My latest paper, Testing the Coase Hypothesis Using Electronic Book Values, with Tim Groseclose in the lead, has just been published. The Coase Conjecture is one of Coase’s smaller conjectures – the first paper is six pages – that has spawned hundreds of follow-up papers and thousands of citations.
The idea is simple. A monopolist of durable goods has a problem with timelessness. Set the monopoly price in period 1 and he will be tempted in period 2 to reduce the price and increase the customers whose prices lie between the period-1 price and the MC. But the same concept applies in the 2nd period, and in the 3rd period, and so on – finally the value is revealed to the MC. Buyers see this coming, the monopoly knows that buyers see it coming, so the monopoly lowers the price at MC in period 1. And since a “period” is simply the interval between price changes, all analysis occurs – in Coase’s phrase – “in an instant.”
Theorists, especially Gul, Sonnenschein and Wilson as well as Fudenberg, Levine and Tirole, formalize Coase’s understanding and show that under normal conditions the concept is transient. Which is surprising, since, as Tim and I say, Coase’s reasoning suggests that most patents and copyrights are worthless – a prediction that is very much at odds with reality. Other theorists, including Stokey, Ausubel and Deneckere, as well as Board and Pycia, have offered different versions of the Coase effect that you get and don’t get.
For all of this theory, there are almost no direct tests of the Coase Conjecture other than a few lab experiments. Ours is one of the first papers to take the imagination into the real world. We look at e-books, an unusually clean setting: digital goods last longer, marginal costs are lower, resale is limited, and prices can be changed quickly. Using the prices of e-books in the public domain as a proxy for marginal costs, we ask: (a) do prices fall rapidly in MC, and (b) is the market clear in the first period? The answer to both is no. E-book prices start above the MC, sales are ongoing in most cases, and prices don’t even drop automatically.
We strongly reject the Coase Conjecture.
The paper has an interesting history. The referees (or referees we assumed were theorists) praised the paper for taking theory seriously but inevitably had a fillip to offer, separating the world of pure theory from empirical tests. On the other hand, the professors said that our tests are too easy because no one takes this theory seriously. Great to see the paper find a home!
We completely reject the Coase Conjecture, but we still have to say why. We can rule out some explanations — it’s not increasing MC, and it’s not consumer perfection (which would support the Pac-Man equation that completely discriminates prices).
Two theories remain: 1) sellers can commit not to lower prices, and 2) the Board and Pycia external options model. I prefer the former, my co-author prefers the latter. For me, giving up is not that difficult. The common story is that profits are like cookies on the table and the monopolist can’t resist – but at least the people tempted by the cookies eat the cookies! Coase benefits are not illusory: the monopolist rushes to MC in period 1 because they know they cannot resist later and therefore do not even get to taste the profit! You’re smarter by half. I say, show me a backbone. Firms are about* commitment – to employees, customers, contractors. Why is there no value? My co-author points out, however, that this is more of a Tabarrok-vibe than a carefully laid out theory.
Tim likes the Board and Pycia model that starts with the basic idea that consumers have external options – if they don’t buy a book today, they will buy another book, rent a movie, or borrow from the library – and most importantly, once they take an external option, the consumer never returns to the market. You might think that outside options would make it *difficult* for a firm to set a higher price, but Board and Pycia show in a very clever but extended argument that if you do it carefully the opposite perfect equilibrium is delayed: outside options give firms a constant incentive to set and maintain a higher price. Tim explains the argument further here (see also our paper for a precise breakdown).
In any case, the Coase Conjecture – at least as modeled by the theorists – fails in the area most favorable to it.
Good theory falls on bad data.
