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The Coase Theorem & The Coase Dividend

March 15, 2013

Essay. The Coase Theorem (Ronald Coase 1937) states that “transaction costs” matter and, therefore, when an economist says “assume that there are no transaction costs” we know that they are talking about a very special kind of world:

“A world without transaction costs has very peculiar properties … the world of zero transaction costs turns out to be as strange as the physical world would be without friction. Monopolies would be compensated to act like competitors and insurance companies would not exist.” – R.H. Coase, 1990, The Firm, The Market, and The Law, U of Chicago.

Most economists make that assumption – that there are no transaction costs – and, to their credit, they tend to say so, but, as a result, we get a World View that is promoted or vaunted as having the Option Pricing Formula (Black & Scholes) and the Capital Assets Pricing Model (CAPM) and Modern Portfolio Theory (MPT) and Economic Equilibrium (Arrow & Debreu), none of which actually exist as far as we know, that is, no one has ever shown us an example of a transaction that has no cost (in this context, not even a “gift” has “no transaction cost” – please see below) or even one that has a negligible cost. In fact, they don’t exist in the world of finance and financial transactions or trade and exchange or bargaining that we are familiar with:

“… in a world involving no transaction friction and no uncertainty, there would be no reason for a spread between the yield on any two assets, and hence there would be no difference in the yield on money and on securities … in such a world securities themselves would circulate as money and be acceptable in transactions …” – Paul A. Samuelson, 1947, Foundations of Economic Analysis, Cambridge, Harvard University Press.

However, there’s no need to throw everything out the window. The results that we mentioned above are in fact theorems of a mathematical variety, but they fail in application because they don’t have a domain that we are familiar with, that is, they don’t apply to what we thought they might. Mathematics itself is in a similar situation. No one has ever seen or touched an irrational, negative, zero or infinite number (about a dozen is all that we can handle) and no one has ever seen a mathematical point, line or circle. In order that these theorems or objects are useful, we need to show or prove that our domain demonstrates the modality of behaviour that these theorems and objects imply, and we know that firms, markets and stock prices don’t demonstrate those properties enough that we might rely on them for prediction, or what comes next.

The question of what firms are and why we have both firms and markets, including, for example, the markets for firms that we are familiar with, is currently a very big question in economics, and we are not aware of anyone who can answer those questions on the basis of what is known. And in such an answer, one must also consider that a person is also a firm.

As investors, of course, in companies or firms, it would seem to be vitally important that we know what “firms” and “markets” actually are, that is, what their properties are in a legal and economic sense that we might be able to “price” them and somehow figure out what they might be worth in “money” terms, and when we put it that way, not knowing what “money” actually is (another shortfall of economics), we need to figure out more simply what we (ourselves) might be willing to pay for it (with cash) regardless of what somebody else might be willing or ought to pay for it (as rendered by accountants and investment analysts) and what are they willing to sell it for.

That problem is actually simpler and it has a solution because when we decide to exchange our cash money now for a piece of paper that is a stock certificate, we have purchased risk (or, vice versa, sold risk) because we don’t know if that “piece of paper” will ever be “worth” more, less or the same as it is now. We can describe (or agree to describe) any investment as the “purchase of risk” and the risk is that we might not get our money back with the same purchasing power as it has now. If then we have paid the “price of risk”, then we must have – by demonstration of the purchase – the confidence that we will, and anything else that we hope for, but do not have a provable basis for hope, is just a gamble. (Please see our Posts on The Price of Risk, August 2012, and The Nash Equilibrium & Its Stock Price, October 2012, which “stock price” turns out to be the “price of risk”.)

Ronald Coase described “transaction costs” in the following way:

“In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on. These operations are often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost.” – Ronald H. Coase 1960, The Problem of Social Cost, Journal of Law and Economics.

and these matter. Moreover, they can be computed as a product (or outcome) of investor (or owner or employee) risk aversion for firms in the units of the balance sheet and they are just as real, meaningful, and comparable to, the more familiar accounting quantities of the total assets, total liabilities, net worth, fixed assets, and inventories. Please see Exhibit 1 and 2 below.

In order to calculate the Coase Dividend™ (as we have called it), we notice that every transaction is (or can be thought of) an investment decision and we (or others on our behalf, such as employees) may at various times contemplate that decision from the point of view of “risk averse” investors or “risk seeking” investors but how we do it, or even how consistent we are, doesn’t really matter because the net result, which in aggregate sums up to or combines to produce the Coase Dividend™, is also constrained to produce a balance sheet for the firm and constrained in action by what we can identify as the “societal standards of risk aversion and bargaining practice” which are not a matter of definition (or coercion) but a matter of demonstration.

In effect, every transaction has a “balance sheet” which might not and generally is not directly computable in money terms, but makes a distinction of the following sort:

If the investors or owners have (N) and the bond holders have (B) and the investors approach the bond holders to strike a new deal with respect to forming or buying a company, or to restructuring the debt of the company that they own, what is the best outcome within the demonstrated societal standards of risk aversion and bargaining practice?

where in the context of any transaction, we can think of the “bond holder” as “risk averse” and the “investor, owner, or employee” as “risk seeking” or, vice versa, depending on who initiates the transaction which may change the status quo, however small.

Exhibit 1: The Coase Dividend™ – Summary for the Dow Jones Industrial Companies

The Coase Dividend - Summary

(Please Click on the Chart to make it larger, and again, if required.)

In the Summary Chart (Exhibit 1 above), the thirty companies of the Dow Jones Industrial Index are shown to have a combined Coase Dividend™ of $178 billion in comparison to what we may also call the “operational-oriented asset accounts” of the inventories, net plant & equipment (net fixed assets) and the accumulated depreciation (so that, effectively, we have the gross fixed assets that have been put to work now and over time, so to speak, by the company and its enterprise as described by Coase) and that the Coase Dividend™ amounts to about 8% of those and almost 10% of the net worth even though it is nowhere to be found on the balance sheet (or income statement).

The Coase Dividend™ is also owned by the company and is effectively an asset of the company that it has earned as a result of its enterprise and “paid to itself” in contrast to the common dividend that it pays (summarized as annual) to the shareholders in order to have an amenable access to the equity markets.

We also note (with reference to Exhibit 2 below) that it is not easy to find a pattern or shorthand for the Coase Dividend™. In broad terms, companies with large operational assets or large liabilities compared to the net worth (such as the banks) will tend to have a higher value of the Coase Dividend™ compared to those which don’t. For example, Exxon and Chevron are comparable and so are IBM and Hewlett-Packard but neither is similar to Intel which has relatively low debt but lots of “operational assets”.

Exhibit 2: The Coase Dividend™ – Dow Jones Industrial Companies – 2013

The Coase Dividend - DJI

(Please  Click on the Chart to make it larger, and again, if required.)

Moreover, entities such as the U.S. Government have both large operational assets and large liabilities (such as $16 trillion at the present time) and we can be grateful that the balance sheet is, in fact, much more than just a balance.

Postscript

We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

The Perpetual Bond™
“Alpha-smart with 100% Capital Safety and 100% Liquidity”
Guaranteed
With No Fees and No Loads on Capital

For more information on RiskWerk, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used.

The Coase Dividend™ is an invention of the author which implements the Coase Theorem as we have described it but otherwise has no recognition in the economic or financial literature and any errors or misinterpretations are due to the author.

Related data may be obtained from us for free in a machine readable format by request to RiskWerk@gmail.com.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.

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