CLASS 13 OUTLINE The Economics of Business Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

In Earlier Episodes… What sort of super powers did the classical entrepreneur possess? How did Knight distinguish risk and uncertainty? How does Knight indicate managers deal with uncertainty? How does the market value uncertainty? What role is there for management if there is no uncertainty? What ultimately limits the growth of firms in Kaldor, A. Robinson, A. Marshall, and Coase worlds? What factors limit entrepreneurial or management capacity? Is Simon concerned with intrinsic cognitive limits, uncertainty, or both? How does he define bounded rationality; how does it compare to irrationality? 2

Earlier episodes, continued 3 What three constraints does Simon use to define a decision-making problem? Given that complexity often overwhelms us, what sort of simplifications does Simon suggest? Do Simon’s modified decision rules guarantee a unique solution? What are the only two ways Simon said organizations could learn? Is individual learning within an organization a social process? What comes to mind when you think of a “nexus of contracts?” How would you relate factors of production and contracts? What are the three elements of an Alchian output program; how do they relate to contracts; what are the implications for valuing various types of contracts (e.g. a customer relationship)? Firms have, in general three sort of choices when they consider acquiring traded goods; what are they? When are spot markets most efficient?

Earlier episodes… 4 What are some of the reasons to pursue a negotiated contract for factor inputs? What role does factor specificity play in decisions regarding contracting or internal production? What are “opportunistic” behaviors; what are examples? Can you distinguish “lock-in” from “hold-up”? What keeps a relational contract going? What is a “complete contract;” how many have ever been negotiated? What sort of evolutionary stages of the law did Ian McNeil discuss as quoted by Williamson? How does Williamson define the “governance structure”?

Coase: The Problem of Social Cost 5 The problem to be examined:  Divergence of social and private costs  Standard (Pigovian) welfare penalized the offender The reciprocal nature of the problem  To avoid harm to B inflicts harm on A  Confectioner’s process disturbs a doctor  Restrict the confectioner to benefit the doctor or vice versa  Restrict a rancher to benefit the farmer or reverse  Alleged Stigler problem of a contaminated stream* This must be in the 1 st or 2d editions of the Theory of Price, I have a 3 rd edition and can’t find it anywhere near p105. There is, however, a long discussion of Coase’s article.

The Pricing System with Liability for Damage 6 Assume annual cost of fencing at $9, crop price is $1 per ton

The Pricing System With No Liability for Damage 7 Assume initial herd is three steers; rancher has no liability to compensate the farmer What would the farmer be willing to pay rancher to reduce herd to two steers, to one steer? How do the farmer’s payments to the rancher compare to the case where the rancher had liability and paid the farmer?

Taking the Cost of Market Transactions into Account 8 With transactions costs the assignment of rights matters Acquisition, i.e. vertical integration, aligns ownership and costs and produces the socially efficient decision If the affected parties are too numerous for efficient contracting the government may intervene with a variety of policy tools; fees, taxes, zoning, prohibition, etc. Reduced administrative costs do not assure overall lowest social cost Government has been known to take non-economic factors into account

Pigou’s Treatment in The Economics of Welfare 9 Coase slams Pigou for incompletely thinking out the problem “Gotcha” on Pigou’s use of the railway example as being factually incorrect and undesirable policy The U.K. law in fact relieved the railroad from liability (aside from some minor exceptions) because it had statutory authority to run steam engines Pigou also seemed to think the railroad should have complete liability for damage to others

The Railroad Example 10 Start with the premise the railroad is not liable for damages What happens when the railroad is liable for damages?

The Pigovian Fallacy 11 “The question at issue is not whether it is desirable to run an additional train or a faster train or to install smoke-preventing devices; the question at issue is whether it is desirable to have a system in which the railway has to compensate those who suffer damage from the fires it causes or one in which the railway does not have to compensate them. When an economist is comparing alternative social arrangements, the proper procedure is to compare the total social product yielded by these different arrangements.” (p17)

Boulston’s Coney Case and Nuisance Law case between neighboring landowners One landowner promoted coney population resulting in destruction of the other’s corn Ruling held the coney promoter was not liable since he had no ownership interest in wild animals who, of their volition traveled to the corn famer’s land The corn farmer was also free to kill the conies Professor Williams objected and Coase agreed, conies should be treated under nuisance law where the damages could be weighed rather than a strict absence of liability

Coase’s “New Approach” 13 Focus on total effect, not the divergence of private and social costs Drop straw man comparisons of laissez faire and ideal world; it promotes looseness of thought Consider factors of production as rights as opposed to physical entities alone Recognize that no rights are absolute; a system of unlimited rights is one of no rights Remember that the cost of exercising a right is always the loss suffered elsewhere in consequence of the exercise

Other Considerations 14 How would you compare the 1960 Coase article’s fundamental insights to those of his 1937 article? What would happen in the railroad example if the railroad was liable and the farmers tried to double their plantings to double their damages? (Consider their ex- ante incentives to plant) What difficulty do you see in implementing Coase’s suggested approach of looking case-by-case at social costs of different property rights’ policy? What weight does Coase give to future or unborn people who might gain or lose from a negotiated contract to cause or curtail a damaging activity?