Utopia, you are standing in it!

This neglect of other aspects of the system has been made easier by another feature of modern economic theory – the growing abstraction of the analysis, which does not seem to call for a detailed knowledge of the actual economic system or, at any rate, has managed to proceed without it.

Holmstrom and Tirole, writing on The Theory of the Firm in the recently published Handbook of Industrial Organization, conclude at the end of their article of 63 pages that "the evidence/theory ratio… is currently very low in this field". Peltzman has written a scathing review of the Handbook in which he points out how much of the discussion in it is theory without any empirical basis.

What is studied is a system which lives in the minds of economists but not on earth.

I have called the result "blackboard economics". The firm and the market appear by name but they lack any substance. The firm in mainstream economic theory has often been described as a "black box". And so it is.

This is very extraordinary given that most resources in a modern economic system are employed within firms, with how these resources are used dependent on administrative decisions and not directly on the operation of a market.

Consequently, the efficiency of the economic system depends to a very considerable extent on how these organisations conduct their affairs, particularly, of course, the modern corporation.

Even more surprising, given their interest in the pricing system, is the neglect of the market or more specifically the institutional arrangements which govern the process of exchange.

As these institutional arrangements determine to a large extent what is produced, what we have is a very incomplete theory.

Four years before his Nobel lecture, Coase was more specific:

Marginal cost pricing is a policy is largely without merit.

How then can one explain the widespread support that it has enjoyed in the economics profession?

I believe it is the result of economists using an approach which I have termed “blackboard economics.”

The policy under consideration is one which is implemented on the blackboard. All the information needed is assumed to be available and the teacher plays all the parts. He fixes prices, imposes taxes, and distributes subsidies (on the blackboard) to promote the general welfare.

But there is no counterpart to the teacher within the real economic system. There is no one who is entrusted with the task that is performed on the black- board.

In the back of the teacher’s mind (and sometimes in the front of it) there is, no doubt, the thought that in the real world the government would fill the role he plays. But there is no single entity within the government which regulates economic activity in detail, carefully adjusting what is done in one place to accord with what is done elsewhere.

Coase argued that  marginal cost pricing is not only inefficient, but even inferior to average cost pricing due to:

(i) the fact that under marginal cost pricing, consumers are not forced to pay the full costs of the goods they purchase, leading to potentially inefficient consumption choices;

(ii) the lack of information necessary for the government to determine whether consumers would be willing to pay an amount sufficient to cover the total cost of the goods produced, and costly nature of attempts to make such estimates; and

(iii) the fact that the governmental subsidy necessary to ensure firm survival under a marginal cost pricing scheme will likely be financed through distortionary taxes, thereby creating or exacerbating a distortion in one market at the same time that it corrects a distortion in another.