The Nature of the State

A brief explanation of Coasian Polity Markets

One way to analyse the problem of government is to recognise its monopolistic nature and
ask how we might deal with that from an economic perspective.

Politicians are prepared to use the Greek “monos” for other industries, but they reserve the
Latin “unis” for their own. Thus the "European Monopoly" becomes the "European Union",
and the "Monopolised States of America" become the "United States".1

But are states and firms really all that different?

From Coase’s Alfred Nobel Memorial Prize Lecture, 1991 (referring to “The Nature of the
Firm”):

“The Russian Revolution had taken place only fourteen years earlier. We knew then very little
about how planning would actually be carried out in a communist system. Lenin had said that
the economic system in Russia would be run as one big factory. However, many economists
in the West maintained that this was an impossibility. And yet there were factories in the West
and some of them were extremely large. How could the views expressed by economists on the
role of the pricing system and the impossibility of successful central economic planning be
reconciled with the existence of management and these apparently planned societies, that is,
firms, operating within our own economy?”

Coase’s great insight in 1937 was to identify the essential similarity between “public”
planning by the state and “private” planning within a firm.

1
The UN Charter even contains an anti-competitive “market-sharing” agreement – the recognition of
sovereignty – under which the regional monopolists have divvied up the planet and agreed not to offer services
to people living in another monopolists’ territory!
For a fuller analysis of the State as a Monopoly, see An Essay in Comparative Constitutional Law
But there is also a difference, as discussed in the famous (perhaps not so famous!) footnote
14 to “The Nature of the Firm”:

“It is easy to see when the State takes over the direction on an industry that, in planning it, it
is doing something which was previously done by the price mechanism. What is usually not
realized is that any business man in organizing the relations between his departments is also
doing something which could be organized through the price mechanism. . . . . The important
difference between these two cases is that economic planning is imposed on industry while
firms arise voluntarily because they represent a more efficient method of organizing
production. In a competitive system, there is an ‘optimum’ amount of planning!”

Conventional economists have generally taken this to mean that firms and states are
categorically different. Firms “arise voluntarily”. States don’t.

But what if states did “arise voluntarily”?

Before exploring that possibility, let's go back to the standard analysis of efficiency in
monopolistic industries. Conventionally, this is interpreted in two dimensions (I'll ignore
dynamic efficiency to keep the model simple):

– “internal efficiency” describes the internal functioning of an organisation, the efficiency

with which it produces a particular bundle of goods and services; and

– “allocative efficiency” describes the organisation’s interaction with the rest of the world,
the efficiency with which it allocates resources to their highest value use.

Typically, a private monopoly is internally efficient because the owners gain nothing from
waste in the production of a given bundle of goods or services. However, as taught in any
first year economics class, typically it will be allocatively inefficient because it prices at the
profit-maximising level rather than setting price equal to marginal cost, thereby over-pricing
and under-producing.

Attempts to regulate monopolies tend to displace one type of inefficiency with the other.
Restricting the profit of a private monopoly may prevent allocatively inefficient over-pricing,
but it also eliminates the incentive to optimise internal efficiency. It may cause over-
investment (the Averch-Johnson effect).

There is a trade-off, and – as long as the monopoly stays intact – no way to avoid it entirely.

If, however, the monopoly may be broken up to create competition then internal and
allocative efficiency may be promoted simultaneously. The desire to maximise profit
promotes internal efficiency while the pressure from competing firms prevents over-pricing.
(The radical re-design of the monopolistic electricity generating industry under Margaret
Thatcher from 1988 - separating out the competitive generation from the irreducibly
monopolistic functions of transmission and "generator dispatch" - is the classic example.)

The same principles may be applied to government. The “efficiency” of any government
(again the archetypal monopoly) may be considered in terms of:

– internal efficiency, the efficiency with which the institutions of government decide upon
and implement a particular distribution of rights; and

– allocative efficiency, the degree to which (for any initial-state distribution of rights) the
final distribution approximates an ideal Coase/Stigler equilibrium which would arise through
voluntary negotiation of all parties in the absence of transaction costs (and Prisoners'
Dilemma which is an "anti-catalyst" for transaction costs2).

Those who place greater emphasis on internal efficiency will tend to be in favour of
streamlined legislatures (the exemplar being the mythical “benevolent dictator”).

In contrast, the conditions of Coase/Stigler equilibrium can be guaranteed only with consent
of all the rights holders. Accordingly, those who place greater emphasis on allocative

2
Under conditions of Prisoners’ Dilemma the prisoners might agree – or might have agreed if they could – that
it was advantageous for them collectively to incur costs to change the distribution of rights. However, in the
absence of an institution for agreeing and for enforcing the agreement, each prisoners has a dominant strategy of
doing nothing. A common institution for agreeing and for enforcing agreements is a “state”. That is why self-
styled “libertarians” invariably want a state which is strictly confined to protecting existing property rights but
denies others the “liberty” of organising themselves collectively to alter such rights. See for example "Obama,
libertarian paternalist", Nudge, 10 April 2008
efficiency will tend to be in favour of decision-making systems which require something
approaching unanimity (the exemplar being the “Wicksellian parliament”).

There is a trade-off.

At this point, some might be asking the question: “Hang on. What if we attack the problem at
its root and eliminate the monopoly?” That way we ought to able to promote internal and
allocative efficiency simultaneously.

And so we come back to the point - attacking the monopoly - but from a different direction.

Now there will be those who argue that "states" have a monopoly on altering rights while
firms do not. But that is a circular argument. States have such a monopoly only if the
government industry is set up a series of regional monopolies. After all, what is a “state”
other than a collection of private individuals tied together by legal rights and obligations?
And, on the other hand, a private firm can legally coerce individuals who are under an
obligation to it just as a state can. Even with states, we see in federations how that "right to
alter rights" is broken up to a degree. And historically we have had examples of such
division: the medieval Church making some laws (e.g. marriage-and-divorce) for all people
and all laws for some people (e.g. clerics) while the King made the rest.

So what might a “free market in government” - a "Marketplace in Sovereignty" - look like?

Following Coase, the scale and scope of states would adjust – just as the scale and scope of
firms adjust – to provide the “optimal amount of planning”. Governmental authority would be
optimally sized and optimally distributed provided that governments could “arise voluntarily”
in a competitive system.

Now this might seem utterly unimaginable. But around the world there are in fact embryonic
movements in this direction.

The Texan “Municipal Utility Districts” may be interpreted as special purpose “micro-states”
which arise voluntarily to provide specific services to their “citizens”.
On a larger scale, Article 29 of the German Basic Law3 (i.e. the German “constitution”)
contains the theoretical machinery for minorities to secede from their Land (i.e. a “state”
within the German federation) even if the majority of the Land opposes it.

In principle, such a mechanism could be scaled up to create a “polity market” for all of
Europe, or the United States (or Australia where I live)– or the entire world.

An essential step in this direction is the development of a “sovereignty market”, an

institutionalised platform for allowing the voluntary exchange and pooling of “rights to
govern”. This is already seen in “multi-speed” or “variable geometry” Europe: the various
“Lands” of Europe (Euroland, Schengenland, Dublinland and Bolognaland) pool specific
governmental powers.

Admittedly these have not always been efficient in scale or scope, but that’s because they’ve
been created by monopoly politicians for political reasons rather than by free market forces.

So the other element is a central meta-government, or “meta-state” (Washington or Brussels,

or Canberra even) which is charged with – and limited to – overseeing the orderly
incorporation of states, liquidation of defunct states, mergers and demergers, and the rules
under which such states contracted into the voluntary pooling of responsibilities.

Rather as ASIC (or the SEC in the US) oversees corporations but does not manage them, the
meta-state would oversee states but not govern them. (Or to use our electricity industry
analogy, the meta-state would be responsible for the irreducibly monopolistic function of
generator dispatch but not for actual generation.)

Intriguingly, corporations law itself contains statutory provisions to remedy “oppression of

minorities”. The remedies include “secession” of the minority from the rest of the company
under the oversight of the Courts. The assets of the firm (including its land even) may be
“partitioned” between the members.4

3
Basic Law Part II. The Federation and the Länder
4
Corporations Act 2001 Section 232, Grounds for Court order
Corporations Act 2001 Section 233,Orders the Court can make
The two limbs (sovereignty markets and the right to incorporate) work together: just as an
efficient market in factors of production allows for smaller firms (with less internal planning)
so an efficient sovereignty market allows for smaller states.

Finally, none of this could even begin without addressing the biggest transaction cost barrier
of them all: the currently monopoly of politicians to initiate legislation. Except in a very few
states, any change at all requires winning over entrenched politicians who view everything
from the perspective of maintaining their own monopoly on power. Unless that is overcome,
no radical change can ever occur.

Imagine a Europe, America (or Australia) structured not as a deadening, centralised, anti-
competitive, monopoly state ruled by rent-seeking politicians, but as a free market
multiplicity of polities pooling their sovereignty to ensure the optimal scale and scope of
planning.

Intractable problems require imaginative solutions. On an increasingly crowded planet,

improving the efficiency of collective decision-making is the biggest problem of all.

And Ronald Coase has already outlined the solutions.

 APPENDIX A

The Economist’s “Washington” Competition Entry

A Prototype Polity Market

July 1993