The great lighthouse mystery

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• What is the proper role of government?
• If they don’t provide for us, who will?
• The answer shouldn’t surprise you…

No, this is not about some children’s adventure story, such as Enid Blyton might have written. It is about something entirely real, that is, Nobel prize-winning British economist Ronald Coase’s fascinating study of lighthouses. (Incidentally, Coase was born and raised in Northwest London, quite close to where I live.)

It was while on holiday recently that I recalled Coase’s work. Here is a photo I took of the local lighthouse:

This particular lighthouse, or faro, stands at the mouth of the Guadalquivir, which flows through Seville on its way to the Atlantic.

You’re probably already asking what, exactly, is the mystery here? Please allow me to explain.

One of the most contested areas of economics has to do with the provision of so-called “public goods”. These are goods (or services) deemed desirable by many but, for whatever reason, cannot be provided naturally by the private sector. Hence the public sector – the government – must step in to provide them instead.

Open up a classic economics textbook and there will be a large section devoted to the topic. And chances are, when it comes to giving specific examples of public goods, lighthouses will be among them.

Why lighthouses? Well, they are clearly useful, essential even, to all who seek to navigate safely around a cape or into a harbour. But how on earth is the lighthouse operator going to charge for the service? There is no toll gate the lighthouse operator is going to shut until the passing ship pays up.

It is this inability to collect revenue that would prohibit anyone from building and operating a lighthouse. Why operate at a guaranteed loss? And so the thinking goes that, if you want to have a lighthouse, the public sector is going to have to provide for it, presumably through taxation.

Sounds reasonable, right? Lighthouses were absolutely essential to navigation and have existed since ancient times. Indeed, the lighthouse at Alexandria was one of the seven wonders of the ancient world.

The conventional wisdom within the economics profession thus has long been that lighthouses must be public goods. In his famous 1848 work Principles of Political Economy, John Stuart Mill wrote that:

It is a proper office of government to build and maintain lighthouses, establish buoys, etc, for the purpose of navigation: for since it is impossible for ships at sea which are benefited by a lighthouse, should be made to pay a toll on occasion of its use, no one would build lighthouses from motives of personal interest.

Ronald Coase, curious fellow that he was, wasn’t convinced. While the conventional wisdom was well established, no actual studies had ever been done. Were lighthouses indeed publicly owned and operated throughout history, or not?

What Coase discovered was fascinating. While there were indeed many historical examples of lighthouses owned and operated by local or national governments, there were as many or more examples of those that were not.

How could this be? How did the private lighthouse operators charge for their services and otherwise cover their costs?

The answer is surprisingly simple. Of course ships need lighthouses to navigate safely. But where are they navigating to and from?

Ports. Ships are always navigating between ports. And lighthouses are thus situated at key locations at, near or otherwise between them.

Port safety has always been a key factor in determining maritime insurance rates, a significant cost. Ships or cargoes sailing to or from a port deemed potentially dangerous cost more to insure. Hence shipping firms work with ports – including paying berthing fees – to improve and maintain port safety.

Here is a photo of a book in my collection. It is an annual edition of Lloyd’s Maritime Atlas. In it, you find lists and tables of every port in the world and the distances between them. This would be a starting point for an actuary to determine the insurance rate for a given ship or cargo moving between ports.

What Coase discovered is that port fees frequently included specific provision for building and maintaining relevant lighthouses. These wouldn’t necessarily belong to the port. They were often independently owned and operated. But there were contracts in place that would pay royalties to the lighthouse operator in exchange for their services.

So there you have it. No government. No taxation. No regulation. No public sector involvement of any kind was necessary to provide for lighthouses. The classic public good of economic textbooks was nothing of the sort.

In closing, Coase writes, “We may conclude that economists should not use the lighthouse as an example of a service that could only be provided by the government.”

What Coase also discovered, however, was that the trend, in Britain at least, was towards centralisation and nationalisation of lighthouse provision. As time went by there were fewer and fewer independent ones.

Why? Coase found evidence that shipping companies and ports placed periodic pressure on government lighthouse agency Trinity House to take over one or more lighthouses because they felt that the fees were exorbitant. If the government were to step in, then they wouldn’t have to step up.

The taxpayer would instead. How convenient.

There are countless other such historical examples of businesses seeking government support or subsidies of some kind. Economists refer to this as “rent-seeking”.

Another Nobel prize-winning economist, James Buchanan, did work on rent-seeking of all kinds and how economically destructive it could be. He was a contemporary and friend of Coase. Indeed, he found Coase’s work on lighthouses a source of inspiration.

One of the things for which Buchanan is best known is for his explanation for why, as a general rule, the public sector tends to operate less efficiently than the private. He discovered that, in the public sector, when a given department or programme runs over budget, rather than find ways to cut costs, they tend to seek more funding instead.

Over time, the more poorly run departments and programmes see the greater increases in funding, whereas those run comparably well, receive less.

In the private sector, by contrast, firms that are run efficiently and generate healthy profits tend to receive more investor funding so that they can expand and grow even more profitable.

Firms that struggle to become profitable may seek additional investor funding, but if they repeatedly fail to turn things around they will eventually have to close up shop.

Hence in the public sector, the funds flow to the inefficient and, in the private, to the efficient. It is thus no wonder why productivity growth tends to be higher in the latter than in the former.

While there are many reasons why investors should be concerned about the new government, its clear bias towards public sector “solutions” for whatever it is they believe ails the country should be among them.

Britain already has a huge public sector. Even record high rates of tax are unable to fund it. The government runs a chronic deficit and Labour have already promised that taxes are going up. The only questions are which taxes and by how much.

It’s not a pretty picture but, as investors, we need to take what actions we can to protect our wealth. This is something I aim to help our members with over at Southbank Wealth Advantage. If you’d like to find out more and join us, you can find out more here.

Until next time,

John Butler
Investment Director, Fortune & Freedom

PS A seismic shift is underway in the economy, but it’s flying under the radar. Only Sam Volkering is raising the alarm. Click here to discover the full story behind the looming “creative destruction” and learn how to position yourself to potentially profit from it.