Tuesday, April 01, 2003

Coase Unplugged

I had the rare privilege of meeting Nobel Prize winning Chicago economist Ronald Coase today. Coase came up with the theory of the firm showing how transaction costs determine industry structure, and also was behind the "Coase Theorem" which demonstrates how, under certain conditions, the economic outcome is independent of how the property is allocated.

The guy is really old, but he was still sharp and witty, and remains focused on looking at real data to figure out what actually happens instead of solely relying on blackboard economics and then looking for corroborative examples. I asked him if the questionnaire based data sets behavioral empirical economists come up with were any good, and he said they were worthless because they don't test what people do when it matters, and that's when folks start to think seriously about costs. He also mentioned that he was unimpressed by a recent Behavioral Law & Economics book for precisely this reason.

(On a semi-related note, a friend and I were discussing how to make sense of people who don't do what they want to, for example, they declare they want to lose weight by going on a diet but then gorge on ice cream. Between the Coase lecture and The Blank Slate, I think it has something to do with how people think about the preference function, but I need to mull on this some more. More later.)

As a brief example of how insightful he is, he casually mentioned that "covering costs and maximizing profits is the same thing." Now everyone believes that a business has to cover its costs, but people view the profit motive as being evil. If you take opportunity cost into account (which you should), i.e. the next best thing the business could be doing if it weren't doing what it was, then the two are the same. So a business that burns $10 a month and could be making $40 but instead chooses to make $20 actually has an economic profit of -$30 ($20 - $10 - $40) even though it has an accounting profit of $10 ($20 - $10). If it chooses to make $40, it has an accounting profit of $30 and an economic profit of $10. Who loses money and runs away if a business doesn't maximize economic profit? Investors.


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