%20-%20https://sketch.com%20--%3e%3ctitle%3e3ECBBF50-FD08-412A-943D-2CFC5E025A16%3c/title%3e%3cdesc%3eCreated%20with%20sketchtool.%3c/desc%3e%3cg%20id='Stylesheet'%20stroke='none'%20stroke-width='1'%20fill='none'%20fill-rule='evenodd'%3e%3cg%20transform='translate(-926.000000,%20-668.000000)'%20id='BUTTONS'%3e%3cg%20transform='translate(100.000000,%20597.000000)'%3e%3cg%20id='BTN-/-RIGHTS'%20transform='translate(816.000000,%2065.000000)'%3e%3cg%20id='ICON-/-Rights'%20transform='translate(10.000000,%206.000000)'%3e%3cpath%20d='M13.5752841,0%20L1.34943182,0%20C0.59375,0%200,0.586666667%200,1.33333333%20L0,22.6666667%20C0,23.4133333%200.620738636,24%201.34943182,24%20L17.6505682,24%20C18.40625,24%2019,23.3866667%2019,22.6666667%20L19,5.36%20L13.5752841,0%20Z%20M13.5752841,1.89333333%20L17.0838068,5.36%20L13.5752841,5.36%20L13.5752841,1.89333333%20Z%20M1.34943182,22.6666667%20L1.34943182,1.33333333%20L12.1988636,1.33333333%20L12.1988636,5.36%20C12.1988636,6.10666667%2012.7926136,6.69333333%2013.5482955,6.69333333%20L17.6235795,6.69333333%20L17.6505682,22.6666667%20L1.34943182,22.6666667%20Z'%20id='Shape'%20fill='%23595959'%20fill-rule='nonzero'%3e%3c/path%3e%3ccircle%20id='Oval'%20stroke='%23595959'%20stroke-width='1.5'%20fill='%23595959'%20cx='9.5'%20cy='13.5355339'%20r='5.5'%3e%3c/circle%3e%3cpolyline%20id='Path-2'%20stroke='%23FFFFFF'%20stroke-width='1.5'%20transform='translate(9.500000,%2013.035534)%20rotate(45.000000)%20translate(-9.500000,%20-13.035534)%20'%20points='8%2016.0355339%2011%2016.0355339%2011%2010.0355339'%3e%3c/polyline%3e%3c/g%3e%3c/g%3e%3c/g%3e%3c/g%3e%3c/g%3e%3c/svg%3e)
The consequence is that, whereas the normal way of testing a theory in positive economics is to test its conclusions, the normal way of testing a welfare proposition is to test its assumptions. The significance of this should not be overlooked. In positive economics, we often simplify our assumptions as cavalierly as we please, being confident in the knowledge that their appropriateness will be tested when we come to apply the conclusions inherent in them to our observations of the world about us. In welfare economics, we can entertain no such confidence. The result is that our assumptions must be scrutinized with care and thoroughness.
(de V. Graaff, Reference de V. Graaff1957: 3)
1. Introduction: making meaning(s)
Ronald Coase's classic article, ‘The Problem of Social Cost’ (Reference Coase1960), is now widely appreciated as the source of the ‘Coase theorem’. As many economists know (but some do not), Coase did not provide us with a ‘theorem’; instead, he utilized a simple pastoral example involving a dispute between a farmer and a cattle rancher over damage to the farmer's crops to show that agents have an incentive to engage in negotiations over harmful effects. His conclusion was this:
It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost (Reference Coase1960: 8).Footnote 1
Much ink has been spilled in the years since Coase penned these words, debating whether Coase's result is, in fact, correct as a proposition in economic theory. The present paper explores one of those episodes: the debate over extortion possibilities that took place during the 1970s. The purpose of this analysis, though, is not to pass judgment on the correctness of the respective arguments on the two sides of this debate or on the validity of the Coase theorem in light of them. Instead, the extortion debate is utilized as a case study in the intellectual history of the Coase theorem. As we shall demonstrate in the pages that follow, the Coase theorem, circa the 1970s, had no settled meaning or content; instead, that meaning and content was created – and in differing ways – by the modeling decisions of scholars who attempted to grapple with and assess the proposition that Coase had laid out in 1960.Footnote 2 These modeling decisions included both the theoretical frameworks laid onto the theorem and the assumptions (including meanings ascribed thereto) said to underlie it.
Virtually every economist will tell you that he or she knows what the Coase theorem is and will be only too happy to tell you that it is true – or that it is false. And if you collected statements of the Coase theorem from 100 different economists, you would get perhaps 20 or more different statements of the theorem.Footnote 3 In short, there are many Coase theorems. This raises the obvious question of how we got to such a position from Coase's 1960 statement, quoted above. The argument here is that the process began in the 1970s as economists began to debate the theorem's validity. Doing so required them to make a number of choices – in particular, as to the underlying assumptions and the specific content given to them and (where relevant) the framework or environment within which the theorem was modeled. These choices, as we shall demonstrate, had the effect of creating Coase theorem worlds and, by extension, Coase theorems. They also worked to foster debate over the theorem's validity or theoretical correctness,Footnote 4 with these debates and perceptions regarding validity turning on the differing contexts within which the contributing authors elaborated their conceptions of the Coase theorem and the assumptions upon which it was said to be grounded. The net effect was that, by the end of the 1970s, the meaning and content given to the Coase theorem had not stabilized; indeed, the 1970s can be seen as a period of destabilization.
We will illustrate this using the vehicle of the debate over the extortion issue that took place in the US economics literature during the 1970s – primarily in the Western Economic Journal (now, Economic Inquiry), but also in the Quarterly Journal of Economics and the American Economic Review. At issue was the question of whether the process of negotiation over externalities introduced the possibility of extortion, and of an attendant misallocation of resources. The stakes here were significant, in the eyes of the participants, for if it could be shown that the extortion critique was valid, the theorem's efficiency claim would be negated. And if negotiated solutions could not be shown to be efficient in theory, there was precious little basis upon which to ground efficiency claims for such solutions (whether in absolute terms or relative to Pigovian instruments) in reality. That is, these were not simply theoretical modeling games. But this story is also fitting for a special issue in memory of Ronald Coase, for the extortion debate speaks to the varied interpretations of one of his fundamental insights and the uses to which his analysis was put by others – as well as to the ‘blackboard economics’ that so concerned Coase and away from which he was urging economists to move in ‘The Problem of Social Cost’.Footnote 5
The discussion will proceed as follows. Section 2 provides a brief overview of the antecedents to the extortion debate, as a prelude to the more fulsome critiques of the 1970s that are dealt with in Section 3. The rebuttals to these critiques offered by Coase theorem supporters are the subject of Section 4. The issue of the appropriate environment within which to model the Coase theorem was, as we shall see, central to both the critiques and the rebuttals, and the issues raised by the respective modeling environments are further probed in the literature that is the subject of Section 5. The discussions in Sections 3–5 present the authors’ respective arguments on their own terms; Section 6 then attempts to historicize the debate, showing how it centered on competing attempts to create precision out of ambiguity and how the attendant creation of Coase theorem worlds is fundamental to Coase theorem history. Section 7 offers a few concluding thoughts.
2. Background
When Coase laid out his negotiation result in 1960, his analysis was set in the context of externality relationships involving two parties – e.g., a farmer and a rancher, a physician and a confectioner – each of whom was assumed to operate within a larger competitive environment.Footnote 6 The potential implications of this assumed framework went largely unremarked in the literature until the early 1970s, when economists began to probe Coase's result – by then christened the ‘Coase theorem’ – more deeply and to model it in ways more sophisticated (by professional standards) than the simple intuitive argument and associated numerical example laid out by Coase. One of those implications, as we have already noted, was the possibility that relying on negotiation to resolve externalities could give rise to extortion.
As it happens, Coase had actually taken note of this possibility already in 1959, when discussing the possibility of negotiated solutions to problems of harmful effects in ‘The Federal Communication Commission’. Here, Coase pointed out (without explicit reference to extortion/blackmail) that, in the real world, ‘a waste of resources may occur when the criteria used by the courts to delimit rights result in resources being employed solely to establish a claim’ (Reference Coase1959: 27, esp. n.54). Having essentially assumed away such behavior in 1959, he did not revisit this issue in 1960. Nor, it would seem, did others take note of this 1959 commentary, as it is not referenced in the literature.Footnote 7 And when Coase finally did offer a few words on his negotiation result and the blackmail issue,Footnote 8 in his McCorkle Lecture at the University of Virginia in 1987, he was content to point out that ‘a regime of zero transaction costs would have provided a poor setting in which to discuss blackmail issues’ (Reference Coase1988a: 657).Footnote 9 But not everyone saw the matter in this way.
The idea that the negotiation approach to resolving externalities could give rise to extortionary behavior was first hinted at in the literature in near-simultaneous contributions by Allen Kneese and Stanislaw Wellisz in 1964. Kneese suggested in his treatise, The Economics of Regional Water Quality Management, that ‘If someone – say, a public agency – stood ready to discourage the discharge of waste by paying the manufacturer’ to reduce or eliminate waste discharge, a problem arises because ‘an industrial enterprise may find it profitable to adopt processes which generate much waste in order to be able to accept payment for reducing discharge’ (Reference Coase1964: 57–58) – a practice which could be considered a form of extortion. When Kneese and Blair Bower published a revised edition of the book 1968, they made the extortion possibility more explicit, alleging that a bribes scheme ‘would of course be an open invitation to extortion’, since ‘The administrative authority would have to stand ready to make payments to industrial plants which never do locate in the area, but which would do so if a payment reflecting the costs these effluents would impose was not made’ (Kneese and Bower Reference Kneese and Bower1968: 104, emphasis added). That is, agents may threaten to enter the market with the goal of securing a bribe to keep them out. Kneese and Bower did not comment on potential inefficiencies associated with this extortionary activity, however, viewing it simply, instead, as a potential source of asymmetry between bribes and charges schemes.
While Kneese's focus was primarily (though not exclusively) on evaluating the relative merits of Pigovian taxes and subsidies as devices for dealing with pollution externalities (and thus on increasing/creating emissions to secure a (larger) subsidy),Footnote 10 Wellisz's reference to extortion possibilities was made in the context of a more significant direct challenge to Coase's negotiation result – the first such challenge to appear in the literature.Footnote 11 In laying out a litany of factors that, in his mind, spoke against the negotiation approach, Welliz, writing in Economica, argued that the bargaining process ‘opens up magnificent business prospects, – specifically, that ‘any activity can be turned to profit as long as it is sufficiently annoying to someone else’. Moreover, he continued, ‘as long as the blackmailers maintain amateur standing’ – that is, if no resources are used up in this process – the effects will be purely distributional and ‘the economist who refrains from social judgment can find no fault with the situation’ (Wellisz, Reference Wellisz1964: 353). Wellisz's concern here was not so much on the efficiency side (though he allowed that these processes are likely to absorb resources), and thus with whether or not Coase's claim on that score was valid, but rather with the idea that a system of bargaining over harmful effects could well give rise to this unsavory sort of behavior and that, in the limit, entire ‘industries’ could emerge dedicated solely to threatening harmful effects.
The final passing mention of the extortion issue prior to the eruption of the full-blown controversy came from MIT's Jerome Rothenberg in 1970. Rothenberg echoed Kneese's Reference Kneese1964 point regarding the incentives that a bribe scheme provides for the choice of technologies of production, but he situated his critique explicitly in terms of Coase's contemplated negotiation process:
If external diseconomies against others can be expected to lead to bribes by victims to desist, then the production of negative externalities becomes a valid by-product of primary production. Profitability is enhanced whenever any firm can select from among its inputs and/or output alternatives those which cause substantial damage to third parties. Resource use will tend to become specialized toward much-augmented third-party interference. The new legal industry of selling protection against disturbance will be highly profitable (1970: 115).
The prospects for extortion, then, could influence the method of production and even the choice of what to produce. As such, Rothenberg concluded, the assignment of property rights will not be ‘allocationally neutral’, contrary to what Coase had suggested, and the results associated with a legal regime of victim liability ‘must be deplored’ (Reference Rothenberg1970: 115).
The potential for extortion, then, was a point of some interest in the early literature discussing Coase's negotiation result, but it was not a point of emphasis. Each of the foregoing invocations of extortion possibilities was made in passing and seems to have been made almost completely independent of the others.Footnote 12 Nor do we find any rebuttals to the extortion claims in this early literature,Footnote 13 though this is consistent with the larger absence of any significant debate over Coase's result in the 1960s (Medema, Reference Medema2014a). It was not until 1971 that the controversy over extortion/blackmail possibilities began in earnest, and this discussion, too, began independent of those that had preceded it.Footnote 14
3. Framing the problem
The intensification of the extortion discussion began with the near-simultaneous publication of two articles, by Donald Shoup of the University of Michigan and the University of Alberta's G. A. Mumey, in 1971. These were two of the earliest critiques of the Coase theorem to appear in the economics literature, and they helped to stimulate a debate over the theorem that was to rage on multiple fronts for the next decade.Footnote 15
Games agents play
It was Shoup who, by a margin of some 2 months, provided the first significant exploration of the extortion issue, doing so in response to an article on the economics of pollution control by the University of Chicago's Richard Zerbe that appeared in the Western Economic Journal (WEJ) in 1970. Zerbe's (Reference Zerbe1970) discussion of private solutions to pollution externalities had repeatedly emphasized the importance of transaction costs and, in the end, suggested that polluter liability may often prove to be the most efficient course of action. But what caught Shoup's attention was Zerbe's invocation of the ‘Coase theorem’Footnote 16 to ground his support for the possibility of private solutions to pollution problems and as a basis for the consideration of making victims liable for pollution-related harms.
The root of Shoup's objection to Zerbe's line of thinking can be found in the context within which the Coase theorem's negotiation process was assumed to work itself out. Echoing Coase's terminology, Zerbe had described the Coase theorem's two-agent bargaining environment in terms of a ‘costless pricing system’ within which agents seamlessly negotiate efficient solutions.Footnote 17 Against Zerbe, Shoup countered that the ‘unambiguous assignment of legal liability’ in these two-agent contexts can give rise to ‘complex game situations’ that introduce the possibility of various forms of strategic behavior. This, said Shoup, suggests that it is wrongheaded to speak in terms of such a ‘pricing system’ for the analysis of these bargaining issues; instead, he argued, the appropriate tool for analysis is game theory (1971: 310).Footnote 18
For Shoup, the ‘game consequences’, as he called them, that would result from dealing with externalities through a system that relied on the assignment of legal liability and subsequent bargaining were several and ‘seemingly inevitable’ (1971: 310). One of these, he said, is threat-making, or extortion.Footnote 19 Shoup did not object to the idea that victims may have an incentive to bribe polluters to reduce emissions under a system of victim liability. But, he said, ‘Once it became apparent that polluters could extract payments for pollution reduction, there would be an incentive for entrepreneurs to threaten to undertake production activities with external pollution costs simply to be bribed not to undertake them’ (1971: 310). Like Wellisz, Shoup pointed out that the effect of these threats is purely distributional if no resources are expended in the threat-making process. But, he said, to the extent that these ‘pollution entrepreneurs’ have to invest resources and actually pollute to secure these bribes, efficiency will be adversely affected (pp. 310–311). Indeed, he continued, the incentives that result from relying on negotiation to resolve pollution problems could give rise to ‘a sort of environmental “protection racket”, with much pollution undertaken solely for bargaining purposes, and with little hope of a Pareto-efficient, much less stable, solution’ (p. 311).Footnote 20 Shoup also noted a further complication not mentioned in previous treatments of the extortion issue – that these same incentives apply to victims when the polluter is made liable, since agents would have an incentive to locate near, or threaten to locate near polluters in order to secure bribes and to invest resources (e.g., undertaking construction) to make these threats credible (p. 312). As such, Shoup argued, negotiated solutions will be both inefficient and dependent upon the direction of liability, in contrast to what the Coase theorem claims.Footnote 21
It bears repeating that Shoup accepted the conclusion that the costless pricing system contemplated by Zerbe would give rise to efficient and invariant solutions to problems of externality.Footnote 22 His concern, though, was with the very idea of modeling the negotiation process within a context that assumes a costless and smoothly operating pricing system of the competitive type and the attendant implicit assumption that the bargaining process involves a positive-sum, cooperative game. The extortion analysis, he pointed out, shows that ‘The legal sanctioning of pollution may also encourage negative-sum games’ (1971: 311). The nirvana-esque conception of the Coase theorem – that, absent impediments to bargaining, misallocations will be resolved by bargaining, a take on the theorem that had led Guido Calabresi (Reference Calabresi1968: 68), a Coase theorem sympathizer, to label it both ‘tautological’ and ‘a kind of Say's law of welfare economics’ (Reference Calabresi1968: 73) – said Shoup, ‘directs attention to important questions’ but ‘does not itself provide any answers in the absence of at least theoretical solutions to numerous game problems’ (1971: 312). For Shoup, ‘one important but under-emphasized aspect of Coase's theorem for the study of the economics of pollution is to direct attention to game theory for insight’ into the consequences of liability rules. ‘Indeed’, he said, ‘the very meaning of the term “transaction costs”’ can only be comprehended in the light of game theory.
Shoup's argument, in a nutshell, was that the Coase theorem is non-sensical because one cannot contemplate a bargaining process absent strategic considerations that are likely to induce inefficiencies. Thus, to draw even theoretical conclusions regarding the possibility of negotiated solutions required, in his estimation, a reframing of the modeling structure under which such problems are subjected to examination (1971: 312).
Threats are free, too . . .
Where Shoup had located the extortion problem in the strategic response to the ‘unambiguous assignment of legal liability’, Glen Mumey, writing in the Quarterly Journal of Economics for November 1971, took the extortion discussion in a very different direction, arguing that the genesis of the problems with the Coase theorem lay in the ‘anarchistic (laissez-faire?) absence of liability law’ (1971: 723) within which he perceived the Coase theorem to reside.
Mumey, whose work to that point had focused mainly on financial economics, would seem to be an unusual candidate to weigh in on the Coase theorem.Footnote 23 But he was not wholly unfamiliar with the general issues contemplated by the Coase theorem, for he had in recent years authored articles assessing the potential invariance of a firm's capital cost across alternative financial structures (the Modigliani-Miller theorem) and the potential equivalence of tariffs and domestic taxes – subjects that, if viewed through Coase theorem lenses, also went to the efficiency and potential allocative equivalence of alternative legal rules (Mumey, Reference Mumey1967, Reference Mumey1970).Footnote 24 In short, Mumey was well versed in the essentials of the Coase theorem's claims, not unlike the environmental and welfare economists who came to the Coase theorem via the exploration of the potential allocative equivalence of Pigovian taxes and subsidies.Footnote 25
Mumey opened his discussion by invoking Stigler's original statement of a ‘Coase theorem’Footnote 26 and then proceeded to restate Coase's own result thusly: ‘Coase contends that, with no transactions cost, victims of social costs will, in the absence of liability placement by law, offer bribes for abstention to the inflictors of the costs’ (1971: 718, emphasis added). This point, he said, had subsequently been generalized by Guido Calabresi (Reference Calabresi1968: 68), who argued that: ‘if one assumes rationality, no transactions costs, and no legal impediments to bargaining, all misallocation of resources would be fully cured in the market by bargains’. Mumey, though, was suspicious of this claim and set out to demonstrate, against Calabresi and Coase, that, ‘In a world of rationality and no transactions costs, the conditions of (1) no legal impediments to bargaining and (2) a voluntary market economy may be incompatible’ (1971: 718, emphasis added).
For Mumey, rational behavior is that ‘consistent with personal goals’, which he assumed to be both ‘selfish and materialistic’. A world absent transaction costs, meanwhile, was said to be one in which ‘information about potential social costs can be frictionlessly transmitted before their infliction’, and ‘the potential victims can frictionlessly offer bribes in amount equal to the potential social costs’ (p. 718). While in Coase and Calabresi's analysis, it was the costless transacting environment that allowed the negotiation process to efficiently resolve externalities, Mumey identified this environment as a cause of the extortion problem.
The issue, Mumey argued, is that costless communication allows not only for the costless transmission of information that facilitates efficiency-enhancing exchanges of rights but also for the costless transmission of threats. If producers of harmful effects are not legally liable for harm caused, Mumey said, bribes from the victims effectively work as ‘a reward for . . . abstention’ from a certain type of action. The possibility of such rewards, he asserted, creates for the rational (‘selfish and materialistic’) agent an ‘economic incentive for inventing a threatening production’ simply to secure a bribe (p. 720). Like Wellisz and Shoup, Mumey recognized that these threats would not inherently give rise to inefficiencies. However, he asserted, the need to ensure that threat commitments are credible makes it ‘difficult to believe’ that resources will not be employed the process of developing credibly threats (p. 720).Footnote 27 In light of this, Mumey concluded that ‘there is a strong case for believing’ that the bargaining arrangements contemplated by the Coase theorem would result in inefficient uses of resources even if the costs of negotiation proper are zero (p. 720, emphasis added).
The greater danger though, from Mumey's perspective, was that the environment contemplated by the Coase theorem is likely to encourage inefficiency via extortionary actions, even if the threat-making process does not require resource commitments. Mumey's position here was grounded squarely in his interpretation of the legal environment within which the Coase theorem operates. He had no quarrel with the claim that we can be allocatively indifferent between making legal liability rest on injurers or victims if the costs of negotiation are zero and no resources are employed in the threat-making process. But as Mumey understood the Coase theorem, it claimed that we can be allocatively indifferent between a system of legal liability and one in which there is no legal liability assigned for externality-related damage – a world that, as he put it, is characterized by an ‘anarchistic . . . absence of liability law’ (p. 723). In such a world, said Mumey, the restraints on rational action necessary for a voluntary market system to function, or at least function efficiently, are lacking, and threat-making activities have the potential ‘to become instant revenue generators’ and ‘the principal modus of income distribution’. Given that resource allocation ‘is inextricably bound to’ the economic system's ‘pattern of reward dispensation’, he concluded, it is ‘hard to believe’ that the resource allocation system ‘could emerge unscathed’ (pp. 722–723).
Thus, where Shoup had located the extortion problem in the game-theoretic concerns that arise under an unambiguous assignment of property rights, Mumey's concern was exactly the opposite. What supporters of the theorem failed to realize, Mumey argued, is that ‘There is a difference between asserting that the placement of liability does not matter, and extending this argument to the assertion that liability laws do not matter’ (1971: 723). In Mumey's hands, the Coase theorem did both and, in doing so, peeled away the institutional forces that were necessary to channel the rational pursuit of self-interest to efficient ends.Footnote 28
4. Defending the theorem against the extortion claim
The claims by Shoup and Mumey that extortion would invalidate the Coase theorem provoked an array of direct and indirect responses defending the theorem against the extortion critiques. These defenses took various forms, but each alleged that the critics had misunderstood the theorem's premises or the context within which it was situated. Armed with a proper understanding of the theorem and its context, theorem supporters argued, it would become clear that the critics had not, in fact, cast any doubt on the theorem's validity. What these defenses of the theorem revealed more than anything, though, was that the theorem's defenders had very different interpretations of the theorem, its assumptions, and its environment than did the critics.
All is for the best . . .
Harold Demsetz, who had been supportively referencing Coase's negotiation result since 1964,Footnote 29 took on Shoup's critique in a 1971 WEJ comment, asserting that it evidenced multiple errors. One of these, he said, was the neglect of ‘a point of intellectual history’. Specifically, Demsetz argued, Shoup's contention that agents may need to invest resources to establish their extortion claims ‘violates the zero negotiation cost assumption underlying the Coase proposition’. This assumption and the world that it reflects, Demsetz said, renders ‘unnecessary’ the employment of resources in the negotiation process, including ‘to create an attitude that “he really meant it”’ (1971: 444–445).Footnote 30 Thus, while the Coase theorem environment may allow for the possibility of extortion, a proper understanding of the zero transaction costs assumption, at least as interpreted by Demsetz, informs us that the theorem rules out inefficient extortionary behavior a priori.
While Demsetz's argument dispensed with extortion-induced inefficiencies by assumption, Jeffrey JaffeFootnote 31 and Richard Zerbe took a different tack in their defenses of the theorem, one based on the nature of agent behavior in a Coase theorem world. Jaffe, who had recently completed his Ph.D. at Chicago and was responding to Mumey's article in the QJE, accepted the basic claim made by Mumey that extortionary activities have the potential to serve as revenue generators (Jaffe, Reference Jaffe1975: 660). He parted company with Mumey, though, on the idea that the need to make these threats credible would give rise to inefficiencies, and he grounded his objection in the implications of what he, like Mumey, saw as ‘a fundamental assumption of Coase's theorem’ – the idea that ‘bargains are rational’ (p. 660).
Consider a situation in which polluters are liable for damage and a laundry (B) is threatening to locate next to a polluting factory (A). B's entry, of course, would to do harm to the A's profits. But B will not enter, according to Jaffe; the rational factory owner will offer, and the rational laundry owner will accept, a bribe that will be sufficient to induce the laundry to remain out of the area. The same logic, he said, informs us that no rational agent will undertake investments in such value-destroying activities; instead, ‘Merely B's potential to create a more destructive resource should be enough to force A into a more generous bargain’ (p. 661).Footnote 32 Thus, while agents may threaten inefficient behavior, the ability of the parties to transact costlessly will allow them to reach agreements acceptable to both without resort to inefficient threat-supporting activities. For Jaffe, then, it was rationality, not (as for Demsetz) the absence of transaction costs per se, that would preclude the utilization of resources for threat-making.Footnote 33
Zerbe's objection to Shoup's extortion critique was very similar to that employed by Jaffe against Mumey, though Zerbe's was of the ex post variety.Footnote 34 Invoking Calabresi's (Reference Calabresi1968: 68) restatement of Coase's result, Zerbe noted that, ‘What I mean (and meant) by the Coase theorem is what Calabresi meant, as quoted with approval by Shoup, to the effect that with rationality and costless transactions all misallocations would be fully corrected through bargaining’ (1971: 314 n.1). This point, for Zerbe, went directly to – indeed, dispensed with – extortion-induced inefficiencies. When it comes to the frictionless world of the Coase theorem, he said, ‘If extortions were wasting resources, costless bargains would be made that eliminate the waste’ (p. 314 n.1). Given that agents will negotiate away any inefficiencies, Zerbe concluded, the only extortion activities that will occur in such an environment will be those that have net benefits associated with them or that have only (non-distortionary) distributional effects.Footnote 35
The competitive environment
Though Demsetz felt that the Coase theorem's zero transaction costs assumption insulated it from Shoup's extortion charge, he was not content to rest his argument on this alone. There remains, he said, a second aspect of Coase's analysis that also neuters the extortion challenge: his assumption of a competitive environment. If the environment is competitive, Demsetz argued, the implications extend to extortionists, and the theory of competitive markets suggests that there is no cause for concern:
Under competition the price of a good, or of an agreement, is held to its cost. Clearly in this case the production of ‘excessive’ smoke simply to ‘extort’ imposes an unnecessary cost on ‘extortionists’. They each would be happy to avoid nonprofitable activity levels for any positive payment (1971: 445).
This, of course, is an argument related to that made by Jaffe. But Demsetz took matters a step further:
In the competitive regime, rivalry between ‘extortionists’ would push to zero the price they receive not to undertake these excessive activity levels. Thus, competing ‘extortionists’ would offer to refrain from extortionist activities for smaller, and ultimately for zero, payment (p. 445).
But this was not the end of the story, as Demsetz argued in a 1972 extension of this analysis. The presence of locational alternatives for the potential extortion victim – which we would expect in a competitive environment – has the effect of compromising the credibility of the extortioner's threat since the potential victim would simply relocate or threaten to do so should the extortioner attempt to make good on his threat (1972: 23). The Coase theorem's competitive environment thus ensures that extortion attempts can do no efficiency-related harm.Footnote 36 Meanwhile, the theorem's negotiation process ensures that the externality will be internalized and thus that the maximum aggregate returns will be realized. The only issue, said Demsetz, ‘is the sharing of this maximum return’ (Reference Demsetz1972: 23).Footnote 37
5. Incompatible worlds?
Shoup, for his part, was unmoved by the objections put forward by Zerbe and Demsetz, continuing to insist in a 1972 response to their arguments that strategic concerns and associated indeterminacies are ‘inevitable’ in a bargaining context, and reiterating that to speak in terms of a frictionless competitive ‘pricing system’ in a Coase theorem world, as Zerbe and Demsetz had done, ‘misused’ the theorem (Shoup, Reference Shoup1972: 220). Shoup's argument, in essence, was that the Coase theorem, while correct as its supporters defined it, was non-sensical by economic modeling standards and was only properly contemplated or modeled within a non-cooperative game theory context.Footnote 38
The illegitimacy of two-agent competition
Shoup's position found at least partial support in a 1974 article by the University of Houston's George Daly, which also appeared in the Western Economic Journal but was separate from (though in no small part inspired by) the to-and-fro instigated by Zerbe's 1970 piece. Daly (Reference Daly1974) observed that ‘The Problem of Social Cost’ had perhaps ‘stirred more interest and controversy’ than any recent article in the welfare economics literature, but also that it, and the Coase theorem in particular, had ‘wrought important changes in the views taken by economists’ regarding the nature of market failure and the appropriate response to it (p. 203). He also accepted the ‘recent formal demonstrations of the validity of the Coase theorem under the restrictive circumstances (no transactions costs or income effects) posited’Footnote 39 and to this extent, at least, was on board with the theorem. Daly's sense, though, was that the theorem's assumptions ‘are, in practice, likely to be incompatible’ with the policy contexts to which economists had been applying them. This critique, as he stressed repeatedly, was not simply one of practical relevance – i.e., that the real world is one of positive transaction costs, which renders the Coase theorem applicably irrelevant – but instead was targeted at demonstrating that the world in the model was an internally inconsistent one (Daly, Reference Daly1974: 203–204).
For Daly, the root of the problem with the Coase theorem – and, by extension, the crux of the extortion controversy – lay in Coase's decision to embed his two-party negotiation result within a competitive environment. Demsetz, he noted, had suggested that competition will preclude extortion-related inefficiencies, but Daly was not convinced. The Coase theorem, Daly said, tells us that ‘markets may be regarded as relatively efficient methods for the provision of internalization in those circumstances where (a) the number of parties involved in the externality is small and (b) competition prevails in that market’ (pp. 208–209). But both supporters and critics of the theorem, Daly argued, had failed to appreciate that ‘the simultaneous existence of competition and of small numbers of externally affected and effecting parties are mutually inconsistent phenomena’ (p. 209, emphasis added). On the one hand, he said, the large numbers of the competitive environment give rise to ‘prohibitive transactions costs’. Absent large numbers competition, however, ‘market solutions are burdened with complex, game theoretic bargaining situations which involve a substantial likelihood of counterproductive (costly) activity’ – i.e., extortion – meaning that efficiency ‘cannot be assured’ (p. 208).Footnote 40 As one or the other of these conditions must win out, Daly argued, the prospects for the theorem's validity are very dim indeed.
All of this led Daly to conclude that the use of two-agent competitive externality models ‘is an illegitimate and misleading procedure’ (p. 210).Footnote 41 While such models may or may not be realistic (and we cannot predict this a priori, he said (p. 211)), the negotiation processes involved ‘are not competitive’ (p. 210 n.8), and to employ models that ‘involve two such contradictory assumptions is necessarily to create ambiguities regarding the nature of the allocative problems which harmful effects raise for market techniques’ (p. 211). The Coase theorem, so read, was not so much wrong as wrong-headed – an ill-conceived attempt to theorize about private resolutions of externalities.
The worst of all possible worlds
Daly further developed this line of argument a year later, hoping to settle the extortion issue once and for all, in an article written with Giertz that was published in the American Economic Review in 1975.Footnote 42 As with Daly's 1974 article, this second effort emphasized the essential correctness of the conclusion reached by supporters of the Coase theorem – that if transaction costs are zero, extortion does not utilize resources and thus has a distributional, but not an allocative impact.Footnote 43 The problem, they argued, is that ‘Any bargaining process is a resource using process’ – i.e., is inevitably attended by ‘transaction costs [that] are greater than zero’ (1975: 999, emphasis added). To the extent that the available gains from exchange exceed the associated transaction costs, bargaining over externalities will generate a Pareto improvement.Footnote 44 But when extortion-related activity is the subject of the bargaining, they continued, there are no available gains from exchange; the extortion-related negotiation process leads the parties back to the very point from which they started. The absence of any offsetting improvement in the allocation of resources (gains from exchange) means that the reality of transaction costs in bargaining necessarily renders extortion inefficient (p. 1000).Footnote 45
This brought Daly and Giertz to what they saw as the great irony in the discussions of negotiated solutions to externalities. It is situations in which negotiations over externalities are most likely to occur – i.e., where transaction costs are positive but low – that we are most likely to observe extortion. Yet, they said, those who extolled the possibilities of negotiated solutions overlooked or minimized blackmail possibilities. On the other hand, those most pessimistic about negotiated solutions to externalities – who raise the specter of prohibitive transaction costs – are also those expressing great concern about extortion, seemingly oblivious to the fact that the same transaction costs, which preclude negotiations of the Coase theorem variety will also preclude extortion (Reference Daly and Giertz1975: 999–1000).Footnote 46 Daly and Giertz found this ‘paradoxical’ (Reference Daly and Giertz1975: 1000), but attributed it to the failure of scholars on both sides of the debate to come to grips with the connections between bargaining, transaction costs, extortion, and efficiency.
The reality of transaction costs suggested to Daly and Giertz that the virtues of the competitive environment were not unlimited and, in particular, that Demsetz's competition-based objection to the extortion critique did not hold water. Demsetz, as we have seen, took the position that extortion will not be supplied in a competitive marketplace because competition among extortionists will drive its return to zero. But this argument, said Daly and Giertz, ‘confuses cause and effect’:
It is precisely the fact that extortionist services are supplied that drives the price to zero. . . . Moreover, if there are positive costs for the extortionist in establishing a credible threat, the price under competition will now approach these costs and not zero. In this circumstance the competitive provision of extortion services will clearly involve a net loss in social welfare by maximizing the resources devoted to this task (Reference Daly and Giertz1975: 1001).
Thus, far from preventing inefficient extortion, a competitive externalities environment, Daly and Giertz maintained, would lead to ‘the worst of all possible worlds’ (p. 1001, emphasis added).Footnote 47
6. Creating precision out of ambiguity?
What is the point of telling the story of the extortion controversy? Is there a reason to care about how this debate played out? If one is interested solely in the determination of correct and incorrect arguments, the identification of winners and losers in theoretical debates, or the move from ‘error’ to ‘truth’, there is not much to learn from the history presented to this point, and the foregoing discussion is anything but satisfying. The authors’ respective treatments of the extortion question – the jabs and counter-punches – have been presented on their terms with nary a word of critical commentary or evaluation of the arguments made. Readers who ‘know’ the Coase theorem are likely tearing out their hair at this point wondering why the present analysis has not made clear to the reader that all of the extortion-based criticisms of the theorem obviously violate one or more of the theorem's underlying assumptions – usually that of zero transaction costs – in the process of establishing their claims against its validity and that the theorem, properly understood, emerged unscathed from this debate.
But any such argument is premised on a claim that the reader actually ‘knows’ what the Coase theorem is – in effect, that there is a Coase theorem or, to draw the subject more narrowly, that there was some objectively known entity, ‘the Coase theorem’ at the time the extortion debate was playing out. Nothing could be further from the truth. The construction of something called the ‘Coase theorem’ was the result of the efforts of a diverse group of economists and others engaged in an exercise of interpreting what Coase had said – and/or what others said about what Coase had said – when laying out his negotiation result in ‘The Problem of Social Cost’. What Coase himself said, however, was far from clear and precise. Yes, there has been wide (though not complete) agreement that Coase claimed an efficient and invariant allocative outcome would result from the processes that he was contemplating. But the assumptions upon which Coase based this conclusion were anything but unambiguous. It was left to succeeding generations of economists to create Coase theorem worlds and attempt to ascertain whether Coase's result held water within such worlds. And, as the extortion and other debates over the theorem's validity make clear, there was no lack of interest in doing so.
‘Hogwash!’ says the skeptical reader. Coase clearly assumed a world of zero transaction costs and the extortion critics were equally clearly violating that assumption, as Demsetz (Reference Demsetz1971) pointed out. But did Coase in fact assume such a world? His illustration of the farmer and cattle rancher was grounded in the assumption that ‘the operation of a pricing system is without cost’ (Reference Coase1960: 2) and his discussion of several 19th century legal cases invoked the context of ‘costless market transactions’ (e.g., Reference Coase1960: 11). What Coase meant by these terms, though, is unclear.Footnote 48 For example, if Coase was actually working in a world truly devoid of transaction costs, why does money – the dollar-valued payments between ranchers and farmers – exist in his world? Money serves no purpose here. One could further argue – as, e.g., Cheung (Reference Cheung1986) and Allen (Reference Allen1991) have done – that property rights are unnecessary in a world of zero transaction costs; yet, Coase seems to have been of the mind (but see below) that they are necessary for negotiations to take place.Footnote 49 Even more tellingly, one could argue that (inefficient) harmful effects would not exist in a world of zero transaction costs; instead, they would be anticipated and negotiated away before they ever manifested themselves.Footnote 50 The long and the short of this is that Coase's ‘world’ of efficient and invariant negotiated solutions clearly had some transaction costs in it – at least if we are to define zero transaction costs in the ‘absence of any and all frictions’ way found in the strong version of the zero transaction costs assumption that has emerged in the decades since Coase penned his article and is favored by Coase theorem defenders.
The fact of the matter is that Coase's Reference Coase1960 article made a very bare-bones argument regarding negotiated solutions to problems of harmful effects, and the debate over the Coase theorem evolved out of attempts by others to put meat on those bones. No small amount of this involved, at least in retrospect, wrestling with the notion of transaction costs – their content, meaning, and what is implied by their absence. The extortion debate is a case study in exactly this. Some critics defined a zero transaction costs world to include costless talk, so to speak, but did not include the investment of resources in threat-making as a species of transaction cost. Others argued that it is simply inappropriate to speak in terms of a frictionless environment in certain contexts – Shoup, for small numbers bargaining and Daly for large numbers bargaining. These were not arguments of relevance, but of theorizing, of how one should appropriately model certain types of interactions and thus of claims that one can make for a theorem that purports to describe such interactions. Viewed from this perspective, the Coase theorem, as conceived by its supporters, was wrong-headed or nonsensical from the get-go and, if understood ‘properly’ (i.e., on the critics’ terms), is simply wrong. Whether the critics’ claims were valid or not, then, depends on how one defines a world of zero transaction costs, and what the extortion debate makes crystal clear is that, circa the 1970s, there was no settled definition of what life in such a world entailed, nor any singular position on whether, purely as a matter of theory, it was legitimate to contemplate life (or certain varieties of it) within such a world – whatever that world's nature may be.
What of Mumey's claim the Coase theorem does not hold in the ‘anarchistic absence of liability law’? Defenders of the theorem would no doubt point to Coase's (Reference Coase1960: 8) assertion that ‘It is necessary to know whether the damaging business is liable or not for damage caused’ to argue that Mumey was violating one of Coase's two central assumptions – the necessity of some legal determination of liability for negotiation to take place. But Coase's meaning is not unambiguous here, either. After concluding his analysis of the situation where the rancher is legally liable for damage caused by his cattle in a section entitled, ‘The Pricing System with Liability for Damage’ (Reference Coase1960: 2–6), Coase turned to a discussion of ‘The Pricing System with No Liability for Damage’. He opened his analysis of this situation by saying,
I now turn to the case in which, although the pricing system is assumed to work smoothly (that is, costlessly), the damaging business is not liable for any of the damage which it causes. This business does not have to make a payment to those damaged by its actions (Reference Coase1960: 6).
Coase makes no mention here of any court determination that the farmer is legally liable for damage, saying only that the rancher is not liable – which could be the result of the absence of any legal decision rather than a formal declaration in the rancher's favor. Of course, Coase's subsequent discussion of several 19th century legal cases involving instances of harmful effects speaks to the consequences of judges making a determination of rights in one direction or the other and, in retrospect, it is easy to read this context back into the example of the farmer and the cattle rancher. But the reality of the situation is that not everyone read Coase in this way – including Mumey, but also others. Indeed, this view that Coase was contrasting injurer liability with the absence of any legal rule of liability even found its way into the textbook treatments of the theorem – discussions that, we should point out, affirmed the theorem's validity – in the 1970s.Footnote 51
Consider next Jaffe's defense of the theorem, which was grounded in the assumption that agents are rational – an assumption also made by Mumey, whose analysis Jaffe was criticizing. Jaffe, recall, tells us that ‘it is a fundamental assumption of Coase's theorem that bargains are rational’ (1975: 660, emphasis added), and he argued the theorem's correctness against the extortion claim by asserting that rational agents will never waste resources on threat-making. Yet, Coase, for his part, had nowhere assumed that agents are rational, nor had he employed any other explicit behavioral postulate.Footnote 52 The source of the rationality assumption is Calabresi, who tucked it into his discussion of Coase's negotiation result in 1968 (though he did not make reference to a ‘Coase theorem’). Calabresi was arguing there that Coase's result applied to situations far more broad than the harmful effects contemplated by Coase in ‘The Problem of Social Cost’, asserting that, ‘if one assumes rationality, no transaction costs, and no legal impediments to bargaining, all misallocations of resources would be fully cured in the market by bargains’ (1968: 68). Mumey (Reference Mumey1971: 718), it would seem, decided that the ‘Coase theorem’ embodied the rationality assumption made by Calabresi, and Jaffe, writing 4 years later, determined both that this assumption was ‘fundamental’ to the theorem and that rationality precludes waste. The former claim – that rationality was a ‘fundamental assumption’ of the theorem – does not hold water when one understands the state of play at the time, and critics of the theorem, such as Shoup, who relied in non-cooperative game theory in staking out their positions, would no doubt quibble with the latter claim.
One final illustration of the ambiguity surrounding the Coase theorem is worth noting here. A common thread in the Jaffe and Zerbe defenses of the theorem is that both were, in essence, appealing to the Coase theorem itself in order to prop up the theorem. Their argument was that theorem-invalidating (i.e., inefficient) extortion will not materialize within the negotiation process because the Coase theorem ensures either that the inefficient threats are negotiated away (via Coase theorem processes) ex ante, prior to having any impact on allocation, or that they will be resolved ex post through the very negotiation processes that cure the initial externality-related inefficiencies. The case can be made that this stance effectively converts the Coase theorem into a tautology, a claim that bargaining will cure all inefficiencies because all inefficiencies are assumed to be cured by bargaining.Footnote 53 It would be difficult indeed to ‘disprove’ such a theorem.
To return to the question with which we began this section, what, then, can we learn from historicizing the extortion debate? The lesson is this. The participants in this debate were discussing something called the ‘Coase theorem’, an idea that was said to embody an economic logic and associated set of claims put forward by Coase himself in 1960 – even if Coase had not hung the ‘theorem’ label on his result. Yet, what is unmistakably clear is that no two of these authors were discussing precisely the same thing. This brings us to perhaps the most fundamentally important thing that one can say about the Coase theorem literature circa the 1970s – that there was no singular Coase theorem, nor, for that matter, singular understanding of what Coase had said in his 1960 treatment of negotiated solutions to problems of harmful effects. The implication of this, historically contemplated, is that the professional understanding the Coase theorem not stabilized at this point. Indeed, a strong argument can be made that the 1970s was a period of destabilization.
No small amount of this was an artifact of the modeling choices made – and, within those modeling decisions, the meanings or content ascribed to Coase's assumptions, the interpretations laid on Coase's analysis, and even the addition or creation of assumptions – by those attempting to conceptualize, to more rigorously formalize (with or without mathematics), and to analyze what had been a simple intuitive argument put forward by Coase in 1960. These choices served to define ‘the world in the model’ (Morgan, Reference Morgan2012) and, by extension, the conclusions reached. Occupying center stage here was the world absent transaction costs, the nature of which was anything but settled at this time. Indeed, the meaning of such a world was being created over the course of the Coase theorem debates and, with that, so too was the Coase theorem.
7. Conclusion
While the extortion question was central to the critiques of the Coase theorem discussed here, this debate, as Daly emphasized, was symptomatic of a larger issue in the Coase theorem literature – one that went to the context in which one can, or should, frame/model Coase's result. This ambiguity was itself derivative of two larger forces that factored into the evolution of this discussion: the fairly loose way (by the standards of the 1970s, at least) in which Coase had framed his own analysis – which was more or less mimicked for the next decade by those supporting the negotiation result – and the increasing fixation of economists taking up the Coase theorem on what Morgan (Reference Morgan2012) has called ‘the world in the model’. The combination of these two forces had led economists, beginning in the early 1970s, to model Coase's result using everything from two-agent bilateral monopoly models to general equilibrium models that assumed perfectly competitive markets with large numbers of externality emitters and receptors and parametric prices – all with the goal of assessing whether or not his result could withstand the test of economic logic.
To read these debates as mere flights of theoretical fancy, though, would be incorrect. As Daly and Giertz pointed out, widespread emphasis was being placed on ‘the important role that can be played by voluntary exchange arrangements in achieving efficient levels of externality generating activities’ (Daly and Giertz, Reference Daly and Giertz1975: 997). This, in turn, was of no small import, given the increasing attention being paid to environmental issues by economists and policy makers. The suggestions made, in certain quarters, that the Coase theorem offered a possible solution to some of these issues played a major role in stimulating scholarship that set out to assess the Coase theorem's validity (Medema, Reference Medema2014c) – a motivation reflected in the increased tendency (very much evident in the extortion debate) during the 1970s to couch discussions of the theorem's validity in the context of pollution damage. The resolution of the validity question, in turn, would speak to the possibility of so-called ‘private’ solutions to externality problems (as against traditional Pigovian remedies) in the real world – both in terms of their efficiency and the prospect of achieving such results absent polluter liability for harm.
Finally, we should not neglect to note that this discussion of the ambiguity surrounding and multiple interpretations of Coase's negotiation result and the ‘Coase theorem’ has left to one side the much larger issue of the treatment of ‘The Problem of Social Cost’ in the economics literature. Coase often lamented later in his career the extensive amounts of (what he considered misplaced) energy devoted by economists to discussing the Coase theorem as compared with the several other (what he considered to be more important) points made in that article.Footnote 54 The extortion debate, of course, was only one facet of this, a veritable toothpick in the forest of Coase theorem literature. Curiously, though, what the extortion debate illustrated – albeit indirectly – is that institutions matter, and that understanding how and why they matter, and the implications of this for economic analysis and policy may require a re-orientation of the ways in which economists practiced their trade. Here, too, transaction costs occupy center stage. Of course, this had been Coase's point all along, but it was a point increasingly lost in economists’ fixation on the world in the model.
