guaranteed a particular rate of return on those assets, that means increasing rates for other customers who have not installed solar.

Offsetting some of that revenue decrease/fixed cost dilemma is the fact that net metering means that the utility is purchasing power from rooftop solar owners at a price lower than the spot price they would have to pay to purchase power in the wholesale market in that hour (i.e., wholesale price as avoided cost) … except what happens when they have already entered long-term contracts for power and have to pay anyway? And in California, the net metering payment to the customer is the fully-loaded retail rate, not just the energy portion of the rate, so even though the customer is essentially still using the network (to sell excess power to other users via the regulated utility instead of buying it), the utility is not receiving the wires charge portion of the per-kilowatt-hour regulated rate.

Sounds like a mess, right? It sure is. And, as Katie Fehrenbacher pointed out yesterday on Gigaom, the disruption of the regulated electric utility in the same way that Kodak, Blockbuster, and Borders have been disrupted out of existence is not a new idea. In fact, I made the same argument here at KP back in 2003, building on a paper I co-authored for the International Association of Energy Economics meetings in 2002 (and here are other KP posts that both Mike and I have made on net metering). I summarized that paper in this Reason Foundation column, in which I argued

Many technological and market innovations have reduced the natural monopoly rationale for traditional electric industry regulation. For example, consider distributed generation. Distributed generation (DG) is the use of an energy source (gas turbines, gas engines, fuel cells, for example) to generate electricity close to where it will be used. Technological change in the past decade and deregulation in the natural gas industry have made DG an economically viable alternative to buying electricity from a monopoly utility and receiving it over the utility’s transmission and distribution grid. The potential for this competition to discipline a transmission owner’s prices for transmission services is immense, but it still faces some obstacles. …

Technological change and market dynamics have made the natural monopoly model of electricity regulation obsolete. While technological changes and market innovations that shape the electricity industry’s evolution have received some attention, their roles in making natural monopoly regulation of transmission and distribution obsolete have not received systematic treatment. For that reason, the policy debate has focused on creating regional transmission organizations to rationalize grid construction, but has not dug more deeply into the possible benefits of dramatically rethinking the foundations of natural monopoly regulation.

I may have been a bit ahead of my time in making this argument, but the improvements in energy efficiency and production costs for solar technology and the shale gas revolution have made this point even more important.

Think a bit about how the regulated utilities and regulators have come to this point. They have come to this point by trying to retain much of the physical and legal structure of traditional regulation, and by trying to fold innovation into that structure. The top-down system-level imposition of requirements for the regulated utility to purchase excess solar-generated electricity and to pay a specific, fixed price for it. The attempts of regulated utilities to block such efforts, and to charge high “standby charges” to customers who install distributed generation but want to retain their grid interconnection as an insurance policy. The fact that regulation ensures cost recovery for the wires company and how that implies that a reduction in number of customers means a price increase to those customers staying on the wires network. And adding on top of that the subsidies and tax credits to induce residential customers to purchase and install rooftop solar. I don’t think we could design a worse process and set of institutions if we tried.

You may respond that there’s no real alternative, and I’d say you’re wrong. You can see the hint in my remarks above from 2003 — if these states had robust retail competition, then retailers could offer a variety of different contracts, products, and services associated with distributed generation. Wires companies could essentially charge standard per-unit transportation rates (assuming they would still be regulated). In that market design, much of the pressure on the business model of the wires company from distributed generation gets diluted. The wires company would still have to be forward-looking and think (with the regulators) about what increased penetration of distributed generation would mean for the required distribution capacity of the wires network and how to invest in it and recover the costs. But the wires company would be just that, a wires company, and not the party with the retail relationship with the residential customer, so all of these distortions arising from net metering would diminish. If I were a wires company I would certainly use digital meters and monitors to measure the amount of current flow and the direction of current flow, and I would charge a per-kilowatt-hour wires transportation charge regardless of direction of flow, whether the residential customer is consuming or producing. Digital technology makes that granular observation possible, which makes that revenue model possible.

That’s why states like California have created such an entangled mess for themselves by retaining the traditional regulated utility structure for integrated distribution and retail and trying to both absorb and incentivize disruptive distributed generation innovation in that traditional structure. Not surprisingly, Texas with its more deregulated and dis-integrated structure has escaped this mess — the only regulated entity is the wires (transmission and distribution) company, and retailers are free to offer residential customers compensation for any excess generation from distributed renewable generation sources, at a price mutually agreed upon between the retailer and the customer in their contract. In fact, Green Mountain Energy offers such a contract to residential customers in Texas. See how much easier that is than what is happening in California?