The Main Course was Transaction Costs: Milton's Dinner with Ronald

We tell the story of the Chicago dinner where Ronald Coase walks into a hostile room, and by the end everyone votes with him, led by Milton Friedman changing his mind in real time. Along the way, we unpack why transaction costs, not moral blame, often explain when law and institutions shape outcomes. 

• the Aaron Director dinner and the vote that flips 

• why Milton Friedman becomes a political symbol and lightning rod 

• critiques from the right and left on markets, shareholder value, trade, and Chile 

• Pigouvian externalities versus Coase’s reciprocal harm framing 

• the Coase theorem as a benchmark and why real transaction costs make institutions decisive 

• the “twedge” on comparative advantage and the “no free lunch” remix 

• listener question on tax horizons, regime uncertainty, and the permanent income hypothesis 

LINKS:

• Who's afraid of Milton Friedman (a video)
• Milton Friedman Lives (a blog post)
• Steve Medema, "What Happened on Blackstone Ave?"
• Mary Roach, BONK

If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !

You can follow Mike Munger on Twitter at @mungowitz 

Transcript

Michael Munger 0:00

This

Why Transaction Costs Matter

Michael Munger 0:01

is Mike Munger, the knower of important things from Duke University. This week, Milton Friedman and the dinner that changed economics. It was about transaction costs. The twedge, some letters, and a book at a week. Straight out of Creedmoor, this is Tidy C.

SPEAKER_02 0:20

I don't think I talk about a system where there were no transaction color, but it's an imaginary system. There always are transaction color.

SPEAKER_01 0:29

When it is costly to transact, institutions matter. And it is costly to transact.

Michael Munger 0:40

Aaron

The Famous Chicago Dinner Vote

Michael Munger 0:41

Director, founder of the Journal of Law and Economics, has invited about 20 people to his house for dinner. It's not a normal guest list. The dinner includes Milton Friedman, George Stigler, Arnold Harburger, Greg Lewis, some of the sharpest price theorists who have ever lived, all in one room, all irritated. They're irritated because one visiting Englishman named Ronald Harry Coase has just submitted a paper to Director's Journal arguing something that these men are sure is just simply wrong and in fact dumb. Before dessert is served, someone, probably Stigler, because he liked keeping score that way, proposed an actual vote. Hands up. Who agrees with Coase? 20 against, one for. Two hours later, after all the plates are cleared, and after a long discussion, they vote again. 21-4 Coase, zero against. Nobody in that room changed history that night by force, credential, or seniority. They changed it by persuasion. And the man who did most of the argument on the wrong side until he wasn't, was Milton Friedman. That's the story I want to tell today.

Who Friedman Was Beyond The Myth

Michael Munger 1:57

But to understand why that vote flip mattered, why that persuasion mattered, why it's one of the great set pieces in the history of economic thought and in transaction costs, because it involved acquisition of new information, which is always expensive. You have to understand two things. First, who Milton Friedman actually was underneath the caricature you're likely to hold, and why, 60 some years later, he has become one of the most reliably hated men in American public life, on the left and increasingly on the right. Milton Friedman was born in Brooklyn in 1912 to immigrant parents and went to Rutgers on a partial scholarship, made his way through University of Chicago in Columbia, finishing his PhD in 46. He joined the Chicago Economics faculty that same year and taught there for most of the next three decades, with a research base at the National Bureau of Economic Research running alongside it. He's remembered correctly as one of the most influential economists of the second half of the 20th century and maybe the most influential, not named Keynes. He won the Nobel Prize in 1976, largely for his work on the quantity theory of money, the argument distilled into the line everyone quotes, that inflation is always and everywhere a monetary phenomenon. He co-authored with Anna Schwartz a monetary history of the United States. But Friedman's influence didn't stay inside monetary economics. He built a generation's understanding of price theory at Chicago. He became, through Capitalism and Freedom in 1962 and then free to choose, both the book and the 10-part PBS series, perhaps the most effective popularizer of free market economics that ever lived. Millions of people who never read a page of formal economics absorbed the case for markets, flooding exchange rates, school choice, and the end of military conscription, because Milton Friedman explained it to them directly, on television, in plain English. And it's worth pausing on that list because, as I recently pointed out in my essay at the Civitas Institute, Friedman himself, near the end of his life, was strikingly modest about how much of this all actually happened or mattered. When Russ Roberts on EconTalk asked Friedman to name his real policy successes, Friedman didn't reach for the whole sweep of the Reagan era, global deregulation or opening up the international markets. He named just two things, ending the draft and floating exchange rates. That's it. That's the self-assessment of a man who is treated by both his admirers and his enemies as the architect of the entire modern global economy. If Friedman's right about the two successes thing and the mostly failures thing, you'd expect him to be a marginal figure in political arguments, respected, slightly dusty name from the Reagan era, like a lot of economists. Instead, he's a live wire. He gets invoked with venom from multiple directions at once, because the venom has only intensified. Let's take the critiques in turn.

Four Critiques And The Real Dispute

Michael Munger 5:13

They're worth taking seriously, even if they're unfair. The unfairness itself is revealing. First, laissez-faire is obsolete. This one's new in the sense that it's coming from the right, not just the left. J.D. Vance and thinkers like Orin Cass argue that Friedman's whole model of self-organizing markets is an artifact of a specific historical moment. An America that was more religiously and morally cohesive, free markets could be trusted to work without state guidance. But today, more atomized, the society, in this view, needs an active industrial policy. Vance has literally said the Republican Party's center of gravity is moving from Milton Friedman to Alexander Hamilton. Second, the shareholder value critique. Famously, Friedman in 1970 wrote a New York Times magazine essay, arguing that the social responsibility of a business is to increase its profits, that managers pursuing their own social agendas with shareholders' money is a kind of unaccountable taxation. That essay gets blamed constantly for the shareholder primacy movement, but that is just misplaced. The 1980s shareholder first ethos actually grew out of hostile takeover pressure and stock-based executive pay, not out of that essay. Third, globalization and the China Shock. Friedman was one of the most prominent unilateral free traders of the 20th century, and critics, drawing on the labor economics literature, the author Dorne Hansen China Shock papers, and others, connect his advocacy to the roughly 2.4 million U.S. manufacturing jobs that were lost between 1999 and 2011 after China's accession to the World Trade Organization. Well, that's really a critique of the whole free trade consensus that Friedman symbolized, more than that of any specific argument that he made. And it ran into an obvious problem. Friedman was analyzing trade between parties operating as commercial equals. Whether China in 2001 was operating on those terms, whether it was playing the trade game or playing a longer strategic military game, is a question that Friedman, who was a thoroughgoing empirical realist, would likely have engaged with directly rather than being caught flat footed. So that criticism is just an anachronism. Fourth, the one that never goes away, autocracies, especially Chile. Friedman spent two weeks in Chile in March 1975. He met Pinochet exactly once for 45 minutes at the end of a long day. Pinochet asked him to put his advice in writing. Well, I might have done that if I was tired and some economist was blabbering at me in my second language. Friedman did put it in letter and in a letter, and we have that letter. It's eight points recommending cuts to money supply growth, spending cuts, trade liberalization. It's the same template of advice, almost a Xerox, that he gave dozens of governments around the same period. Taiwan, Israel, Japan, West Germany, UK, Iceland, Estonia, on and on. And there's one that people conveniently forget: China. Friedman made two extended trips to China in 1980 and 1988, had a two-hour meeting with the Premier in the Great Hall of the People. Well, everybody says Friedman and Pinochet, but nobody says Friedman and Zhao Jang. But by any measure, the regime that was more murderous and more repressive, China, also followed Friedman's advice. That asymmetry is the tell. Corey Doctorau has called Friedman a crank, cheerleader, and enabler of genocidal maniacs, and admits in print he cheers himself up by imagining Friedman being tormented in hell. So that's an illustration of the kind of extremism in the reaction that Friedman provokes. Why the hate underneath all four critiques? Well, partly it's a genuine, serious argument about whether free markets need a certain kind of social scaffolding to function. That's the Vance cast line. It deserves engagement, not dismissal. I disagree with it. But a lot of it isn't really an argument at all. It's a caricature that survives because it has become freedmen has become a symbol. Chile becomes a synecdoche for the whole man. 45 minutes stand-in for a 50-year career. The actual content of capitalism and freedom, the case for floating exchange rates, volunteer army, negative income taxes, those get erased entirely. Which is a shame, because if you want to understand who Friedman was, not a symbol, a working economist in a room full of other working economists, there's no better window into it than watching him publicly lose an argument in real time and then change his mind in front of everyone and start advocating very effectively for the other side. Which

Coase Versus Pigou On Externalities

Michael Munger 10:12

brings us to the dinner. To understand why 20 top Chicago economists thought Ronald Coase was mistaken, you need the background problem he was writing about. Externalities. The standard economic treatment of externalities in 1960 came from Arthur C. Pagou. Going back to his 1920 book, The Economics of Welfare, Pagou's framework is intuitive and it's still what most economists think about externalities today. If a factory's smoke damages its neighbors, factories imposing a cost on society that it doesn't pay for. Private cost of production is lower than the true social cost, and so the obvious fix is to make the factory pay, tax it in amount equal to the damage. It will either reduce its pollution to the efficient level or pay for the privilege. So the polluters at fault make the polluter pay. Kose's 1960 paper, The Problem of Social Cost, which was published in the second volume of Director's Journal of Law and Economics, took a can opener and just opened that framework up. Coase's argument starts with a deceptively simple example, not smoke, but cattle. Rancher's cattle stray onto a neighboring farmer's land and damage his crops. Pegovian instinct is to ask who's at fault? Should the rancher be libel? Coase points out this is the wrong question because the harm here is reciprocal. If we stop the rancher's cattle from straying, we harm the rancher. If we let them stray, we harm the farmer. There's no metaphysically correct assignment of blame. There's only a question of which arrangement produces more total value. And there is Coase's actual claim, the one that detonated in that dining room. If bargaining between the rancher and the farmer is costless, if they can find each other, negotiate, and strike a deal without any friction, then it literally doesn't matter for the purposes of economic efficiency which way the court rules. Say the judge rules the rancher is liable for crop damage. Fine, but if the rancher's cattle raising is worth more than the crops he'd be damaging, he'll pay the farmer to accept the damage, or he'll pay for offense, whichever is cheaper. The efficient amount of cattle grazing will happen anyway. Now say the judge rules the other way. The farmer has no claim, the rancher owes nothing. If the crops are actually worth more than the extra grazing, the farmer will pay the rancher to keep the cattle away, again, reaching the efficient outcome. The farmer might even pay to build a fence if that's the cheapest result. So again, we reach the efficient outcome through a different set of side payments. Either way, same amount of cattle, same amount of crops. The law determined who paid whom, but it didn't determine the efficient outcome. That's what economists later dubbed the Coase theorem, though Coase didn't invent that name, George Stigler did. Coase later grumbled, the whole thing was widely misunderstood because he wasn't trying to talk about a world with no transaction cost. And in fact, the first voice in the music at the beginning of this podcast is Coase saying, But there always are transaction costs. But still, at this dinner, Coase was able to show that it was the transactions cost that were important, not the assignment of property rights. Coase considered this result obvious. Decades later, asked about the reaction to his paper, he said, with genuine puzzlement. People were impressed that he changed their views, but he wasn't particularly impressed with himself because all he was doing was stating the obvious. To Kos, once you actually specified the problem correctly, once you asked what happens when two parties can bargain freely over mutually affecting activity, the invariance result just falls out of ordinary rational actor logic. It's obvious. Any legal assignment that left value on the table would get traded away. It's not a special theory, it's what rational and costless mean in words. The Chicago economists at directors' table did not find it obvious. In fact, they thought it was wrong, and they were all really smart and frankly a little bit arrogant. And so they were outraged that Coase would simply flatly deny their awesomeness. Their instinct, the Pegovian instinct, trained into every economist of that generation, was that liability rules change outcomes. Full stop. That's the entire point of having a liability rule. Coase's paper had been sent to Director for a review before publication, and Director and several colleagues thought they'd caught Coase in an actual arithmetic level error in the passage laying out this argument. Director wrote back and asked him to cut it. Coase refused, and this was a long time before email made everything instant, offered to come to Chicago in person and defend himself. So in the spring of 1960, Coase flew to Chicago. He presented first at George Stigler's workshop, a warm-up round in front of an audience that was entirely unconvinced. That evening, the Real Confrontation, dinner at Aaron Director's house. Guest list, as I said, included director Stigler, Friedman, Harburger, Martin Bailey, Ruben Kessel, Greg Lewis, John McGee, Lloyd Minz, about ten other people. They were there to take this arrogant Englishman apart. Stigler recounted the evening in his memoir, Memoirs of an Unregulated Economist. It's actually worth quoting him directly because nobody has improved on the description. This is Stigler. We strongly objected to this heresy. Milton Friedman did most of the talking as usual. He also did much of the thinking as usual. In the course of two hours of argument, the vote went from twenty against and one for coast, that is Coase voting for himself, to twenty-one for coast. What an exhilarating event. I lamented afterwards that we had not had the clairvoyance to tape it. End of quote. Think about the mechanics of that sentence for a second. It tells you exactly what kind of economist Milton Friedman was. He didn't lead the room to Coase's side by being polite or by yielding ground or finding a diplomatic synthesis. By every account, he came out swinging. He was, in one retelling, the one interrogating Coase the hardest of all, started throwing the sharpest elbows in the room. He wasn't a pushover, he wasn't there to be nice. He was there to find the hole in the argument. And over two hours, he discovered he couldn't find one. Every time the Ruth, the room, threw a standard Pegovian objection at Coase, but surely the rancher should be libel because that's the whole point of tort law, Coase had an answer, and the answer survived every attack. At some point in that two-hour argument, Friedman's own logical abilities, the rigorous, relentless, take no prisoner's price theory he'd spent 15 years teaching to Buchanan, Becker, every other student that came through his course, turned on the room's initial assumption instead of on coast. If you trace out what actually happens under costless bargaining, with each party maximizing and no impediment to trade, exchange, and negotiation, the liability rule really, really doesn't change the allocation of resources. Changes the distribution of wealth, who pays whom. But that's always true of ownership. Doesn't change the efficient outcome. By the time the plates were cleared, Friedman had not just conceded the point, he had become the person making Coase's case for him to the rest of the room. That's a formidable advocate. And that's why 21 for Coase, not 20 holdouts that were grudgingly outvoted by one loudmouth, genuine, complete conversion, consensus, led by the man who'd been arguing hardest against it three hours earlier. Milton Friedman publicly changed his mind, admitted he was wrong, and then became an advocate for the new position. Well, two things came out of that dinner, and they're both worth naming. First is the paper itself. Coast went back, informed by that discussion, wrote the version of the problem of social cost that actually got published in 1960, the one that's now the single most cited article in the history of legal scholarship. And critically, the famous zero transaction cost result, the theorem part, which was never the point of the paper, even though it's only the only part most people remember. Kose's real argument came in the second half. Since transaction costs in the real world are never actually zero, the whole question of how you assign property rights and design legal institutions matters enormously, precisely because bargaining is costly, slow, sometimes impossible. The frictionless world was a benchmark to show you what to explain. What causes the significance of liability is not morality, it's transaction cost. Coase spent the rest of his career frustrated that economists fixated on the fictional zero cost half of the argument, mostly ignored the point he actually cared about. Second thing that came out of that dinner is Milton Friedman's character on display, in a way the Chile letter and Prophet's essay never quite capture. Here's one of the most confident, combative intellects of the 20th century, sitting across the table from a visiting Englishman with no Chicago pedigree and losing an argument publicly in real time. And instead of digging in, pulling rank, trying to change the subject, said, You're right, I was wrong, and here's why. And then he spent the rest of the evening, and arguably the rest of his career, as one of the most energetic promoters of the idea that just kicked his butt. That's not the Friedman of the Doctor O cartoon or the other caricatures. That's a scientist. Whatever you think of the rest of his career, monetarism, deregulation, free trade, letters to Pinochet, that dinner in Aaron Director's dining room in 1960 is as good a demonstration as exists anywhere in the history of economics, what it actually looks like to be a serious scientific economist. Whoa,

The Twedge On Nontrivial Truths

Michael Munger 20:11

that sound means it's time for the twedge. A giant in physics and mathematics, Stanislav Ulam, who worked on the Manhattan Project, used to tease social scientists about the weakness of their fields. He famously challenged Paul Samuelson with this prompt Name me one proposition in all of the social sciences, which is both true and non-trivial. Eventually, Samuelson gave his answer. Comparative advantage. Samuelson argued that David Ricardo's law of comparative advantage is mathematically true, entirely non-trivial, as evidenced by how many highly intelligent people still don't understand or believe it, and it's the fundamental law that explains how international trade benefits countries even if one is better at producing absolutely everything. Now, the physicist's view is that the universe is a closed system governed by the first law of thermodynamics. You can't create matter or energy out of nothing. The economist's view is that the economic world is governed by scarcity. You can't create goods and services or time out of nothing. But time does have an opportunity cost. Now, that answer that Samuelson gave, comparative advantage, has over time come to be replaced by an answer that supposedly Milton Friedman gave, although there's no evidence of that, and that is there is no such thing as a free rent, free lunch. And that's evidence of the economist's view that scarcity that's actually equivalent to conservation of energy. So over decades of academic storytelling and campus jokes, the real life exchange, where Ulam demanded a non trivial truth and Samuelson said Samuelson said comparative advantage, frequently gets remixed now by professors and students into the punchier, more intuitive version that you've heard. A physicist demands the law of economics, an economist said there is no such thing as a free lunch.

Listener Letter On Tax Horizons

Michael Munger 22:20

This week's letter is from WH. Dear knower of important things. The Regime Uncertainty Podcast was excellent. I understand your point of view of constantly changing rules causing uncertainty leading to increased transaction cost as well as other intended and unintended consequences. Somewhat related would be the proposition of tax time horizon, which is more of a certainty issue. A short time tax horizon, like a one-time tax rebate, has little effect on consumption and investment behavior, but politicos sell the idea as jump starting the economy. Pause the quote for a moment. This is exactly Milton Friedman's point in his famous theory of permanent income. The permanent income hypothesis would claim that only if the change is going to be permanent and predictable does it have any real effect. Back to the letter. The short tax horizon tells the consumer and firms that it'll be taxes as usual after the one time or a short-lived tax event. Behavior remains the same. On the other hand, a meaningfully long tax horizon, for example, a tax change is for the next seven years, causes behavior to change because certainty allows consumers and firms to make consumption and investment decisions calculating their choices, knowing taxes will remain the same over an extended period. Regime uncertainty has similar aspects to short-term tax horizons regarding expected results, while regime certainty has expected results that are similar to long-term tax horizons. I'm just saying. By the way, greetings from the Great White North, WH. Well, thanks, WH. That is an important point, and it's one that Friedman certainly thought was important, so thanks for bringing it up. It connects well with this week's podcast.

Book Pick And Wrap Up

Michael Munger 24:21

The Book of the Week is I've been reading it over the past week and it's quite a page turner. Mary Roach. The book is Bonk, B-O-N-K, The Curious Coupling of Science and Sex 2008, published by Norton. The book is hilarious, but you'll also learn a lot from it. And of course, well, Mary Roach herself participated in some experiments, and her description of that is worth it. Well, that's it for this week. I'll talk to you again next week on The Answer is Transaction Costs.