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Transaction cost reduction and innovations for spontaneous cities:

Promoting a 'meeting' between Coase and Schumpeter *
Lawrence WC Lai and Frank T Lorne
Planning Theory published online 18 July 2013
DOI: 10.1177/1473095213492970

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PLT0010.1177/1473095213492970Planning TheoryLai and Lorne

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DOI: 10.1177/1473095213492970
cities: Promoting a ‘meeting’ plt.sagepub.com

between Coase and

Schumpeter*

Lawrence WC Lai
University of Hong Kong, Hong Kong

Frank T Lorne
New York Institute of Technology,Vancouver

Abstract
In urban spatial economic analysis, two largely disjunctive pro-market approaches influenced by
Ronald Coase and Joseph Schumpeter have emerged in the discussion of spontaneous cities. They
are transaction cost–based Coasian analysis and innovation-based Schumpeterian analysis. As an
original attempt to contribute to planning theory using Coasian and Schumpeterian economic
concepts, this article reviews the relevant literature, elucidates the conceptual differences between
the two approaches and argues that they are not only theoretically compatible but also practically
inseparable. An attempt has been made to pin the two approaches down using standard economic
concepts with reference to the writings of Schumpeter. Three groups of actual examples from land
law and property development are used to demonstrate and elaborate on this argument.

Keywords
Coase, innovation, Schumpeter, spontaneous cities, transaction cost

Introduction
This is an exploratory article to canvass a possible synthesis of aspects of the Coasian
and Austrian schools of economic thought that have influenced planning theory in con-
nection with the paradigm of spontaneous cities. This paradigm in urban studies (Webster

*The subtitle alludes to a statement in the insightful suggestion of Zawislak et al. (2012).

Corresponding author:
Lawrence WC Lai, Department of Real Estate and Construction, University of Hong Kong, Hong Kong.
Email: wclai@hku.hk

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2 Planning Theory 0(0)

and Lai, 2003) has arisen to engage rationalist, comprehensive, design-oriented and top–
down government-led urban planning. Spontaneity is the capstone concept, which con-
veys the notion of design by a huge number of anonymous individuals who do not know
each other. Such a design outcome naturally emerges in the absence of any conscious
design by one designer or hierarchy. This paradigm has been well received by architects
interested in urbanism (Hélie, 2009), as they, by tradition, generally favour a designed
order. Interestingly too, this paradigm, in so far as it is predicated on received economic
concepts, has been propelled in a byzantine manner by two distinct approaches: the
Coasian transaction cost approach and the Austrian economic innovation approach, the
intellectual fathers of which were Ronald H. Coase (1910–), and Joseph A. Schumpeter
(1883–1950) and Friedrich A. Hayek (1899–1992), respectively. Hayek and Coase won
the Nobel Prize in 1974 and 1991, and were London School of Economics colleagues at
one time.
The writing of this article was spurred by the idea of economists Zawislak et al. (2012)
that there is need for a synthesis of the thinking of Coase and Schumpeter:

The question made by Coase (1937) ‘Why do firms exist?’ is only partially answered by
transaction costs economics. According to Coase (1937), the scope of the firm is determined at
the margin. It will expand the number of internal activities until the costs of internalizing one
more transaction just balances out the costs of an equivalent transaction on the market … To
answer these questions, one should promote a ‘meeting’ between Coase and Schumpeter. Coase’s
(1937) coordinator is not necessarily an agent of change, but of efficiency … His role is to
choose according to market expectations the best generic mode to organize the production of any
given product under the hierarchical structure of a firm … (section 2.2, p. 16, authors’ italics)

The interest of Zawislak et al. is in the ‘theory of the firm’ or more precisely economic
organization based on Coase’s (1937) work. The literature review in Section II below
traces the notion of ‘spontaneous cities’ and argues that the time is ripe for another ‘meet-
ing’ between Coase and Schumpeter in urban planning and development research arising
from the Coase Theorem based on Coase’s work on social cost (Coase, 1960), which
offers a far more general theory of transaction cost. This is because these are areas of
research in which both ‘institutional constraints’, which are definitely Coasian, and ‘spon-
taneity’, on which Schumpeter and his fellow Austrian economists have a lot to say, both
place an important role. Section III is an original and formal elucidation of differences and
relationships between Coasian and Schumpeterian domains in terms of neoclassical eco-
nomic analysis. A conceptual distinction between the two lies in the interpretation of the
long-run average curve, with coasion approach emphasizing the achievement of a given
long run average curve, while Schumpeterian innovations seek to forcefully push down-
ward the curve while upgrading the quality of the units of consumption measured along
the horizontal axis. Section IV then presents three groups of real-world examples to show
how Coasian institutional support for Schumpeterian innovations operates.

Literature review: Coase and Schumpeter side by side

The origin of the term ‘spontaneous cities’ as a formal concept is uncertain but can be
traced to the 1960s in the works of such scholars as Egli (1962). Lagopolus (1993) found

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Lai and Lorne 3

the Medieval city to be ‘spontaneous’ or ‘organic’ in the sense that it did not follow a
preconceived plan, although among the ‘spontaneous’ cities, the emergence of a ‘sponta-
neous’ pattern was found. Kostof (1991), as cited by Shalabi (1998), distinguished
between ‘planned’ and ‘spontaneous’ elements of an urban city. Donne (1992), while dis-
cussing Rome, identified an ‘official’ Rome and an informal and spontaneous Rome.
Leontidou (1990, 1993) found post-modern elements that had long evolved in older
Mediterranean cities. Generally, such works appreciated spontaneous development as
something natural and as elements or factors in a type of urban design that distinguished
them from planned cities, although the term ‘spontaneous’, can refer to the chaotic infor-
mal development that characterizes many Mediterranean cities (Pace, 1997, 2002;
Hamouche, 2004). Spontaneous development has also been accepted as a phenomenon of
Islamic settlements along the Mediterranean (Nour, 2012). Shalabi (1998) gave the fol-
lowing useful summary of planned-versus-spontaneous cities as a matter of design choice:

The crudest categorization of a city can be as: planned or spontaneous … [Kostof]. Spontaneous
cities have a very organic structure with random open spaces and curved streets. Planned cities,
however, have a more methodological structure such as grid-like street patterns. (p. 22)

But some architects, Le Corbusier, for instance, typically those in favour of modern-
ism, were not fond of spontaneous cities and preferred a planned order:

The Swiss architect Le Corbusier is famous for designing a complete city around the automobile
and building models of his design … In so doing he adopted a process of urbanization that was
completely planned hierarchically, applying the processes familiar to architects at the scale of
an entire city. He also ridiculed the morphology of spontaneous cities as being the product of
donkey-paths. (Hélie, 2009: 77, authors’ italics)

While Modernism has had a great impact on urban design, spontaneous development
is returning to architecture. The work of Hélie (2009) is a good example of the revival of
the idea of spontaneity in urban planning, and does so in exemplary Hayekian terms for
all that Hayek himself was averse to planning beyond the neighbourhood scale and was
highly critical of the UK Town and Country Planning Act (Hayek, 1960; Lai, 1999). Two
good examples of recent contributions that revealed the influence of Hayek on theorizing
urban settlements are the works by Webster and Lai (2003), subtitled, ‘Managing
Spontaneous Cities’, and Gordon (2012), titled Spontaneous Cities. Both works cite
Coase and Hayek. Gordon’s treatise adopted the conventional plan-versus-market
dichotomy. However, informed by a Chicago-style economic understanding of ‘con-
strained maximization’ (Cheung, 1998), Webster and Lai clearly specify that spontaneity
is not runaway spontaneity, but ‘constrained spontaneity’ or ‘spontaneity shaped by insti-
tutions that evolve to reduce the costs of human interactions’ (Webster and Lai, 2003: 4).
This concept of constrained spontaneity anchors the Austrian Economics of Hayek1 to
Coasian neo-institutional economics focused on transaction costs (Alexander, 2001a,
2001b).
Implicitly, Moroni (2012) did the same in recommending ‘relational rules’ instead of
‘directional rules’, which correspond, respectively, to a spontaneous market based on the
freedom of contract and to top–down rationalist master planning by edict. In contrast,

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4 Planning Theory 0(0)

Gordon (2012) explicitly connected Coase with Austrian economics in a similar way to
Webster and Lai (2003): ‘Coase (1937) famously shows that organizations emerge to
reduce transactions costs. It is then that we get better technologies’. In Coase’s (1937)
mind, ‘organisation’ refers to the firm, the institution as an alternative to the invisible
hand of the market. The difference between the approaches of Webster and Lai (2003)
and Gordon (2012) lies in the former’s greater reliance on Coase’s (1960) work. Along
with Cheung (1982), Webster and Lai explained the importance of institutions holding
that ‘planning by edict’ and freedom of contract can be combined to form ‘planning by
contract’ embodying ‘directional rules’. In complement to Webster and Lai, Gordon
(2012) pointed to a direct relationship between institutions and innovations in that the
firm is an institution, and better technologies involve innovations. Interestingly, the
aforesaid authors did not capitalize on the work of Schumpeter, another Austrian econo-
mist famous for his contribution to the theorization of innovations.2 But by connecting
institutions with innovations, Gordon (2012) did provide a meaningful direction for
combining the ideas of Coase and Schumpeter.
In the planning and development literature, the first conscious attempt to combine
Coase with Schumpeter was made by Yu et al. (2000), whose model of sustainable devel-
opment was a novelty in that it replaced the linear neoclassical production function with
a fussy function that had an area. That idea was followed by Lai and Lorne (2006), Lai
(2010) and Lai and Lorne (2012). Foldvary (2012) deemed the last work controversial,
as it presented the case of a regulated and legally protected monopoly in public transport
engaging in Schumpeterian innovation.
Our survey would not be complete without mentioning that outside neo-institutional
and Austrian economic domains, an important non-economic paradigm of ‘self-
planning’ or ‘self-organisation’ ensuing from the work of Portugali (1999) in the field of
synergetics has made its impact felt in the planning field. Important examples of works
belonging to this genre are as follows: the work of Foster (1997), which addresses
Schumpeter specifically; essays collected in Alfasi and Portugali (2012), for instance, De
Roo and Rauws (2012); and in the works influenced also by Moroni (2007) such as those
by Alexander et al. (2012), Alfasi and Portugali (2012), Andersson et al. (2011) and
Holcombe (in press). A further synthesis of all allied strands of thoughts on spontaneity
is beyond the scope of this work, dedicated as it is to the economics qua economics3 of
Coase and Schumpeter. However, insofar as the concept of ‘free agents’ (Portugali, 1999:
75–76), or ‘teleocracies’, or the need for a deliberate intended order (Moroni, 2007) is
present to engage with choice-theoretic and subjectivist economics focused on Coase
and Schumpeter, it is certain that top–down interventionist thinking for planning of the
old school is facing more and more intellectual opposition.
In any event, the above survey of the literature points towards the prospect of a syn-
thesis of choice-theoretic Coasian neo-institutional and subjectivist Austrian–
Schumpeterian economics. The time is ripe for this synthesis, as neo-institutional
economists, who are not in the field of urban development, have actually urged such a
synthesis. Consider the questions and answers of Zawislak et al. (2012): ‘Why [did] the
firm [come] into being in the first place?’ or ‘How does it perpetuate itself over time?’ To
answer these questions, one should promote a ‘meeting’ between Coase and Schumpeter
(Zawislak et al., 2012).

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Lai and Lorne 5

Table 1. A comparison of the Coasian and Schumpeterian paradigms.

Coasian Schumpeterian
Operational Transaction costs – equi- Innovations – disequilibrium
concept marginal principle induced economics
equilibrium
Drivers of Rational economic agents as Entrepreneurs as idea creators
economic activities experts of transaction cost and recombinators
minimization
Aim Bottom line of profit and losses A quest to prove unrecognized
and an assumption of the potential – new combinations
plausibility of joint maximization or recombinations of ideas
Reform focus Laws and institutions Unclear
Modes of Price and non-price, lowering New products, increasing
competition concentration concentration
Cost consequences Minimizing long-run marginal / Downward shift of the long-run
average cost based on a known marginal / average cost function,
production function assuming that there can be
a new (lower) production
function

For Coase to ‘meet’ Schumpeter in the minds of urban theorists who accept the fact,
if not idea, of spontaneous cities to the satisfaction of students in economics, there is a
need to explain the distinctive features of Coasian transaction costs and Schumpeterian
innovations. To this we now turn.

Two paradigms, Coasian transaction cost and

Schumpeterian innovations, compared
Coase and Schumpeter coexisted in a window of opportunity in the history of economic
thought, with each developing his own respective approach to solving economic prob-
lems.4 It would be unlikely that they could have collaborated as their ways of viewing
problems and their approaches were very different. Indeed, one could easily argue that
their insights essentially conflicted in their implications. Why is this?
Table 1 summarizes a number of differences. The key concepts of Coasian analysis
are transaction cost, a neoclassical concept of values and the cost of production. The
Coasian novelty is adding transaction cost to the neoclassical marginalist revolution that
happened during the 19th century. The solution reached was one of pure exchange, but
subject to transaction costs, in addition to production cost constraints, to fulfil all mar-
ginal principles. Thus, the real world is always efficient. The economic problem remains
in terms of constructing a model of constrained maximization with transaction costs
added as an extra constraint.

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6 Planning Theory 0(0)

The Schumpeterian world is driven by innovation with the consequence of, if not
conscious intent to, dramatically overthrowing the status quo rather than engage in
harmonious exchanges under it. This would throw the existing equilibrium into dise-
quilibrium by combining and recombining actors, production functions, concepts and
practices.
Coasian economic players are anonymous, rational individuals in the tradition of
classical and neoclassical economics, although institutions become an important variable
in their quest to reduce transaction costs. The Schumpeterian perspective looks for entre-
preneurs who are bearers of the ‘animal spirit’ of capitalism. Dynamic spontaneity origi-
nates from a flash of genius that distinguishes men from a pure animal spirit. It is ‘animal’
in that it is a case of ‘I’m right and you’re wrong’.
The gist of this is that the real generic difference lies in the different paradigms of
competition that can generate drastic managerial actions – the micro actions that make
up a spontaneous city. As economists, both Coase and Schumpeter had something to say
about competition. To Coase and his followers, competition is through price and non-
price rivalry to achieve the greatest possible joint welfare maximum that entails an
exchange of rights through bargaining or organizing transactions by firm formation
depending on transaction costs. The Coasian approach implies cooperative construction
in the sense that the outcome is mutually acceptable due to its emphasis on contractual
arrangements. To Schumpeter and his followers, however, competition is conducted by
means of innovation such that a successful innovator supersedes those who fail to catch
up with the world. Schumpeter stated, ‘Competition … commands a decisive cost or
quality advantage and … strikes not at the margins of the profits and the outputs of the
existing firms but at their foundations and their very lives’ (Schumpeter, 1975: 82–85).
Thus, Schumpeter’s approach to innovation embraces destruction, which is known as
‘creative destruction’.5 This poses the question of how construction and destruction can
coexist.6 Zawislak et al. (2012) were aware of this sharp difference:

Coase’s (1937) coordinator is not necessarily an agent of change, but of efficiency. His role is
to choose, according to market expectations, the best generic mode to organize the production
of any given product under the hierarchical structure of a firm. (Zawislak et al., 2012)

So, how can the two really meet? The account below fills in gaps in the work by Lai and
Lorne (2006), which dealt with the consequences of construction and destruction, but not
how they cooperate to achieve these consequences.

Coasian transaction cost and Schumpeterian

innovations taken together
Figure 1 demonstrates the relationship between Coasian and Schumpeterian econom-
ics. To simplify, we assumed a horizontal average and hence, marginal cost function.
Technically, a Coasian exchange solution can be summarized as a drive to attain a
long-run average cost curve (LRAC). This pure exchange domain is Region A. Coasian
legal and institutional arrangements can be developed purely for the purpose of maxi-
mizing the size of Region A. In contrast, Schumpeterian economics operate in Region

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Lai and Lorne 7

Price Region of Coasian pure exchange

Region of Schumpeterian innovaons enabled

by Coasian instuonal rewards/protecon
A
x
LRAC

B
y
LRAC*

Efficiency units of Q
Qx Qy

Figure 1. Coasian pure exchange and Schumpeterian innovations enabled by Coasian

institutional arrangements.

B, which is created by innovations that drive the LRAC1 further down to long-run
average cost curve (LRAC)2. Such innovations often fundamentally alter the nature of
the product, Q, and hence, the horizontal axis is not the standard measure of the units
of a homogenous good, but efficiency units of a generic type of product. Successive
innovations in telephones, for instance, are a case in point. Instead of viewing different
model phones as different demands and supplies of different models, one can view the
problem theoretically as a form of demand and supply for the information bits
communicated.7
We highlighted the explanation of creative destruction in italics to show a contrast
between a traditional Coasian analysis and that in which the analysis was integrated to
include creative destruction. Clearly, the ‘margins of profits’ refer to a static margin of
profits typically used in a static sense to attract entry. The fulfilment of the intersection
of D and LRAC can be considered superficially ‘dynamic’ in that it takes some time for
new firms to enter an industry, even if such firms are using the same technology.
Likewise, negotiating out of externalities takes time and is subject to transaction costs,
lawyer fees and so on, so the static equilibrium of D equals LRAC (or a point close to it)
can only be attained with a time path. Yet, this is not the type of market dynamism that
Schumpeter addressed. To him, competition caused by innovation was like ‘bombard-
ment’ being compared to ‘forcing a door’.8
Now the question before us is how can one go down from the Coasian upper room
(Region A) of pure exchange to the Schumpeterian cellar (Region B) of innovation while
staying below a given long-run average function? In other words, how can the disequi-
libriating Schumpeterian entrepreneur capture Region B by jumping from A to B?
In line with the thinking of Yu et al. (2000), we hold that this jump or descent can only
happen when there are enabling institutional system rewards or intellectual property pro-
tection. In other words, some kind of Coasian institutional arrangement that differs from
those for pure exchange or bargaining must be at work. Notice that price competition is
what will result in an ‘either-or’ scenario such that either A or B, but not both A and B, can
be realized to the consumer. If production is characterized by technological changes in

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8 Planning Theory 0(0)

pushing down LRAC and LRMC, price competition will simply displaces the status no
matter how efficient a transaction cost institution has been enabled or designed under the
old technology. However, B cannot be sustained if there is no intellectual property protec-
tion for the new technology, as price competition again will dissipate B completely to the
point where price equals the new LRAC and LRMC, labelled as LRAC* in figure 1.
Thus, paradoxically, a market institution emphasizing pure exchange with completely
flexible prices cannot enable the co-existence of A and B. Recognition of prior rights
must be worked into new rights in order for both A and B to accrue to the ‘firms’ – the
institution and the consumer. Likewise, if legal and firm institution protections do not
exist, A and B will all go to the consumer. Since institution and innovators are left with
nothing in this case, one would not expect the scenario of a repeated dealing for A and B
to be continued in the future. This means that at best, all a society can achieve, even with
zero transaction costs, is A.
In reality, the intermingling of A and B is an ongoing process. This is so because an
innovation cannot bring any real economic effect if there is no subsequent growth in the
number of transactions for that innovation. Thus, Region B is not devoid of Coasian
rights entitlements as well as the subsequent exchanges that ensue from the adoption of
an innovation. This is implied by the famous ‘corollary of the Coase Theorem’ coined by
Polinsky (1974). Indeed, the expansion of the market from Qx to Qy denotes this dimen-
sion of transactions. In this sense, Coase and Schumpeter have met. So, this account fills
the core of the concepts of ‘constrained spontaneity’ or ‘spontaneity shaped by institu-
tions’, as mooted by Webster and Lai (2003).
Ignoring the technicalities9 of the economists employed above, one may say that this
explanation is merely common sense: an entrepreneur cannot sustain his or her creative
destruction in a business or social environment that is hostile to him or her. The inability
to sustain a flash of genius can happen when a society effectively represses, punishes or
discourages creativity (as in the case of China before 1979) and/or prohibits a reasonable
degree of destruction, like the redevelopment of properties, for instance. Coasians have
a lot to contribute to provide an environment convivial to innovation. In the next section,
we shall examine three groups of related examples that demonstrate the operation of
Coasian institutional support for Schumpeterian innovation.

Examples of the interaction between institutional

changes and innovations
The three types of example provided for discussion are all related to the economic analy-
sis of law in land and property development. All demonstrate the notion of ‘constrained
spontaneity’. The first was a doctrine of law, a ‘servitude’, that was the capstone of the
urban research on ‘non-zoning’ (Siegan, 1970). The influence of this can be found in the
paradigm of ‘private planning’ (Foldvary, 2005; Webster and Wu, 2001), traceable to the
work of Boudreaux and Holcombe (1989), within a broader interest in property rights
and in institutions for planning and housing (Adams et al., 2005; Alexander, 2001b; Ball,
2006; Buitelaar, 2003; Evans, 2004; Foldvary, 2009; Lai, 1997; Staley, 2006; Webster
and Lai, 2003). The emphasis was on the notion of a negative legal burden converted
through innovation into a positive asset. The second example deals with the innovation

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Lai and Lorne 9

incentive implications of the term of years of the leasehold interests on sale. It is also a
landed interest that runs with the land. It is not classified as a servitude, but it can be both
a constraint on and an incentive to development at the same time. The third group of
examples is the unusual and hence spontaneous combination of uses normally consid-
ered incompatible in modern private property development importing an element of
social concern.

Example I: the doctrine of interests and obligations ‘running with land’

People often take the law of contract in common law for granted. The Coasian emphasis
on contracts or contracting is a good reason for recollecting the law. The law of contract,
on which Coasian bargaining is supposed to be predicated, is inadequate for dealing with
a wide range of issues. In Coase’s seminal paper ‘The Problem of Social Cost’ (Coase,
1960), the law cases discussed are not generally land law, but tort law, which is a com-
mon law innovation that overcomes the limitations of the doctrine of ‘privity of con-
tract’, but that does not protect the interests of third parties. Another doctrine has also
emerged in land law to overcome a second problem of the law of contract (i.e. the danger
of over-bargaining). As far as transactions of landed properties are concerned, contract
law is essential, but inadequate because the terms of a contract do not ‘run with the land’.
The common law legal system has overcome this in land law by adopting, as a major
innovation,10 the doctrine of interests running with the land in that landed interests bind
not only the first buyer or owner, but with all successors of the landed interests, too. It
covers a vast number of ‘land use servitudes’ or burdens. In the legal literature, this doc-
trine has become exalted as a means of private planning or ‘non-zoning’, as demon-
strated by the classic work of Siegan (1970) on Houston, which was followed-up by such
scholars as Buitelaar (2009), Qian (2010) and Zhu (2011). In mainstream legal research,
the doctrine has been defended against criticism that it needs streamlining or ‘judicial
removals’ to tackle the problem of holding out (see, for instance, Merrill, 1985). One
defence by Epstein (1981/1982) resorted to the need to respect the freedom of contract
and another by Sterk (1984) used arguments of Pigovian market failure, namely, ‘exter-
nalities, inadequate foresight, and intergenerational imposition’ (p. 661). And Dnes and
Lueck (2009) used Coasian transaction cost analysis that stresses efficiency. The follow-
ing passage from Dnes and Lueck (2009) best illustrates this position:

Servitudes on land are a prime example of how the common law supports the fragmentation and
specialization of property rights in space, time, and use. The underlying economic rationale for
this fragmentation is based on the gain from specialization in the ownership and use of land and
the avoidance of high costs in laying in services … (p. 991)

Indeed, this doctrine enables the seller or donor of a property to leave obligations that
bind the buyer or donee not just for one period of time but for all time, and enables the
buyer to obtain rights that do not disappear after his or her death. In effect, it contracts
out a lot of uncertainty that cannot be pre-empted under an ordinary law of contract.
The above can be considered both a Coasian institutional arrangement for transaction
cost reduction and a Schumpeterian innovation, which scholars have yet to develop fur-
ther. It is Coasian in the sense that it is a way for the first transactors in land to contract

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10 Planning Theory 0(0)

out the re-bargaining and constrain the transaction costs of over-bargaining processes. It
is Schumpeterian in the sense that it inhibits negotiations and, thus, limits the freedom of
contract over certain rights and liabilities and creates a land market, which is a new mar-
ket for interests that run with the land that would be impossible under law of contract
alone. The synthesis of Coasian and Schumpeterian activities is that the foundation of the
land law is the voluntary assumption of rights and obligations (i.e. contractual), but the
spirit of it is to establish some built-in rigidities or constraints concerning land.
The doctrine does not repress creative development ideas. Rather, it spurs developers,
a special kind of entrepreneur, to devise means to capitalize not only on the rights but
also the obligations, regarding land, take easement, for instance. The duty to maintain
uninterrupted public passage on one’s private land, which can be negatively treated as a
legal burden or a tax in kind (loss of developable land due to the need to keep it free from
obstruction),11 and the need to handle this with minimum effort, can be boldly converted
into an attractive siphon of shoppers for a commercial centre. The range of choices for
responding to a legal servitude or burden is as wide as can be imagined, and hence, is
spontaneous in this sense. The law’s requirement is that there must be a passage, so an
innovator decides how that passage can materialize. The implicit ‘animal spirit’ converts
a burden12 into a win–win–win benefit for proprietors, pedestrians and the wider public.
Whether it works well or poorly depends on the fittingness of the innovative attempts.

Example II: time is of the essence

This example follows up the discussion on property law. In traditional thinking about
private property rights on land, the freehold estate, or ‘legal fee simple absolute in per-
petuity’, is taken as the norm, while the leasehold estate is treated as its inferior. The real
distinction between a freehold and a leasehold is that the former does not have a pre-
specified term like the latter,13 yet both are vulnerable to eminent domain or confiscation
(‘taking’) by the state.
Archival documents reveal an interesting political dialogue between the Colonial
Office in London and the bureaucrats of Hong Kong during the formative stage of the
then-British colony, that is now famous for the system of selling leasehold land interests
that has survived the 1997 handover to China. Doubting the survivability of the colony
under China, London disallowed local officials from granting freehold interests. The lat-
ter responded ‘obediently’ by granting leasehold interests for a term of 999 years – a
period that was described as ‘virtually perpetually’, in order to attract investment in land.
London was not pleased with that and eventually allowed the golden mean of leases with
terms for 50 years (for ‘farm lots’) and 75 years (usually renewable for a further 75
years) for non-farm lots (Hongkong Land Commission, 1887; Ho 2006; Nissim, 2008).
From the traditional private property rights angle, a shorter lease is inferior to a longer,
much less a perpetual, lease. However, Hong Kong’s leasehold system has worked as a
kind of Coasian framework for spontaneous development via the market. As leasehold
interests in Hong Kong are sold in an overt market rather than as gifts of the state, the
return on each plot of land sold is evaluated by the price mechanism. As each plot is sold
to the highest bidder, the land buyer would not waste it, although wasting a resource is,
subjectively speaking, a form of private right. The land can be said to have been lent to

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Lai and Lorne 11

the lessee at market price and accordingly the lessee would avoid wasting it. In this way,
borrowed time will speed up innovation.
The rationality of the market also ensures that the developer will seek to innovate so that
the extra price he or she pays over and above the next highest bid yields a higher return that
the latter may not be able to anticipate. That difference is a measure of a secret vision, not
shared by competitors due to the transaction costs of information. Interestingly, the state
also plays a role in seeding innovation by default, if not intentionally, by varying the terms
and conditions of the sale of land lots. In the earliest Crown Leases, there was a typical
building covenant that restricted development in certain areas to that of a ‘European-type
house’ or a house of ‘European style’ of worth not lower than a specified amount. In terms
of the built form, such a clause produced a modern town with European architecture in an
Oriental society, where Chinese people were a numerical (and, soon after, financial) major-
ity. In planning terms, it was the genesis of what has been described as ‘planning by con-
tract’ (Lai, 1998, 2005, 2010), which involved both the state and market as a type of
planning distinct from private planning by restrictive covenants or by a club (Grant and
Mittelsteadt, 2004; Hoyts, 2005; Lai et al., 2012; McKenzie, 2005; Manzi and Smith-
Bowers, 2005) or company (Lai and Kwong, 2012), which is typical for gated communi-
ties. As a result, the City of Victoria that emerged between 1842 and 1976 was truly a
spontaneous city to the extent that land use was controlled purely on a contractual basis in
the absence of any statutory zoning plan. However, even where planning laws impose fur-
ther ex ante constraints on the land market, the entrepreneurs can still innovate to subdue
them, a scenario to which we turn.

Example III: novel combination of uses

Perhaps the most vivid example of how Coase can meet Schumpeter is the way heritage
buildings in the world cope with the powerful market forces of new developments by
combining elements in a socially or environmentally creative manner. At the outset, one
can intuitively perceive a scenario where entrepreneurs find win–win design solutions
that preserve heritage assets and thereby create additional values for the surrounding
land. However, the transformation can go deeper than the mere creation of value or a net
increase in value of B at the expense of institutional loss associated with A. The approach
here suggests looking at the preservation of both A and B. Although not a universal phe-
nomenon, this we do see as being played out in some circumstances.
Combination, in the words of Schumpeter, is the essence of innovation, but such a
combination has sometimes been played out in a way that is more than a mere reduction
in transaction costs. An apiary has been combined NOT with an apple farm (Cheung,
1973), but with the roof of a five-star hotel in Vancouver (Lai, 2011: 233–234), some-
thing that was unheard of or dreamt of as being possible in 1973! A transaction cost
approach would only predict that more and more apiaries would be bundled with apple
farms. In the very expensive property market of Southern Manhattan in New York City
close to the famous Wall Street, we can still see the tomb of Alexander Hamilton in the
garden cemetery of Trinity Church. Discounting religious or scientific values, the oppor-
tunity costs of the relics of a famous person cannot possibly be so high that his bones
become permanently valuable to a location, even if that historical figure may be

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12 Planning Theory 0(0)

Figure 2. Manchurian factories along canals converted into luxurious apartment units. (Photo:
first author’s).

of monumental importance to the history of his country. Yet, in this example, a ‘sponta-
neous’ configuration of a city (a locality) emerged as if a living dead body were contract-
ing with others to bring about the environmental outcome.
Mixed neighbourhoods of this kind are being played out less dramatically in many
parts of the world in terms of regional neighbourhood transformations. Older neighbour-
hoods have been slowly transformed into sustainable neighbourhoods by retaining many
of their existing buildings and housing stock, but opening themselves to a variety of resi-
dential scenarios. Some Manchurian factories along canals have been converted into
luxurious apartment units mixed imaginatively with riparian recreational tourism.
(Figure 2) In North America, mixed uses can ‘quietly’ break zoning laws that are often
regarded as exclusionary, if not discriminatory. For instance, a single family house may,
via a community spirit of social justice, allow several adults to dwell in some sort of sup-
portive housing. Such an arrangement, however, is not normally perceived by some as a
‘first best’ position for the neighbourhood’s image, as folks in the neighbourhood have to
be served by grocery deliveries from a dedicated social service several times a week. The
most interesting observation about these emerging neighbourhoods, which display a
spirit of charity rather than the exclusivity conveyed by ‘gated communities’ in North
America, is that they are sometimes considered the ‘toniest’ neighbourhoods in the city.
This remains the case despite the fact that in other cities of the world, this combination
of people with different backgrounds living in the same estate is sometimes perceived as
something close to being a slum.14
Often, Coase meets Schumpeter not by living side by side, but by fostering some type
of transformation into the new while preserving the old. In North America, Leadership in
Energy and Environmental Design (LEED) and a wide variety of other organizations

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Lai and Lorne 13

have done work on sustainable heritage buildings with the aim of converting these old
assets into net positive values. Yet, as one can easily imagine, not all heritage buildings
can stand the test, and many have ultimately been destroyed in the spirit of Schumpeter’s
creative destruction.
Clearly, a change in the production function of the ‘use’ of a building is a great part of
how heritage can or cannot be ‘transformed’. What a building or canal in Manchester
was used for 100 years ago may not be a possible use today even if the building and the
canal can be physically preserved in their original state. A most alarming revelation in
pondering how Coase may meet Schumpeter in this exercise is that most of the landmark
heritage buildings that have had successful transformations are those which were pri-
vate-to-public conversions. There are numerous examples in North America of private
estates being converted into public parks, museums, libraries and so on. They testify to
the appearance of a new institutional arrangement governing their modern uses: a ‘social
contract’ (the mandate for the state) that has replaced a set of ‘private contracts’. This is
an outcome in which Coase would probably agree with Schumpeter. Although Coase
would not agree with Schumpeter’s bold 1950s supposition that there would be a transi-
tion from democracy to socialism, in this case, both would probably say, ‘I told you so!’.

Conclusion
Our interdisciplinary journey, informed by the theory of planning, economic and legal
concepts, through the idea of ‘spontaneous cities’, stressing spontaneity in an institution-
ally constrained manner, has brought Coase from the ‘upper room’ of pure exchange
efficiency down to the lower cost cellar of Schumpeterian innovations. As the examples
demonstrate, this transforms servitudes into creativity, uses limited time for maximal
benefits and turns negative externalities into positive spillovers. It is an economic defini-
tion of sustainable development, which goes far beyond transaction costs of pur
exchnage.
Although they are essentially different in terms of scope of operation as demonstrated
using neoclassical techniques in this article, Coasian transaction cost reduction and
Schumpeterian innovations have no inherent contradictions. Indeed our illustrations
showed institutional and societal features existed long before Coase and Schumpeter and
possibly continuously evolve in future.
By the use of three sets of examples, this article illustrates the differences between the
ideas of Coase and Schumpeter as well as their possible compatibility. The legal exam-
ples presented here must be viewed in light of a Posnerian econ-law perspective (Posner,
1992), itself built on the bed rock of Coasian analysis. This holds that law basically
serves the role of transaction cost reduction. This function is captured in this work as part
of the Coasian ‘upper room’ function. The innovative aspect of the common law to note
is that the law does promote innovation while also being a mechanism to reduce transac-
tion costs.
With regard to the third type of example, it should be stressed that the conversion of
private ownership to public ownership is an important conjecture. The theoretical issue
raised is this: given that Coase can meet Schumpeter, what additional implications for
institutional arrangements could be deduced? Here, our observation that many heritage

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14 Planning Theory 0(0)

sites are being converted into public from private ownership reveals that although neither
Coase nor Schumpeter had thought about the issue, their followers would probably both
want to claim credit for being the first to suggest the outcome we have indicated.15
Coasians apparently treat economic interactions as a silent tournament for efficiency
based on mutually accepted rules for minimizing transaction costs. By contrast,
Schumpeterians downplay cost reduction and seek climaxes of value creation so that
players ‘innovate or die’. While neither see the human economy as one operating like a
harmonious symphony of individual vocations executed with excellence, in the final
analysis, elements of both the Coasian and Schumpeterian paradigms (and surely other
forces not examined here) are simultaneously at work in transforming society even if
policy and legal development might not keep up with their pace. It follows that there are
institutional features and matters observed that are puzzling when evaluated under only
one paradigm. Laymen may shrug their shoulders and assert that such features are irra-
tional or anomalous. A framework informed by techniques of economics provioding a
broader interpretation that brings a meeting between Coase and Schumpeter is suggested
here. Whether this framework implies an intrinsic change in the economic system as
Schumpeterians claim, or whether a unified property right framework is called for
remains to be seen.

Acknowledgments
The authors are grateful to the useful comments and advice by the Editors and three anonymous
Referees in particular to bringing to their notice the contribution of the synergetics of Professor
Juval Portugali. They also thank Dr. Stephen NG Davies, former lecturer in Western political
thoughts, University of Hong Kong, for editing the revised manuscript and drawing their attention
to the concept of “strange attractors” in chaotic dynamics. Finally, they thank Professor Medema,
University of Colorado Denver, for his inspiration in connection with the Coase Theorem and
Martha Welsh for contributing the example of her neighborhood of Kitsilano in the city of
Vancouver in footnote 14. All faults are the author’s.

Notes
1. A host of literature on planning has been based on Hayek’s idea. See, for instance, Pennington
(2006) in addition to Gordon (2012) and Foldvary (2012), who are cited in the text.
2. Unlike the young Hayek and the much younger Coase, Schumpeter passed away too early to
win a Nobel Prize in Economics, which did not exist in 1950.
3. Mainstream economists have recognized in chaotic dynamics that an apparently unconnected
set of seemingly independent ‘survival’ decisions by managers can result in the emergence
of a spontaneous order. There is an obvious mathematical cognate in what is called a ‘strange
attractor’. See, for instance, Rosser (1999).
4. See Schumpeter ([1928]1934, [1943]1975), Coase (1937, 1969).
5. Schumpeter described the essence of creative destruction in the following way:
In capitalist reality as distinguished from its textbook picture, it is not that kind of competition
which counts but the competition from the new commodity, the new technology, the new
source of supply and, the new type of organization (the largest-scale unit of control, for
instance) – competition which commands a decisive cost or quality advantage and which
strikes not at the margins of the profits and the outputs of the existing firms but at their
foundations and their very lives. This kind of competition is as much more effective than the

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Lai and Lorne 15

other as a bombardment is in comparison with forcing a door, and so much more important
that it becomes a matter of comparative indifference whether competition in the ordinary
sense functions more or less promptly; the powerful lever that in the long run expands output
and brings down prices is in any case made of other stuff. (From Capitalism, Socialism and
Democracy by Schumpeter (1975) (orig. pub. 1942), pp. 82–85, italics added)
6. To someone in the field of real estate and construction, the question seems of little signifi-
cance, as demolition and construction are very much a routine process in the business. Yet,
this is by no means a trivial question when it comes to heritage buildings. Also, violence
occurs often during the evacuation process in redevelopment projects for neighbourhoods
and testifies to the difficulties in creative destruction because a win–win construction process
often cannot be conducted simultaneously.
7. The approach here is similar to the concept of using ‘efficiency units’ as the quantity dimen-
sion to formulate demand and supply akin to the problem of light bulbs studied by University
of California, Los Angeles (UCLA) economists during the 1980s. See, for instance, Liebowitz
(1982). The use of efficiency units instead of the usual unit measures of goods was due to the
fact that a good may change dramatically in quality or kind and, hence, the usual homogenous
product assumption could not hold.
8. Both ‘bombardment’ and ‘forcing the door’ are terms of Schumpeter. See Footnote 2, ante.
9. Conceptually, this analysis does not restrict the meaning of Schumpeterian innovations to a
purely technical kind that denies Coasian institutional innovations. Suffice it to say that any
Coasian innovation, meaningful and possible only in a world of positive transaction costs (i.e.
through the operation of the Polinsky ‘corollary’; Lai, 2007; Polinsky, 1974), at best brings
transaction costs down to zero, but cannot open a trap door on the floor of the upper room,
however powerful it is in removing unnecessary barriers for exchange. Only Schumpeterian
innovations can create their vent. If they are purely technical to begin with, they would have
an institutional effect, along the line of thinking of Nobel laureate Douglass North (1990).
10. See Maitland (1936) for various innovations in common law by the court in England which
reduced costs of litigation.
11. See Leverson Limited v. Secretary for Transport LDMR 32/2000.
12. A good biblical example of an entrepreneur was Jacob, who improved the quality of his
father-in-law’s goats. See Genesis 30:37–40.
13. A distinction drawn by Gerald Rowe, Barrister who taught the first author at the University of
Sydney in 1983.
14. We thank Martha Wolsh for providing us with following observation in her living
neighbourhood:
“Example on our street is that only one house is single family (the others are duplexes, two-
family suites, bed-and-breakfast[s], etc.). Even in one-family house[s], there [live] a couple
of generations. Kits Point is also ‘boxed in’ by a small high street of commercial/dining
services, offices, a museum, a school of music, [a] planetarium, a marina, and [a] beach park
with [a] beachside restaurant. A fully integrated mixed-use neighbourhood that has slowly
evolved without overt city bureaucratic decisions.”
15. Coasians could say that it is the desire to reduce transaction costs that leads to private entrepre-
neurs being replaced by public entrepreneurs. Schumpeterians, liking democracy and social-
ism as an answer so much, would likely say the same as a matter of ideology. In the real world,
probably many of the public entrepreneurs would look for Schumpeter for philosophical back-
ing for their initiatives, as transaction cost minimization is not on their radar screens. Yet, say-
ing something differently does not mean that there are truly different underlying reasons.

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16 Planning Theory 0(0)

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Author biographies
Lawrence WC Lai is Professor in Law, Economics and Planning, Department of Real Estate and
Construction, University of Hong Kong. B.Soc.Sc. (Hons) (HK), M.T.C.P. (Syd), M.Soc.Sc. (Econ)
(HK), LL.B. (Hons) (Lond), Ph.D (HK); Registered Professional Planner, F.R.I.C.S., UK (P&D),
F.H.K.I.S. (P&D); Registered Professional Planner.

Frank T Lorne is Professor in Management with NYIT Vancouver. Trained in the neoclassical
tradition of economics in the 70s in the 20th Century. He coauthored with Lawrence Lai in mnay
subjects of interdisciplinary nature for the 21st Century.

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