# Zero Marginal Utility Goods

Standard consumer theory says that rational consumers will select their consumption of goods A and B such that $\frac{MU_A}{P_A} = \frac{MU_B}{P_B}$, with of course the tiny disclaimer that for some pairs of goods, there will be a corner solution; that is, for some goods A and B, some consumers will optimize not according to the preceding expression, but by consuming zero of either good A or good B.

Now, is that really a tiny disclaimer? Don’t we each get zero marginal utility from most goods? I made this point on Twitter yesterday and got this reply from Alex Tabarrok.

Now, it’s true that in a world of discrete goods, when price is high, that will result in a corner solution. But sometimes marginal utility is just really low, zero, or even negative due to storage and disposal costs. There are some things that even most billionaires do not buy.

I pointed Alex to a squirrel yard statue, which I found by searching “knick knacks” on Amazon.com (it was the fourth item). He yielded.

This resulted in a fun game of finding weird, zero-marginal-utility stuff online. Among other good items, Adam Ozimek found Vanna Speaks, Adam Gurri the Misty Mate Pet Misting System, and Jim Ulbright a life-size Anubis statue.

What can we learn from this exercise? I think there are a few things. First, while it’s fun to have a laugh at some of the weird products on the market, somebody is buying at least some of this stuff at least some of the time. I was memorably reminded of this because when Daniel Lin nominated gold lamé MC Hammer Parachute Pants as a ZMU good, Adam Ozimek vociferously disagreed. He ended up buying a pair for himself.

It’s tempting to think of the economy as supplying goods we all want to everyone (in uneven proportions of course), but it’s important to remember that the economy also supplies goods that most of us would not want to the few people who want them, including ourselves. This is not a trivial problem and it may not be solved smoothly through time. Fischer Black built his theory of the business cycle around the idea that it is difficult to match today’s production to tomorrow’s tastes, but it is also difficult to find the right buyers for today’s products.

Second, there is a direct analogy from the goods market to the labor market. Once you concede that most goods provide zero marginal utility to most consumers, you almost must concede that most workers provide zero marginal product to most firms. The math is the same. The ZMP hypothesis, therefore, is not some extraordinary claim that defies common sense.

Just as matching weird goods to weird people is hard, matching some workers to the right firm is hard. Nominal shocks can make this harder even in the absence of sticky wages and prices. People who have nominal debt change their consumption patterns when a nominal shock hits, and both people and firms can misinterpret nominal shocks in the short run per the Lucas Islands model. In the face of changing consumption and production patterns, Black’s Noise plays a role, and when the consumer-product matching problem is hard, the firm-worker matching problem is that much harder. Again, this is true even if wages and prices are totally flexible, and even if you support NGDP targeting (I do).

Oddly since these ideas owe much to Hayek, some Hayekians are slow to accept the ZMP hypothesis. Don Boudreaux at Cafe Hayek tells a comparative advantage story to rebut ZMP that is completely devoid of firms and therefore employment, in which all parties have perfect information and do not need to discover patterns of production. But ZMP is on the march; Karl Smith, a diehard New Keynesian, is starting to make some pro-ZMP noises.

So when you start to think that ZMP is a weird claim, just remember ZMU goods. I myself am not expecting to have much difficulty remembering ZMU goods. One is on its way to me. Tweeter @fbaseggio has bought for me the squirrel yard statue.

I’m looking forward to installing it in Alex’s office when he isn’t there.

# What Does Steve Jobs Show Us About Central Planning, Democracy, and Occupy Wall Street?

Karl Smith playfully suggests that it is ironic that Steve Jobs has so many fans among Austrian economists:

Apple was principally the complete opposite of the decentralized local-knowledge driven catallaxy that Austrian’s trumpet. It was a highly centralized, tightly controlled integrated company that managed every step of the process from design to retailing.

…Apple seemed to operate on the basis of “Five Year Plans” in which the Politburo decided what the future was going to look like and did what was necessary to bring it into being.

This is exactly what is supposed to not work, yet it worked spectacularly.

I am not an Austrian, but I do have a certain fondness for Hayek. I also believe that Steve Jobs is about as close to a Randian hero as can be expected outside of a novel. But contra Karl, I don’t think there is any tension here. In fact, I think a Hayekian (and Alchianian) view of competition can help us better understand why Steve Jobs was so great, and Steve Jobs can show us why in politics central planning, democracy, and voice-based political reforms are doomed to mediocrity or failure.

As a preliminary, let’s get out of the way the fact that it is well understood by Austrians and their fellow-travelers that central planning will always exist in a market economy. Coase’s The Nature of the Firm makes exactly this point. Firms are islands of command and control in a sea of free exchange. The exact boundaries of the firm in a market economy depend on transaction costs and the costs associated with central direction of resources. Hayek also articulates this in his most popular article, The Use of Knowledge in Society. The question is not whether planning will be done, but who is to do the planning?

Readers may be less familiar with what I will call the Hayek-Alchian view of competition. In “The Meaning of Competition,” an essay in Individualism and Economic Order, Hayek argues that “competition is by its nature a dynamic process whose essential characteristics are assumed away by the assumptions underlying static analysis” (p. 94). Armen Alchian takes this further in his 1950 article, Uncertainty, Evolution, and Economic Theory. Alchian models the economy as an environment that selects practices for survival on the basis of positive or negative profits. It’s not firms’ motivation that matters; it is results. This evolution-based account is necessarily more dynamic than the profit-maximizing (motivation-driven) model that economists usually adopt.

Framed in this way, we can now ask the important question: Is Apple successful because it was big and centrally directed, or is it big and centrally directed because it was successful? From a Hayek-Alchian perspective, the answer is clearly the latter. Having a Randian hero centrally direct a lot of resources is not, in spite of Apple’s story, a recipe for success. Instead, following a recipe for success will result in a lot of resources to direct. Finding a recipe for success, not accumulating the resources to direct, is the hard part. That is why we need competition.

And that is why Steve Jobs was great. He had a recipe for success, a vision that worked, and he fought relentlessly for it. It could have been luck; an implication of Alchian’s view is that “[e]ven in a world of stupid men there would still be profits” (p. 213). But I don’t think it was pure luck. Here’s to the crazy ones.

The fact that Steve Jobs centrally directed billions of dollars of resources well does not mean that central planning has much hope in our political context. States do not face the market test, or if they do, it is on large time scales that make evolution toward relatively efficient forms of organization too slow to be useful.

However, if states did face the market test, I think I would be happy to live under the central planning of a Steve Jobs figure. Let a thousand nations bloom, let governance firms enter and exit, let customers migrate between jurisdictions easily. I think under these conditions, central planning would “work,” not in the sense that it would be 100 percent efficient, but that it would discover the recipes for the kinds of political products we all want to buy.

This is the biggest problem, in my view, with democratic political reform. Whether it’s the Tea Party or Occupy Wall Street, most reformers think things will get better if only their voices are heard more clearly. That is a pitiful, static, zero-sum conception of progress. What we really need are institutions that subject entire governments to Hayek-Alchian competition. When we have that, I think we’ll all be happy with centrally planned politics, but central planning won’t deserve the credit; the competitive process will.

# What’s Right and Wrong With Austrian Macro?

“There’s something wrong with everything. In macro; not, you know, in life.” That may not be a verbatim quotation, but I remember Tyler explaining this in PhD macro I, and it has stuck with me. You don’t really understand a school of macroeconomic thought until you can dispassionately evaluate both its strengths and weaknesses. If your answer is that it has no strengths, then you don’t understand it; lots of very smart people developed the theory for a reason. If your answer is that it has no weaknesses, then you don’t understand it; lots of very smart people disbelieve the theory for a reason.

I’m writing this post on Austrian macro because the Austrian school seems to be both en vogue with and poorly understood by Tea Party types. For that matter, it is poorly understood by critics of the Tea Party. I’ll be the first to admit that I am not the most qualified person in the world to write this post. I am not an Austrian or a macroeconomist. Lots of people, including some GMU first-years who are taking the macro prelim this weekend, could do a better job than I will do. Maybe they can comment and refine the post that way. Let’s get started:

What’s right with Austrian macro?

The starting point for modern macroeconomics is what is known as dynamic stochastic general equilibrium (DSGE) models. These models vary depending on the point that the theorist is trying to make, but in the broadest class of them, there is in fact very little economics even going on. Say we start with Long and Plosser’s classic RBC model. How many goods are there in Long and Plosser? One (plus leisure). How many people are there in Long and Plosser? One! How much trade is there in Long and Plosser? Zero. Now, if what you mean by economics is intertemporal optimization in the face of random shocks, then Long and Plosser is an economic model. But as Hayek argues, “This, however, is emphatically not the economic problem which society faces.” DSGE models are poorly suited to evaluating changes in an economy with arbitrarily diverse agents with arbitrarily diverse preferences and arbitrarily diverse information sets. This critique of DSGE-style macro is part of the core of Austrian theory.

Furthermore, in the Austrian view, capital is heterogeneous and multi-specific. If you invest in a pet store, and then decide you want to convert it to a massage parlor, that is costly and time-consuming. This opens the door to malinvestment. In many RBC and New Keynesian models, capital is homogeneous, meaning that it is costless to switch from one investment into another. Kydland and Prescott explicitly assume time-to-build, but this is not the only friction in real-world investment.

According to the Austrians, production functions for the multi-specific capital are discovered over time. In virtually all RBC and New Keynesian models, production functions, the way of transforming the single type of capital into the good or (rarely) goods are specified in advance and do not change. Austrians emphasize competition as a discovery procedure. Entrepreneurs are constantly trying to find new ways to turn existing capital stocks into goods that consumers may want. This discovery procedure is obviously sensitive to policy shocks.

What is wrong with Austrian macro?

The biggest problem with the Austrian school is a legacy of the fact that much (not all!) of the theory was developed before the rational expectations revolution. Even if you think rational expectations is bogus, the fact is that many Austrian models do not explicitly state what is driving expectations. If the monetary authority inflates, everyone is tricked. This is clearly problematic. A better Austrian theory in my opinion would evolve along the lines of the Lucas islands model. I have written before that I think our current situation is one of severe model uncertainty. Some people think money is tight and others think money is loose. If that is the case, then even if people have, say, Bayesian expectations, many of them will be tricked, resulting in monetary distortions.

The other major weakness in Austrian business cycle theory is that it focuses way too much on one particular distortion, monetary policy. Now, the Austrians have an answer to this; they argue that money is one half of every single transaction in the economy, so if money is distorted, then that is a big problem. I don’t think this is true. First, monetary distortions will cause primarily intertemporal distortions. This may be problematic, but as I wrote above, one of the biggest strengths of the Austrian model is that it takes seriously the heterogeneity of goods, capital, and preferences. Focusing primarily on intertemporal investment gives away that huge gain. Austrians should be more open to examining other distortions, such as the subsidization of fixed-value financial claims (FDIC insurance, favoring debt versus equity) and industrial policy. I think Arnold Kling is onto something with his emphasis on Patterns of Sustainable Specialization and Trade.

What is misunderstood about Austrian macro?

The Austrian mantle has been claimed by the Tea Party, but very few Tea Partiers are familiar with modern Austrian scholarship. Michelle Bachmann famously takes Mises with her to the beach, but there is a great deal of Austrian theory that is post-Mises. In particular, most of the modern Austrians I have talked to are not goldbugs. They understand that the most important characteristic of money is not its store-of-value property. In general they favor rules versus discretion in monetary policy, but those rules are ones that non-Austrians can easily get behind. For instance, George Selgin writes, “Scott Sumner’s general views on macroeconomics are so much in harmony with my own that, in commenting on the present essay, I’m hard pressed to steer clear of the Scylla of fulsomeness without being drawn into a Charybdis of pettifoggery.” Furthermore, to the extent that Austrians like gold as currency, they like it because they believe it would “win” in a free-market competition against fiat currency, not because gold is special per se. A simple test would be to get rid of capital gains taxes on gold and other assets and see what wins.

Modern Austrians view policies like NGDP targeting as coming straight out of Hayek, who wrote about the importance of preventing a “secondary deflation.” Consequently, the mainstream accusation that Austrians favor no policy in the face of a financial crisis is misguided. The correct policy, according to many Austrians, is to adopt the most non-distortionary monetary policy there is, which is to keep nominal spending at the expected level. Letting spending collapse is itself a distortionary policy.

The Tea Party is populist, but it seems to be populist for the sake of populism. Austrian theory, on the other hand, is anti-elitist because it believes that neither elites nor anyone else can successfully “manage” the economy. There is consequently a certain populist interpretation of Austrianism; but the theory is not so much about giving the masses what they want as about letting a decentralized process take place. This is the main reason I am skeptical about the political adoption of Austrianism. It is being used as a rhetorical tool in a cultural dispute, not as a way of understanding the nature of the economic problems we face.

# 100 Posts: A Retrospective

This is the 100th blog post on elidourado.com. That may not seem like a lot. Some bloggers write that many in an afternoon. However, that’s not my style; with few exceptions, mostly halting experiments, I’ve tried to write meaty and thoughtful posts. Looking over my oeuvre now it’s clear I did not always succeed. But on the whole, I’m pleased with the result: I’m not an internet celebrity, but there is a merry band of nerds who read what I write, offer good feedback, and help me refine my views.

My first blog post was written on November 8, 2009, 582 days ago. That post, Monetary Confusion, has received only 12 pageviews to this day. It took 144 days to write something that attracted commenters in the double digits. Chris Anderson linked to A Theory of Google on Twitter. It’s still my second most-viewed post.

My most-viewed post is Why Does Apple Offer Free Engraving? I had no idea when I wrote it that it would take off like it did. It received 10,000 pageviews the first day it was up. If I had known so many people were going to read it, I would have taken more care in writing it. I had to write a follow-up post to clarify why answers other than the one I offered could not be correct.

My most profitable post is the recent Can the War on Drugs Bootstrap Bitcoin? A kind soul took me up on my tongue-half-in-cheek suggestion to send me some of the peer-to-peer cryptocurrency. I am grateful.

My most searched-for post is my summary of Friedrich Hayek’s The Use of Knowledge in Society, which appears on the first page of the (de-personalized) Google results for that phrase.

In 19 months of blogging, I wrote only one funny post, *The Great Stagnation*, a Straussian Reading. At least, it was intended to be funny, and it is the only post tagged “humor.” None of the people who commented on the post seemed to get the joke. Speaking of tags, I offer this neat tag cloud that you can use to browse the blog archives.

I cherish my commenters, but the quality of comments I received was not uniformly high. On the whole, I would say that my theory of blog comments continues to be validated. The prize for the most offensive comment goes to a pseudonymous “Economist” who called me “the lowest form of shit on the planet” because of my big government (!) views.

Fortunately, “Economist” is not representative of my readers, for whom I am most grateful. The community surrounding this blog is smart, supportive, interesting, and unafraid to challenge me. People say that blogs are dying, but I plan to keep blogging as long as you guys stick around.

If you’re new around here, don’t be shy. Feel free to participate in the comments, or to say hello on Twitter. And neglect not the RSS feed, which will not overwhelm you; it has had only 100 posts in 583 days.

# Economics as Thermodynamics

When human and physical capital accumulate, output grows. Most people would agree with this statement, but what does it mean? This depends on the meaning of the words capital and output. I don’t offer a precise definition, but both ideas seem to have something to do with useful configurations of matter and information. That is, capital and output are orderly. And whenever I think of order, I think of thermodynamics.

The second law of thermodynamics says that the entropy of the universe tends to a maximum. We cannot be sanguine about the very long-term prospects for the universe. But even though entropy increases in closed macroscopic systems, in open microscopic systems it may decrease for a period. Fortunately, Earth is an open microscopic system that is constantly (well, for now) importing negentropy from the sun, which is blowing up (tending toward disorder). This means that order is possible on Earth.

We can draw (arbitrary?) distinctions between the kinds of order that we observe on Earth. One kind of order we call “life”—we call the discipline that studies the production and depletion of this kind of order “biology.” Another kind of order we call “consciousness.” Consciousness is related to biology—it is a kind of spontaneous order that occurs within brains, which are living—but it is also studied by psychologists and philosophers.

Another kind of order is social order. This is the order that arises by interactions between (discrete?) consciousnesses. It is the domain of the social sciences, particularly economics. These interactions might include violence, altruism, and exchange. The task of economics, then, is to give an account of how these interactions (note to Hayek: not just exchange!) create or destroy order.

It is striking to me that many people reject the idea of intelligent design for life or consciousness, but accept it for social order. Social order involves conscious beings who consciously design things, but it is not itself designed. It grows organically, for the same reason that the other kinds of order grow: the application of energy, which in the case of Earth originated in the sun.

Everything I have written so far has been non-normative. What are the ethical implications if we are willing to take a leap and say that order is good and disorder is bad? We should view actions which increase entropy as bad. Indiscriminate killing (and even indiscriminate ransacking), for instance, would be bad. Eating smart animals (including, but not limited to, other humans) instead of plants or dumb animals would be bad. Interfering with order-producing social processes (such as trade) would be bad. All this seems fairly plausible to me.

That’s what I have so far. What do you think?

# The Use of Knowledge in Society

Welcome to the second installment in our series of discussions of the Most Insightful Articles in economics. This post is going up a little later than I had planned, but hopefully you have stuck around. Today we are discussing Friedrich Hayek’s 1945 article The Use of Knowledge in Society.

Whereas Coase invites us to consider (and dismiss) a world without transaction costs, Hayek invites us to consider (and dismiss) a world in which all information is known to a single mind. In this world, Hayek points out, allocating resources in the most rational or efficient way is strictly a math problem, a more complicated version of some of the problems I make my Intermediate Micro students do. “This, however, is emphatically not the economic problem which society faces.” In the real world, information is dispersed, incomplete, and frequently contradictory. How can we use all this dispersed, incomplete, and contradictory information to make the best use of the resources we have?

When we engage in decision-making about resource allocation—whether collectively or individually—we are engaging in what Hayek calls “planning.” This raises two questions. First, how can those who possess some fragments of information communicate them in a useful way to the planner? Second, who should do the planning—one person or many people—and should it be centralized or decentralized? Under what arrangement can we make the best use of all the knowledge that is dispersed in society?

Most of the knowledge that exists in society is not universal, like F=ma. Instead, it is local; in Hayek’s words, “the knowledge of the particular circumstances of time and place.” Everyone knows at least something that no one else knows. For instance, I need a new holder for my EZ Pass because my old one melted in the sun. How likely is it that anyone else would know that? For society to make the best use of its resources, it must develop a method to collect and exploit local knowledge, not just universal knowledge.

It is essential that this method be robust in the sense of being able to withstand constant change. The world is not static. Statistical aggregates hide the innumerable small changes that occur. For instance, if my demand for eggs rises and my neighbor’s demand for eggs decreases by the same amount, my neighborhood’s demand for eggs has not changed. Nevertheless, the optimal allocation of eggs has changed; this suggests that statistical aggregates are not an appropriate basis for allocating resources.

“[T]he economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place.” To solve the problem, we need some form of decentralization. Decentralized actors need to be able to 1) exploit their local knowledge while 2) making use of some sort of summary of the local knowledge possessed by others that is relevant to their decisions. This summary can strip out a lot of “why” questions. The actor does not need to know why some resource is more or less scarce than before, but he does need to know if it becomes more or less scarce.

The problem is solved by the price system. “[P]rices can act to coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan.” If there is some new and valuable use for tin, the price of tin will rise and people will economize on tin without even knowing why they are doing it. “The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all.”

“We must look at the price system as such a mechanism for communicating information if we want to understand its real function…The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.” This is not to say that the system operates with 100% efficiency. But it is nevertheless a marvel that changes occur and tens of thousands of people adapt by moving in the right direction, without any orders being issued. “I have deliberately used the word ‘marvel’ to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design…this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.

Hayek was more aware than most intellectuals of the extent and significance of our ignorance, and of the importance of extending the range of human cooperation beyond that which could be imagined by a single mind. The idea of a spontaneous order, that some phenomenon could be the product of human action, but not of human design, has been around since at least Adam Ferguson of the Scottish Enlightenment. It is striking that so many people persist in attributing both omniscience and deliberate design to society. We will discuss something else that people erroneously attribute to society next time when we review Ken Arrow’s 1950 paper, A Difficulty in the Concept of Social Welfare.

Suggestions for discussion: I have quoted extensively from this paper because it is very quotable. What are the best quotations that I have left out? Approximately how many bytes of local knowledge are there? Is it conceivable that a very powerful computer could solve the economic problem society faces? Are there other difficulties beyond the sheer quantity of information? What is it about undesigned phenomena that makes people uneasy? What is the greatest deliberately-designed triumph of the human mind and how does it compare in importance to the discovery of the price system? Is there any value at all to the math problems I make my Intermediate Micro students do? Does Hayek’s way of thinking about prices yield any insight into what happens when relative prices are distorted by taxes and subsidies? I look forward to your comments!

# The Nature of the Firm

Welcome to the first installment of our series of discussions of the Most Insightful Articles in economics. Today we are discussing Ronald Coase’s 1937 article The Nature of the Firm.

Ronald Coase wrote only a handful of academic journal articles—nearly every one is a blockbuster. He won the Nobel Prize 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.” He is still alive at the ripe old age of 99; if you do the math, that means he wrote the article we are discussing today when he was 26. This gives me the sneaking suspicion that I am “behind.”

One useful way of thinking about the market is as a coordinating system. The price mechanism serves as a means for directing the flow of every resource to its highest valued use. Suppose that a hurricane hits New Orleans, and as a result the price of plywood increases. That increase in price performs an important coordinating function. As a Virginia resident, when I observe the price of plywood going up, I am induced to delay my plans to build a shed in my backyard. That is, I conserve plywood. This leaves more plywood available to go to New Orleans, where it is most needed. The price system is impersonal, meaning that I don’t even have to know or care about the people in New Orleans in order to behave in a way that is beneficial to them. We will talk much more about the role of prices in the next installment.

However, the market is only one of two main ways that resources are directed. The other mechanism is command and control. Within firms, the autonomous impersonal coordination of the price system is replaced by a conscious interpersonal coordination mechanism. The boss has to gauge or guess if employees are pulling their weight, and to figure out if there are enough computers and office space and coffee and so on. The whole purpose of a firm is to engage in production without the coordinating assistance of the market mechanism. Why should this be? Why would anyone want to avoid a system that sends resources to their highest valued use?

It must be the case that there are costs intrinsic to using the price system. These “transaction costs” include the cost of discovering what the relevant prices are and the cost of negotiating complete contracts that plan for all contingencies and eliminate opportunism. When an entrepreneur starts a firm, she is making a bet that she can direct resources within the firm with enough efficiency so as to produce at a lower cost than the market could produce. That is, she is betting that she can economize on transaction costs. This, Coase argues, is the raison d’être of a firm.

Coase then asks, “[W]hy, if by organising one can eliminate certain costs and in fact reduce the cost of production, are there any market transactions at all? Why is not all production carried on by one big firm?” There must be some countervailing cost that increases with firm size that makes it uneconomical for firms to continue increasing their “insourcing” forever. The main answer that Coase gives is that it gets harder for the entrepreneur to direct resources as the number of resources increases. At some point, the firm is directing so many resources internally that the cost of directing one more resource is equal to the cost of just relying on the market to direct it, transactions costs and all.

The theory can now be used to discuss what affects firm size. Factors that decrease transaction costs or increase organizing costs will tend to make firms smaller. Factors that do the opposite will tend to make firms larger. One factor that increases transaction costs is taxes on market exchange. If it costs firms extra money in taxes to buy furniture, they may decide to make their own furniture in-house. (For discussion: how does the income tax affect the household’s decision to have a second partner go to work or stay home? Hint: households are firms!) A second factor is technology. As communications technology improves, it becomes cheaper to organize over a wider spatial area, increasing firm size. On the other hand, technology also reduces the cost of using the market, e.g. locating prices, and therefore would tend to reduce firm size.

We can keep going with this. Here are some issues that Coase did not discuss. Another factor is bankruptcy and contract law. The fact that there are default rules for contracts lowers the costs of creating contracts (assuming the law is reasonably efficient). Fewer contingencies need to be specified in advance. This makes the cost of using the market lower, decreasing firm size. Next, consider employment regulations. These tend to make it more expensive to direct resources (at least human resources) internally, and therefore firms will be smaller when there is extensive employment regulation. Finally, what if there is a complete breakdown in law and order? This will tend to increase transaction costs, making markets less attractive. Firms will increase in size, and in fact, humans might revert to a tribal existence (tribes are firms!). Law and order, and markets generally, are what enable us to live our lives in a reasonably individualistic way.

Coase also spends a fair bit of space contrasting his theory with Frank Knight’s theory of the firm. I won’t spend a lot of time on this, but we can discuss it in the comments if people are interested. If you want food for thought on this, how plausible is Knight’s view if there are insurance markets and no transaction costs?

To sum up, using the price system is not free. The fact that there are transaction costs means that people will attempt to limit the number of their transactions to economize on these costs. This implies that they will seek alternative methods of directing resources, which we find in firms. The other method, command and control, does not scale well forever. Therefore, there are natural economic limits to the firm’s size.

I’ve raised a few questions above, but here are a few more. How does Coase’s notion of what it means for a firm to be large or small differ from our usual metrics? What is the role of market discipline (profits and losses) in ensuring that firms do not become inefficiently large? If you were an inventor with strong humanitarian impulses, would you want to invent a technology that lowers the cost of transactions or of organization? In a world with no transaction costs, would there still be unemployment? How does the existence of the concept of morality affect transaction costs?

The discussion is not limited to my questions, of course. Feel free to raise whatever issues in the paper you want to discuss. Our next article will be Friedrich Hayek’s 1945 piece The Use of Knowledge in Society. I will be in Las Vegas at a conference early next week, so our next discussion will not be until the latter part of the week. See you in the comments!