Thursday, August 19, 2010

The silliness of the Coase Theorem

Easily the most famous result in law and economics, the Coase Theorem states that whenever an externality is possible and there are no transaction costs, two parties will bargain themselves to an efficient solution regardless of the initial assignment of property rights. In Coase's original example, a cattle-raiser's herd damages the crops of a nearby farmer, and Coase argues that even if the farmer has no legal right against damage from his neighbor's cattle, the two will arrive at the same efficient outcome that would have occurred in a world with farmer rights (albeit perhaps with a different distribution of wealth).

In a narrow sense, the Coase Theorem is correct. If the parties are bargaining about a single, static externality, the outcome will be "efficient" regardless of initial property rights (assuming that we exclude distributive concerns from our definition of efficiency). But this completely ignores the impact on incentives to create an externality.

Suppose that we inhabited a world where farmers had no property rights against encroachment by cattle. In this world, the first thing I'd do is start a company (preferably with an nefarious-sounding name like Multinational United) that raised cattle specially bred to ravage cropland. I would locate these cattle near a large number of farmers and announce that each they had to pay me $100,000 to avoid being overrun by the herd. For most farmers, this would be worthwhile, and I'd make a bundle of money.

Of course, this would be inefficient: if any farmers didn't find it worthwhile to pay the $100,000, their farms would be destroyed. And even if we assumed that evil Matt had perfect information and could charge a special rate to each farmer to make sure that it was worthwhile for everyone to pay, this would be inefficient in a different way. Payments that varied according to ability to pay would effectively be a tax on productive assets, which in the long run would discourage the accumulation of those assets.

After I set up a lucrative business exploiting farmers, I would retire by moving into dense residential neighborhoods, buying houses, and blaring extremely loud music at different corners of each house until I was paid compensation by the nearest homeowner. Again, this would be monstrously inefficient. If I committed to charging $50,000 a year to everyone, some people might not be able to pay, and would be forced to suffer the hearing damage and general psychological trauma that comes from listening to my music. If I charged different rates according to accumulated wealth and income (making it so that everyone could pay), I'd be creating a large implicit tax on wealth and income. Either way, this is far from the efficient utopia envisioned by Coase—and it can all happen in a world without transaction costs!

If there was ever a case where you had to wonder whether some economists were actually confused impostors from the planet WZ-15, this would be it...


Tord Steiro said...

I have always thought that the Coase theorem hold little water as it will always be costly to bargain the settlements, but I have never reflected about the effect on incentives.

I now wanted to conclude with something really smart on the Coase theorem in relation to rent-seeking and rent-creation, but, it seems, unfortunately I am not smart enough...

Darf Ferrara said...

I think at best you are being ungenerous with Coase. At the time it was published it was thought that Pigou was the last word on welfare economics. Coase showed that there was another way to look at the problem. It isn't the last word on the subject, but it is an impressive start.

And while you can construct examples where property rights lead to inefficient outcomes, Elinor Ostram earned a Nobel last year for finding examples where (essentially) Coasian bargaining takes place. It doesn't work everywhere, but finding when and where it will work is an important part of Econ/Law, and also the theory of the firm.

Pedro Linares said...

Matt, I think you are forcing the case. The examples you describe are called extortion, and are therefore punishable. Of course you might have the incentive to carry out this activities under the Coase theorem, and also without it. But hopefully the legal system will stop you from doing so. The Coase theorem is still valid, in my view, for addressing non-illegal activities.

Tord Steiro said...

@ Pedro:
The point I did not manage to make was; 'who defines what is legal, and how?' and, further, on what kind of system could the Coase theorem lead to effective outcomes?

Or, perhaps, more important, under which conditions will the Coase theorem lead to highly ineffective outcomes? Which I believe is what Matt was talking about in the first place.

This is perhaps not very important to people in their everyday lives, but it is interesting to explore where the Coase theorem may get us if we, for - say - ideological reasons, decide that it is the only right way of doing things.

My idea was that the principles would be abused by elites in order to boost rent-seeking in any non-democratic regimes. In democracies, however, this is more difficult, but as long as you can use (or abuse) the Coase theorem to justify compensation one way or the other, it can also be (ab)used to defend elite rent-seeking in democracies.

So yes, the Coase theorem is valid under certain assumptions, and one of these assumptions should be the nature of the legal system and local power structures - something economists rarely bother to take notice of.

The last part here is what I never thought about before, so thanks to Matt for spelling it out.

(And I am probably not yet smart enough to be clear, no?)

Matt Rognlie said...

Darf Ferrara:

I shouldn't say that Coase's result is meaningless -- interpreted in the right light, it does offer a useful starting point to further analyses of contracting and efficiency. One modern interpretation is that it is an illustration of the importance of transaction costs and incomplete contracting; the Coase theorem tells us that if transaction costs were zero, we would live in the best of all possible worlds. Since we don't, there must be something wrong with the assumption, and we should focus our research there. (I'm told this was actually Coase's stated view on the topic in his 1990 Nobel lecture. George Stigler muddied the waters for many years, however, by preaching the Coase Theorem as if its assumptions were clearly true.)

Pedro Linares:

I think Tord Steiro summarizes my thoughts in this case very well: my exaggerated example would probably be classified as illegal extortion, but in general it's unclear where "extortion" ends and legitimate Coaseian bargaining begins. Suppose that I was an actual cattle rancher whose herds happened to frequently stray into other fields. If I had the property rights in this example (i.e. the right to have my cattle wander wherever they wanted in the absence of a contract), the transfer payments from the farmer to me that would be necessary to induce me to keep my cattle within a fence (assuming it was profitable for me to allow them to roam) might be very high, even if that was the social optimum. Thus I could extract massive amounts of the value from a farmer's physical capital, simply by locating my cattle ranching operations nearby. Yet if this counts as extortion, tons of other Coaseian outcomes would also count as extortion.

(As a much more knowledgeable 5th year grad student pointed out to me, the inefficiency here -- an attenuated incentive to invest in capital because I might come by and extract all your surplus later -- is really a result of incomplete contracting, because if we all got together at the beginning of time and signed a complete contract specifying our future actions in every contingency, the Coase Theorem would get us to the efficient outcome. But the fact that it's necessary for everyone to get together at the beginning of time and write a contract that covers every imaginable contingency for the Coase Theorem to really work says a lot about the practical failings of the Coase Theorem.)

Darf Ferrara said...

Matt, you're post inspired me to take another look at Coase as it relates to your examples. In the first example you assume that the farmers had no property rights. If you are to apply Coase, then it appears that you are assuming that Multinational United has property rights to all the land. Coase says that MU will use the land in a way that is efficient. This would likely involve some ranching. In the second example you are assuming that you (that is, MU) have ownership (essentially) of the right to make noise on another persons property. Again, is that the most efficient use that MU can make of the ownership of sound over that property? In both cases, the problem isn't too much property rights, it is that property rights are not well defined.

A couple of other points: When Coase refers to efficiency, it is Pareto optimal. Different property rights allocations lead to different distributions, but social welfare is maximized given the new distribution. This might be an argument for rethinking whether or not Pareto is the ideal to strive for, but it doesn't negate Coase.

A second point is that Coase applies to goods that are produced with positive externalities (the common example is Beekeepers and Orchard owners). Pigou wouldn't help in this case.

I've learned this (and plagiarized some) from Steven Landsburgs Price Theory book. If you can get ahold of it you should read it. It has more examples and applications.

Anonymous said...

In fact, although you examples sounds very "inefficient", it is not. The efficiency concerns how much the society as a whole get. So if you can get compensated without incurring other costs, it is efficient. It is just not fair...
And, if, for example, you are going to play loud music and requires a higher amount of money than your neighbors can pay, then it should mean that you are earning more utility from the music than the neighbors are suffering from it. Otherwise you are not rational- then you are not the kind of person that economics is studying...

if you just blackmail them, and they pay you...then it's just a redistribution of wealth- which is not about efficiency at all..IT IS UNMORAL, BUT IS NOT INEFFICIENT.

Those models in economics are very abstract and are under some "unrealistic" assumptions...But they are a good abstraction after all..

Rick Eaton said...

Hello. Always loved econ. No advanced classes but seemed to really suck it up as a business school graduate. Rick is the name from IN and I own (whatever that means !) riparian land and am concerned about water pollution and the affects of man-made drainage.

I believe Coase shoots down his entire argument when he admits that each individual has different values. How can you maximize the value of the total product? I interact with individuals not society. I've never meet society.

I want the stream on my land very close to pristine. Let's bargain. Say you want to dump one bucket of poop in the stream. OK...I'll let you do for a price of one billion dollars. If it's about markets do I not have the option of not accepting offers?

I admit my bias toward property rights. How can markets exist without them?

Also I find the cows v. crops example silly. It assumes both parties agree on the relative values of cows and crops. My individual values may have nothing to do with market values.

What if having, say, 10% of the population in slavery maximizes the value of the total product? Would it be selfish for you to not submit to being a slave?

Thanks for a great place to discus
this famous paper.

YM said...

Two points (that are not unrelated).

(1) You speak of the "efficient utopia envisioned by Coase". As Ronald Coase himself has stated, "The world of zero transaction costs has often been described as a Coasian world. Nothing could be further from the truth."

See for example this paper:

(2) Also, in constructing your examples, you have implicitly appealed to transaction costs.

In a "Coasian" world (of zero transaction costs), homeowners own not only a piece of land and a house, but also the right to be free from someone doing what you have described (i.e. blaring loud music at them).

So it appears you may not be correct in saying that "it can all happen in a world without transaction costs". In such a world, we would indeed be in an efficient utopia.

The point that Coase wanted to make was that there are very real and large transaction costs in the real world; so let us study the real world with positive transaction costs, rather than dwell on this efficient utopia.

E.g. as stated in his Nobel lecture:

"This is the infamous Coase Theorem, named and formulated by Stigler, although it is based on work of mine. Stigler argues that the Coase Theorem follows from the standard assumptions of economic theory. Its logic cannot be questioned, only its
domain. I do not disagree with Stigler. However, I tend to regard the Coase Theorem as a stepping stone on the way to an
analysis of an economy with positive transaction costs. The significance to me of the Coase Theorem is that it undermines
the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem
demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My
conclusion; let us study the world of positive transaction costs."