DRI-275 for week of 6-1-14: The Triumph of Economics in Sports: Economics Takes the Field to Build Winning Teams

An Access Advertising EconBrief:

The Triumph of Economics in Sports: Economics Takes the Field to Build Winning Teams

In the previous two EconBriefs, we spoke of a popular attitude towards sports. It looks nostalgically to a hazy past, when men played a boys’ game with joyous abandon. Today, alas, sports are “just a business,” which is “all about the money.” As elsewhere, “greed” – a mysterious force no more explicable than a plague of locusts – has overtaken the men and robbed them of their childlike innocence.

This emotional theory of human behavior owes nothing to reason. It is the view now commonly bruited by those who describe the financial crisis of 2008 and the Great Recession as the outcome of free markets run rampant. People are irrational, so the result of “unfettered capitalism” must naturally be chaotic disaster.

Economics is the rational theory of human choice. For a half-century, it has opposed the irrationalists from two directions. Its free-market adherents have been led by the Chicago School of Frank Knight, Milton Friedman and George Stigler. That school embraced a theory of perfect rationality: perfect knowledge held by all market participants (later modified somewhat by a theory of information only slightly less heroic in its assumptions), perfectly competitive markets and (where necessary) perfectly benevolent government regulators and/or economist advisors.

The neo-Keynesian opponents of Chicago accepted individual rationality but asserted that individually rational actions produced perverse results in the aggregate, leading to involuntary unemployment and stagnant economies. Only counteracting measures by far-seeing government policymakers and regulators – following the advice of economist philosopher-kings – could rescue us from the depredations of free markets.

The debate, then, has largely been defined by people who saw market participants moved either by utter irrationality or complete rationality. But our analysis has revealed instead an evolutionary climate in which participants in professional sports pursued their own ends rationally within the limits imposed by their own knowledge and capabilities. The great free-market economist F.A. Hayek observed that capitalism does not demand that its practitioners be rational. Instead, the practice of capitalism itself makes people more rational than otherwise by continually providing the incentive to learn, adapt and adopt the most efficient means toward any end. Professional sports has exemplified Hayek’s dictum.

Early on, in its first century, the pursuit of individual self-interest left baseball owners, players and fans at loggerheads. The first owner to address himself to the task of improving the product provided to sports fans was Bill Veeck, Jr., who introduced a host of business, financial and marketing innovations that not only enhanced his own personal wealth but also treated his fans as customers whose patronage was vital. The attitude of ownership toward fans prior to Veeck can be gleaned from the dismissal by New York Yankees’ general manager George Weiss of a proposed marketing plan to distribute Yankee caps to young fans. “Do you think I want every youngster in New York City walking around wearing a Yankees’ cap?” snorted Weiss. Veeck made owners and administrators realize that this was exactly what they should want.

Although few people seemed to realize it, economics had yet to play its trump card in the game of professional sports. Economics is the study of giving people what they want the most in the most efficient way. What sports fans want the most is a winning team – and that is exactly what economics had failed to give them. It failed because it had never been deployed toward that end. Even Bill Veeck, despite his success in improving the on-field performance of his teams, had not unlocked the secret to using economic principles per se to win pennants and World Series.

As sometimes happens in human endeavor, baseball had to traverse a Dark Age before this secret was finally revealed.

The Dark Age: Municipal Subsidies and the Growth of Revenue Potential

During Bill Veeck’s swan song as baseball owner in 1975-1981, baseball had entered the period of free agency. The reserve clause tying players to a single team had been drastically modified, allowing players to eventually migrate to teams offering them the best financial terms. As we indicated earlier, this development – viewed in isolation – tilted the division of sports revenue from ownership to players.

This created the pretext by which owners were able to extract subsidies from municipalities throughout the nation. Owners could truthfully claim that they were earning less money as a result of free agency. What they left out was that they were earning more money for a host of other reasons. The obscure nature of player depreciation hid the true financial gains of sports-team ownership from the public. Moreover, the early years of free agency coincided with the advent of massive new revenue sources for owners. Television had brought baseball to millions of people who otherwise saw few games or none; broadcast rights were becoming a valuable asset of team ownership. Radio-broadcast rights increased in value as the increased visibility of teams and players enhanced their popularity. These increases were just gaining speed when the vogue of sports-team subsidies became a national pastime of its own.

The movement of baseball teams had long been viewed as analogous to the movement of businesses. Even the loss of popular teams like the Brooklyn Dodgers and New York Giants to westward expansion of baseball in Los Angeles and San Francisco was grudgingly accepted, since baseball still remained in New York City and the Mets were added as an expansion franchise in 1962. But when the Athletics moved from Kansas City to Oakland in 1967, Missouri Senator Stuart Symington decided that the federal government could not countenance “unfettered capitalism” in the baseball business. He demanded that major-league baseball replace Kansas City’s lost franchise. This opened the floodgates to the intrusion of politics in baseball.

If it was fair for politicians to dictate where major-league baseball should operate, then franchises should be able to demand favors from local governments – or so reasoned baseball owners. And demand them they did.

Owners demanded that teams build new, larger, better-appointed stadiums for their sports teams. Cities should fund construction, own the stadiums, operate them, maintain them and lease them to the sports teams for peanuts – otherwise, owners would pack up and move to a city that would meet their demands.

What was in it for the host city? After all, not everybody is a sports fan. Owners sensed that they needed something to offer the city at large. Thus was born one of the great con games of the 20th century: the notion of sports as economic-development engine of growth. Owners seized on the same thinking that animated the dominant neo-Keynesian economic model. They sponsored “economic-impact studies” of the effect sports teams had on the local economy. In these studies, spending on sports took on a magical, mystical quality, as if jet-propelled by a multiplier ordained to send it rocketing through the local economy. And everybody “knew” that the more spending took place, the better off we all were.

It is hard to say what was worse, the economic logic of these studies or their statistical probity. It was not unusual to find that a study would add (say) the money spent on gasoline purchases at stations adjacent to the stadium to the “benefits” of sports team presence. Of course, this implies that locating the team as far as possible from the fans would increase the “benefits” dramatically; it is a case of cost/benefit analysis in which the costs are counted as benefits. This novel technique inevitably produces a finding of vast benefits.

As time went on, sale of team artifacts and memorabilia was added to the list of supplemental revenue. Larger stadiums, lucrative TV, radio and cable rights, team product sales – all these drove revenues to owners through the roof as the 20th century approached its close. With municipalities subsidizing the ownership, maintenance and improvement of stadiums, it is no wonder that the capital gains available to owners of sports teams were phenomenal. Ewing Kauffman bought the Kansas City Royals’ franchise for $1 million in 1968. At his death in 1993, the team’s value was estimated at well over $100 million.

One might have expected the usual left-wing suspects to recoil in horror from the income redistribution from ordinary taxpayers to rich owners and rich ballplayers – but no. Newspaper editorialists threw up their hands. The economists who supported free agency said that the major-market teams would get the best players, didn’t they? And hadn’t things worked out just that way, before free agency as well as after? If small-market taxpayers want to win – or even have a team at all – they’ll just have to ante up and face the fact that “this is how the game is played in today’s world.” Besides, doesn’t economic research show the economic-development benefits of sports teams?

Heretofore, economics had operated beneficially, albeit in a gradual, piecemeal way. Now the distortion of economics by the owners and their political allies meant that it was serving the ends of injustice.

Economics – and baseball fans – needed a hero. They got one – several, actually – from a pretty unlikely place.

Middle American Ingenuity to the Rescue

Bill James was born in tiny Holton, KS, in 1947. From childhood, he was a devoted sports fan. Like countless others before him, he was fascinated by the quantitative features of baseball and studied them obsessively. He was unique, though, in refusing to take on faith the value of conventional measures of baseball worth such as batting average, fielding average and runs batted in. James developed his own theories of baseball productivity and the statistical measures to back them up.

In 1977, he published the first edition of his Baseball Abstract, which subsequently became the Bible for his disciples and imitators. James was suspicious of batting average because it deliberately omitted credit for walks. (Ironically, walks were originally granted equivalent status with hits in computing batting average; “Tip” O’Neill’s famous top-ranking average of .485 in 1887 was accrued on this basis. The change to the modern treatment took place shortly thereafter.) While it may be technically true that a walk does not represent a “batting” accomplishment, it is certainly the functional equivalent of a single from the standpoint of run-producing productivity. (Veterans of youth baseball will recall their teammates urging them to wait out the opposing pitcher by chanting, “A walk’s as good as a hit, baby!”) Moreover, walks have many ancillary advantages. Putting the ball in play risks making an out. A walk forces the opposing pitcher to throw more pitches, thereby decreasing his effectiveness on net balance. Waiting longer in the count increases the chances that a hitter will get a more hittable pitch to hit, one that may be driven with power. For all these reasons, James made a convincing case that on-base percentage (OBP)is superior to batting average as a measure of a hitter’s run-producing productivity.

Rather than the familiar totals of home runs and runs batted in, James argued in favor of a more comprehensive measure of power production in hitting called slugging percentage (SP), defined as total bases divided by at bats. This includes all base hits, not just home runs. Instead of runs batted in, James created the category of runs created (RC), defined as hits plus walks times total bases, divided by plate appearances. James also sought a substitute for the concept of “fielding average,” which stresses the absence of errors committed on fielding chances actually handled but says nothing about the fielder’s ability or willingness to reach balls and execute difficult plays that other players may not even attempt. Moreover, fielding must be evaluated on the same level with offensive production since it must be just as valuable to prevent run production by the opposing team as to create runs for the home team.

These measures and maxims formed the core of Bill James’ theory of baseball productivity. His Baseball Abstract computed his measures for the major-league rosters each year and analyzed the play and management of the teams each year. Gradually, James became a cult hero. Others adopted his methods and measures. The Society for American Baseball Research (SABR) sprang up. The intensive study of quantitative baseball – eventually, sports in general – came to be known as “sabermetrics.” Even with all this attention, it still took decades for Bill James himself to be embraced by organized baseball itself. That, too, happened eventually, but not before sabermetrics left the realm of theory and invaded the pressbox, the front office and the very baseball diamond itself.

Moneyball Takes the Field

Billy Beane was a high-school “phenom” (short for phenomenal), a term denoting a player whose all-round potential is so patent that he “can’t miss” succeeding at the major-league level. Like a disconcerting number of others, though, Beane did miss. He played only minimally at the major-league level for a few years before quitting to become a scout. He rose to the front office and was named general manager of the Oakland Athletics in 1997. Beane’s mentor, general-manager Sandy Alderson, taught him the fundamentals of Bill James’ theories of baseball productivity. To them, Beane added his own observations about player development – notably, that baseball scouts cannot accurately evaluate the future prospects of players at the high-school level because their physical, emotional and mental development is still too limited to permit it. Thus, major-league teams should concentrate on drafting prospects out of college in order to improve their draft-success quotient.

Beane hired a young college graduate from HarvardUniversity – not as a player but as an administrative assistant. Paul DiPodesta was an economics major who was familiar with the logic of marginal productivity theory. The theory of the firm declares that managers should equalize the marginal productivity per dollar (that is, the ratio of output each unit of input produces at the margin to the input’s price) between inputs by continually adding more of any input with a higher ratio until the optimal output is reached. Of course, the problem in applying this or any other economic principle to baseball had always been that the principles were non-operational unless a meaningful measure of “output” could be found and the inputs contributing to that output could be identified. That was where Bill James and sabermetrics came in.

In 2001, the Oakland team had won the Western Division of the American League. But their star player, Jason Giambi, has been wooed away by a seven-year, $120-million dollar contract offered by the New York Yankees. It was the age-old story, the “Curse of the Bambino” all over again in microcosm. Oakland’s success had ramped up the value of its players on the open market; replacing those players with comparable talent at market rates would bust the payroll budget. Various other Oakland players were lost to injury or disaffection or free agency. Throughout baseball, opinion was unanimous that the Athletics were in for hard times until the team’s talent base could be rebuilt through player development.

Beane and DiPodesta used the most basic sabermetric concepts, such as ONB, SP and RC, as their measures of productivity. Using publicly available information about player salaries, they calculated player productivities per dollar and discovered the startling number of players whose true productivity was undervalued by their current salaries. Methodically, they set out to rebuild the Oakland Athletics “on the cheap” by acquiring the best players their budget could afford through trade or purchase of contracts. They substantially remade the team using this approach. Despite a slow start, their rebuilt club eventually tied the all-time major-league baseball record by winning 21 straight games and successfully defended the Western Division championship in 2002 and 2003. Author Michael Lewis outlined their story and the rise of sabermetrics in baseball in his 2003 best-selling book Moneyball, which later became a 2011 movie starring Brad Pitt that received six Academy Award nominations.

For the first time, baseball management had explicitly used an economic production function – marginal productivity theory with an operational definition of product or output – to maximize a meaningful object function – namely, “wins” by the team. And they succeeded brilliantly.

Money See, Money Do

In 2003, new Boston Red Sox owner John Henry hired Bill James as a consultant to management, to put the theories of sabermetrics into practice in Boston. During 2001 and 2002, the team had lugged the second-highest payroll in major-league baseball to disappointing results. But in 2003, with a lower- (6th-) ranked payroll, the Boston Red Sox laid the ghost of Babe Ruth by winning their first World Series since 1918. Over the succeeding decade, the Red Sox became the success story of baseball, winning the World Series three more times.

Was this a case of what Rocky’s manager Mickey would call “freak luck?” Not hardly. Thanks to the success of Oakland and Boston and Michael Lewis’s book, the tale of Bill James and sabermetrics traveled. Throughout baseball, sabermetrics ran wild and economics reigned triumphant. In 2003, the Detroit Tigers lost an American-League-record 119 games. In 2006, with only the 14th-highest payroll out of 30 major-league teams, the Tigers won the American League championship. In 2008 and 2009, the Washington Nationals were the worst team in baseball. In 2012, with baseball’s 20th-highest payroll, they had baseball’s best record. In 2010, the Pittsburgh Pirates lost 105 games. In 2013, with baseball’s 20th-highest payroll, they made the post-season playoffs. The Cleveland Indians rebounded from sub-.500 seasons to playoff finishes twice between 2006 and 2014, despite never ranking higher than 15th in the size of their payroll; usually, they ranked between 20th and 26th.

The crowning achievement was that of the perennial cellar-dwelling Tampa Bay Devil Rays. Cellar-dwelling, that is, in the size of their payroll, but not necessarily in the season standings. After years of dismal finishes, the 2008 TampaBay team became American League champs despite ranking 29th (next to last!) in the size of their payroll. They have made the playoffs in four of the six subsequent years, but their payroll continues to languish at the bottom of the major-league rankings.

The New Frontier

Does this mean that the generalization about large-market teams getting the better players and enjoying the better results was and is a lie? No, it was and still is true. But like all economic propositions it is subject to qualification and careful statement.

First, it is a ceteris paribus proposition. It is true that “you can’t beat the stock market (averages)” but every year some people (particularly professional investors) do it. You can’t do it systematically by trading on the basis of publicly available information. The few people who succeed do it on the basis of (unsystematic) luck or by uncovering new information (legally) before it becomes generally known. The market for professional sports is not nearly this efficient; techniques of sports productivity evaluation are not nearly as refined and efficient as those of stock evaluation and trading, which leaves much more room for systematic exploitation by techniques like those of sabermetrics.

Second, the term “large market” is no longer limited by geography as it has been during the first century and a half of U.S. professional sports. Ted Turner’s promotion of the Atlanta Braves using his cable-TV stations blazed the trail for turning a local team into a national one, thereby increasing the value of the team’s broadcasting and product rights. Today, there is no inherent geographic limitation of the size of the market for any team – no reason, for example, why the Kansas City Royals or Chiefs could not become “the world’s team” and sit atop the largest market of all.

The Evolutionary Approach to Free Markets

The correct approach to economics is not the irrationalist view that has clouded our understanding of professional sports. Neither is it the perfectionist view of the ChicagoSchool, which has oversold the virtues of free markets and damaged their credibility. It is certainly not the remedial view of the neo-Keynesian school, which has failed whenever and wherever tried and is now undergoing its latest serial failure.

The evolutionary approach of the true free-market school, so nobly outlined by Hayek and his disciples, fits the history of baseball like a batting glove. It is now in full flower. Taxpayers need no longer be violated by owners who promote false economic benefits of sports and hide the real ones. Fans no longer need languish in a limbo of psychological unfulfillment. Economics – not politicians, regulators or academic scribblers – has come to the rescue at last.

DRI-326 for week of 9-1-13: Quantity vs. Quality in Economists

An Access Advertising EconBrief:

Quantity vs. Quality in Economists

Students of economics have long complained that economics texts focus too much on quantity and not enough on quality when evaluating goods. The same issue arises when comparing economists themselves. The career of Nobel Laureate Ronald Coase, who died this week at age 102, is a polar case.

Economists advance by publishing articles in prestigious, peer-reviewed journals. The all-time leader in the number of articles published is the late Harry G. Johnson. Despite dying young at age 53, Johnson compiled the staggering total of 526 published articles during his lifetime.

The use of advanced mathematics and abstract modeling techniques has enabled economists to rack up impressive publications scores by introducing slight mathematical refinements that add little to the substantive meaning or practical value of their achievement. When asked to account for the comparative modesty of a list of publications only one-fourth the size of Johnson’s, Nobel Laureate George Stigler countered, “Yeah, but mine are all different.”

Coase stands at the other extreme. His complete list of articles numbers fewer than twenty, but two of those are among the most-frequently consulted by economists, lawyers and other specialists, not to mention by the general public. He published a long-awaited, widely noticed book in 2012 despite having passed his centenary the year before. His life is an advertisement for the value of quality over quantity in an economist.

Another notable aspect of Coase’s work is its accessibility. In an age when few professional contributions can be read and understood by non-specialists, much less by interested non-economists, Coase’s work is readily comprehensible by the educated layperson. Now is the time to rehearse the insights that made Coase’s name a byword within the economics profession. His death makes this review emotionally as well as intellectually fitting.

Why Do Businesses Exist?

At 26 years of age, Ronald Coase was a left-leaning economics student. He pondered the following contradictory set of facts: On the one hand, socialists ever since Saint-Simon had advocated running a nation’s economy “like one big factory.” On the other hand, orthodox economists declared this to be impossible. Yet some highly successful corporations reached enormous size.

Who was right? It seemed to Coase that the answer depended on the answer to a more fundamental question – why do businesses exist? Be it a one-person shop or a huge multinational corporation, a business arises voluntarily. What conditions give birth to a business?

Coase found the answer in the concept of cost. (In his 1937 article, “The Nature of the Firm,” Coase used the term “marketing costs,” but the economics profession refined the term to “transactions costs”.) A business arises whenever it is less costly for people to organize into a hierarchical, centralized structure to produce and distribute output than it is to produce the same output and exchange it individually. And the business itself performs some activities within the firm while outsourcing others outside the firm. Again, cost determines the locus of these activities; any activity more cheaply bought than performed inside the firm is outsourced, while activities more cheaply done inside the firm are kept internal.

Like most brilliant, revolutionary insights, this seems almost childishly simple when explained clearly. But it was the first lucid justification for the existence of business firms that relied on the same economic logic that business firms themselves (and consumers) used in daily life. Previously, economists had been in the ridiculous position of assuming that businesses used economic logic but arose through some non-economic process such as habit or tradition or government direction.

Today, we have a regulatory process that flies in the face of Coase’s model. It implicitly assumes that markets are incapable of correctly organizing, assigning and performing basic business functions, ranging from safety to hiring to providing employee benefits. To make matters worse, the underlying assumption is that government regulatory behavior is either costless or less costly than the correlative function performed by private markets. As Coase taught us over 75 years ago, this flies in the face of the inherent “nature of the firm.”

The “Coase Theorem”

In mid-career, while working amongst a group of free-market economists at the University of Virginia, Ronald Coase made his most famous discovery. It assured him immortality among economists. Just about the best way to make a name for yourself is to give your name to a theory, the way John Maynard Keynes or Karl Marx did. But in Coase’s case, the famous “Coase Theorem” was actually devised by somebody else, using Coase’s logic – and Coase himself repudiated the use to which his work was put!

To appreciate what Coase did – and didn’t do – we must grasp the prior state of economic theory on the subject of “externalities.” Tort case law contained examples of railroad trains whose operation created fires by throwing off sparks into combustible areas like farm land. The law treated these cases by either penalizing the railroad or ignoring the damage. A famous economist named A. C. Pigou declared this to be an example of an “externality” – a cost created by business production that is not borne by the business itself because the business’s owners and/or managers do not perceive the damage created by the sparks to be an actual cost of production.

Rather than simply penalizing the railroad, Pigou observed, the economically appropriate action is to levy a per-unit tax against the railroad equal to the cost incurred by the victims of the sparks. This would cause the railroad to reduce its output by exactly the same amount as if it had perceived its sparks to be a legitimate cost of production in the first place. In effect, the railroad “pays” the costs of its actions in the form of reduced output (and reduced use of the resources necessary to provide railroad transport services), rather than paying them in the form of a fine. Why is the former outcome better than the latter? Because the purpose is not to hurt the railroad as retaliation for its hurting the farmer, the way one child hurts another in revenge for being hurt. A railroad is a business – in effect, it is a piece of paper expressing certain contractual relationships. It cannot feel hurt the way a human being can, so the fine may make the farmer feel better (if he or she received the fine as proceeds of a tort suit) but does not compensate for the waste of resources caused by having the railroad produce too much output. (“Too much” because resources will have to be devoted to repairing the damage caused by the sparks, and consumers value the resources used to do this more than the farmer values the loss.) In contrast, when the costs are factored into the railroad’s production decision, everybody values the resulting output of railroad services and other things as exactly worth their cost.

Of course, the catch is that somebody has to (1) realize the existence of the externality; and (2) calculate exactly how much tax to levy on the railroad to neutralize (or internalize) the externality; and then (3) do it. In the manner of a philosopher king, Pigou declared that this task should be assigned to a government regulatory bureaucracy. And for the next half-century (Pigou was writing in the early 1900s), mainstream economists salivated at the prospect of regulatory agencies passing rules to internalize all the pesky externalities that liberals and bureaucrats could dream up.

In 1960, Ronald Coase came along and gave the world a completely new slant on this age-old problem. Consider the following type of situation: you are flying from New York to Los Angeles on a low-price airline. You have settled somewhat uncomfortably into your seat, survived the takeoff and are just beginning to contemplate the six-hour flight when the passenger in front of you presses a button at his side and reclines his seatback – thereby preempting what little leg room you previously had. Now what?

This is not actually the example Coase used – it was used by contemporary economist Peter Boettke to illustrate Coase’s ideas – but it is especially good for our purposes. Using the same logic Coase applied to his examples, we reason thusly: It would be completely arbitrary to assign either of us a property right to the space preempted by the seatback. Why? Because the problem is not to stop bad people from doing bad things. Instead, we are faced with a situation in which ordinary people want to do good things that are in some sense contradictory or offsetting in their effects. On the airplane, my wish to stretch out is no more or less morally compelling than his to recline. The problem is that  we can’t do both to the desired extent at the same time without getting in each other’s way; e.g., offsetting each other’s efforts.

Indeed, this is true of most so-called externalities, including the railroad/farmer case. Case law usually treated the railroad as a nefarious miscreant imposing its will on the innocent, helpless farmer. But the railroad’s wish to provide transport services is just as reasonable as the farmer’s to grow and harvest crops. It is not unthinkable to enjoin the railroad against creating sparks – but neither should we overlook the possibility of requiring the farmer to protect against sparks or perhaps even not locate a farm within the threatened area. Indeed, what we really want in all cases is to discover the least-cost solution to the externality. That might involve precautions taken by the railroad, or by the farmer, or emigration by the farmer, or payment by the railroad to the farmer as compensation for the spark damage, or payment by the farmer to the railroad as compensation for spark avoidance.

 

In general, it is crazy to expect an uninvolved third party – particularly a government regulator – to divine the least-cost solution and implement it. The logical people to do that are the involved parties themselves, who know the most about their own costs and preferences and are on the scene. These are also the people who have the incentive to find a mutually beneficial solution to the problem. In our airline example, I might offer the man in front of me a small payment for not reclining. Or he might pay me for the privilege of reclining. But either way, we will bargain our way to a solution that leaves us both better off, if there is one. One of us would object to any proposed solution that did not leave him better off.

Of course, it would be useful for bargaining purposes to have an assignment of property rights; that is, a specification that I have the right to my space or that the man in front of me has the right to recline. That way, the direction of compensatory payments would be clear – money would flow to the right-holder from the right-seeker.

What if bargaining does not produce an efficient outcome, one that both parties can agree on? That means that the right-holder values his right at more than the right-seeker is willing to pay. But in that case, no government tax would produce an efficient outcome either.

On the airline, suppose that I value the leg room preempted by the reclining seat at $10. Suppose, further, that airline policy gives him the right to recline. If I offer him $6 not to recline, he will accept my offer if he values reclining at any amount less than $6 – say, $5. Notice that we are now both better off than under the status quo ante bargain. I get leg room I valued at $10 – or course, I had to pay $6 for it, but that is better than not having it at all, just as having the airline’s cocktail is better than being thirsty even though I had to pay $5 for it. He loses his right to recline, but he gets $6 instead – and reclining was only worth $5 to him. He is better off, just as he would be if he accepted an airline’s offer of $500 to surrender his seat and take a later flight, as sometimes happens.

We cannot even begin to estimate how many times people solve everyday problems like this through individual bargains. The world would be vastly better off if we were trained from birth in the virtues of a voluntary society where bargaining is a way to solve everyday disputes and make everybody better off. That training would stress the virtues of money as the lubricant that facilitates this sort of bargain because it is readily exchangeable for other things and because it is the common denominator of value. Instead, most of us are burdened by an instinctive tribal suspicion that money is evil and bargaining is used only to seek personal advantage at the expense of others. Experienced businesspeople know otherwise, but throughout the world the Zeitgeist is working against Coase’s logic. More and more, government and statutory law are held up as the only fair mechanism for resolving disputes.

University of Chicago economist George Stigler used Coase’s logic to devise the so-called Coase theorem, which says that when the transactions costs of bargaining are zero, the ultimate price and output results will be the same regardless of the initial assignment of property rights. This is true because both parties will have the incentive to bargain their way to an efficient improvement, if one exists. The assignment of property rights will affect the wealth of the bargainers, because it will determine the direction of the money flow, but economists are concerned with welfare (determined by prices and quantities), not wealth. No government regulatory body can improve on the free-market solution.

Coase disagreed with the theorem named after him – not because he disputed its logic, but because he foresaw the results. Economists would use it to look for circumstances when transactions costs were low or non-existent. Instead, Coase wanted to investigate real-world institutions such as government to compare its transactions costs to those of the market. He knew that real-world transactions costs were seldom zero but that government solutions almost never worked out as neatly in practice as they did on the blackboard. In fact, he invented the phrase “blackboard economics” to refer to solutions that could never work in practice, only on a theoretical blackboard, because real-world governments never had either the information or the incentive necessary to apply the solution.

Why China Became Capitalist

Ronald Coase devoted his last years to learning how and why China evolved from the world’s last major Communist dictatorship to the world’s emerging economic superpower. In Why China Became Capitalist, he and his research partner Ning Wang delivered an account that contravened the popular explanation for China’s rise. China’s ruling central-government oligarchy has received credit for the country’s emergence as the growth leader among developing nations. Since the Communist Party retained political control throughout the growth spurt, it must have been responsible for it – so the usual explanation runs. Coase and Wang showed that government’s presence as the agency in charge of political life does not automatically entitle it to credit for economic growth.

The death of Mao Zedong in 1976 rescued China from decades of terror, famine and dictatorship. Mao’s designated successor, Hua Guofeng, was an economist who outlined a program of state-run investment in heavy industry called the “Leap Outward.” This resembled the various Five-Year Plans of Soviet ruler Joseph Stalin in general approach and in overall lack of results. Hua’s successors, Deng Xiaoping and Chen Yun, abandoned the Leap Outward in favor of an emphasis on agriculture and light industry. Although Deng was the political figurehead who garnered the lion’s share of the publicity, Chen was the guiding spirit behind this second centralized plan designed to spur Chinese economic growth. It placed less emphasis on production of capital goods and more on consumer goods. Chen allowed state-controlled agricultural prices to rise in an effort to stimulate production on China’s collective farms, which had failed disastrously under Mao, resulting in approximately 40 million deaths from famine. He also allowed state-run enterprises a measure of autonomy and private profit, heretofore unthinkable under Communism.

Although these central-government measures were the ostensible spur to China’s remarkable growth run, Coase and Wang assign actual responsibility to the resurgence of China’s private economy. Private farms had always existed as part of the nation’s 30,000 villages and towns, much as neighboring Russians continued to nurture their tiny private plots of land alongside the Soviet collective farms. And, just as was the case in Russia, the smaller private farms began to outdo the larger collectives in productivity and output. Mao fanatically insisted on agricultural collectivization, but his death freed private farmers to resume their former lives.  By late 1980, the Beijing government was forced to officially acknowledge the private farms. In 1982, China formally abandoned its costly experiment with collective agriculture and de-collectivized its farms. Official grain prices were allowed to rise and grain imports were permitted.

Agriculture wasn’t the only industry that flourished at the local level. Small businesses in rural China labored under official handicaps; their access to raw materials was not protected and they had no officially sanctioned distribution channels for their output. But they bought inputs on the black market at high prices and groomed their own sales representatives to scour the nation drumming up business for their goods. These local Davids outperformed the state-run Goliaths; they were the real vanguard of Chinese economic growth.

Growth was slower in China’s major cities. Mao had sent some 20 million youths to the countryside to escape unemployment in the cities. After his death, many of these youths returned to the cities – only to find themselves out of work again. They demonstrated and formed opposition political movements, sometimes paralyzing daily life with their protests. This forced Beijing to permit self-employment for the first time – another Communist sacred cow sacrificed to political expediency. This, in turn, created an urban class of Chinese entrepreneurs. This led to yet another government reaction in the form of Special Economic Zones, somewhat reminiscent of the U.S. “enterprise zones” of the 1980s. Economic freedom and lower taxes were allowed to exist in a controlled environment; Chinese officials hoped to encourage controlled doses of capitalist prosperity in order to save socialism.

Gradually, the limited reforms of the Special Economic Zones became more general. Increased freedom of market prices was introduced in 1992, taxes were lowered in 1994 and privatization of failing state-run enterprises began in the mid-1990s. For the first time, China began to replace local and regional markets with a single national market for many goods.

Coase and Wang identify perhaps the most important but least-known capitalist element to arise in China as the improved pursuit of knowledge. They accurately attribute the recognition of knowledge’s role in economics to Nobel Laureate F.A. Hayek and note the increasing popularity of books and articles by Hayek, his mentor Ludwig von Mises and classical forebears such as Adam Smith. The economics profession has pigeonholed the subject of knowledge under the heading of “technical coefficients of production,” but the authors know that this is only the beginning of the knowledge needed to make a free-market economy work. The knowledge of market institutions and the dispersed, specialized “knowledge of particular time and place” that can only be collated and shared by free markets are even more important than technical knowledge about how to produce goods and services.

The upshot of China’s private resurgence has been to make the country a “laboratory for capitalist experimentation,” according to Coase and Wang. That laboratory has brewed a recipe for unparalleled economic growth since the 1990s, leading to China’s admittance into the World Trade Organization in 2001. The final piece of the puzzle, the authors predict, is a true free market for ideas – the one thing that Western economies have that China lacks. When this falls into place, China will become the America of the 21st century.

Thus did Ronald Coase add a landmark study in economic history to his select resume of classic works.

Quality vs. Quantity

Never in the history of economics has one economist achieved so much productivity with so little scholarly output. Ronald Coase economized on the scarce resources of time and human effort (ours) by devoting the longest career of any great economist to specializing in quality, not quantity, of work.