Underappreciated Coase and Alchian

by Don Boudreaux on January 22, 2005

in Myths and Fallacies

One of my candidates for most underappreciated article ever published in economics is Ronald Coase’s "The Marginal Cost Controversy," (Economica, 1946)

Coase’s insights are richer than most people suspect, so it’s always risky to try to summarize any of this great scholar’s articles in a few sentences, but here’s my go at this 1946 article:

Economists: loose your devotion to marginal-cost pricing. The best prices are not necessarily those that equal marginal cost. Prices above marginal cost help convey important information – namely, information about the value of the capital invested that makes provision of the good or service possible in the first place. This information, in turn, is important to entrepreneurs searching for profitable places to invest their money and energies.

For example, consider a bridge spanning the Mississippi River. Jones builds the bridge and charges tolls to pay for it. When the bridge is not congested, the marginal cost of allowing each driver access to the bridge is zero. Is the optimal toll zero? According to textbook theory: yes. According to the much-wiser Coase: no. If Jones were forced, by whatever means, to charge a price equal to his marginal cost of zero, clearly he would not recover his cost of building the bridge. Equally importantly, other investors would have no way of knowing if, and how much, additional investment is appropriate in building bridges to span the Mississippi.

By charging tolls that maximize his profits – even if these prices are above marginal costs – Jones helps to send informative signals to other potential bridge builders on the value of building additional spans across this river.

Coase’s point seems obvious. But it remains shockingly unheeded by economists who, hypnotized from the first with the sterile, static beauty of the (woefully misnamed) "model of perfect competition," are in awe of prices that equal marginal cost.

Jim DeLong has this very nice discussion of this matter, in the context of intellectual property, published at Tech Central Station.

All of which remind me of another of my candidates for most underappreciated article in economics: Armen Alchian’s original and amazingly insightful essay "Costs and Output" (reprinted in Alchian’s Economics Forces at Work). In the real world, time and plans matter. Alchian and Coase (and Hayek, of course) understand this fact; surprisingly, too many economists don’t.

Here’s an implication of Alchian’s article – an implication that, I admit, I now only sense but which I hope one day to spell out clearly. It’s this: the notion of pricing below cost as a means of ‘predatorily’ seeking monopoly power is incoherent.

I challenge any graduate students reading this post to read Alchian’s article, reflect on it, discuss it with professors and fellow students — and beat me to the completion of this task.

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