A Map for Making Government Useful

What Ronald Coase taught us about how government can be more effective.

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This undated photo provided by the University of Chicago Law School shows professor Ronald Coase. Coase, a Nobel Prize winner and pioneer in applying economic theory to the law, died Monday, Sept. 2, 2013, after a short illness at a Chicago hospital. He was 102. The former University of Chicago professor was the oldest living Nobel laureate before his death. The British-born economist won the Nobel in economics in 1991.

Ronald Coase passed away the other day. He won the Nobel Prize in economics for unraveling why we need corporations and why we don't need government. But his work may point to ways that the latter can be more like the former.

In the first of his two papers that earned him the Nobel, "The Nature of the Firm" (1937), Coase addressed why corporations form when classical economic theory couldn't account for them. The answer lay in "transaction costs," the time and expense required to line up arrangements in the production process: It's basically cheaper and easier to integrate all the steps in manufacturing a car, for instance, than for separate craftsmen to make a transmission and sell it to a chassis manufacturer, who would then sell the assembled chassis to another entity that assembles and sells complete cars.

This recognition of transaction costs led eventually to the second paper, "The Problem of Social Cost" (1960). Here, Coase addressed how best to deal with the costs that one business imposes on another (or on non-businesses), known as "externalities." Externalities are things like pollution, noise, unsightliness and other by-products of a business activity that, in Coase's opening phrase, "have harmful effects on others."

The idea had gained some traction that the "polluter" should be taxed by the government to pay for the damage he inflicts; Coase demonstrated that the solution wasn't necessarily to make the polluter pay – equally plausible was to have everyone else buy out the polluter.

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The implications of Coase's analysis, which became known as the "Coase Theorem," were significant. It meant that, in a world without transaction costs – in other words, where it is cheap and easy to negotiate a solution – it doesn't matter who's "right" or "wrong," it doesn't matter who is initially given the legal right (for example, the right to pollute versus the right to clean air), and it doesn't matter who ends up paying. As long as the parties are free and able to balance one's costs against the other's, social value will be maximized.

The Coase Theorem says that, without transaction costs, a factory owner could negotiate a deal with the neighbors to pay them to endure the pollution – or the neighbors could get together and pay the factory owner to stop polluting. The results for society would be the same: If the factory owner paid, the price of widgets would go up to compensate for the extra cost; the wider public buying the widgets would wind up paying the cost of pollution reduction.

Of course, transaction costs are part of the real world: It's not all that easy to identify all the people affected by the pollution, or to get them all together to negotiate a deal. So, again, "transaction costs" led to a real-world result different from what pure theory might say: In this case, it made more sense for courts simply to impose the cost on the polluter rather than the diffuse population of pollution-sufferers.

Coase's work originated in a market-based hostility to regulation and taxes. But the solution in "The Problem of Social Cost" requires a government to allocate rights and to establish courts to adjudicate them (and enforce payment). And it shows that – at least if government does the job properly of pricing the externalities – neither society nor businesses need suffer under a regulatory regime compared to the theoretical optimal outcome. More crucially, though, the Coase  theorem provides one of the better explanations for how government might actually be useful.

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With their large economies-of-scale and a pre-existing structure for reaching all citizens, governments basically can, and increasingly do, serve to reduce transaction costs. The prescription drug debate in recent years, for instance, centered on using government not to mandate that drug manufacturers cut prices, but to aggregate consumer purchasing to drive prices down. Despite the prohibition on negotiating lower drug prices that Congress enacted in 2004, many states found ways to provide their residents lower-priced drugs through various cooperative purchasing arrangements.

The same approach could be applied to health insurance (and was originally proposed by all the Democratic presidential candidates in 2008, prior to the formulation of Obamacare): Because of their size, government employee benefit plans are able to offer a wider range of choices at better prices than they (or most other employers) could obtain otherwise. By allowing the general public to buy into such programs, the resulting huge public buying co-op would keep constant competitive pressure on the market to lower prices and improve satisfaction for all consumers.

Of course, that's basically what a "public option" would have done. The main argument against the public option was that the government would artificially set prices low and unfairly compete private business out of business. But this is something we know a great deal about stopping: It's called unfair competition in the anti-trust literature, and it can be applied to public sector just as much as private sector competition.

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Governments now go head-to-head with business in their role as consumers-in-chief, using market clout rather than mandates to buy everything from cheaper prescription drugs to safer guns to more human rights. The role of government is changing, in short, from cop to co-op. Government also can efficiently aggregate individuals not just to consume but also to invest – financing projects with high costs or high start-up barriers like the Interstate Highway System, the space program or a modern military.

In the past, this has produced the Internet and the home mortgage industry. The federal government could similarly bootstrap a competitively-priced market that doesn't yet exist – as it did with home mortgages – and then get out, as it did with the Internet in various other useful areas, such as long-term care insurance or human capital investment.

In short, there are ways that government can be useful if, like Ronald Coase, we think differently about a problem, conceive of government in the same economic terms as businesses, and ground our solutions not just in theory but also in the real world.

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