Last year on my old blog, I stirred some controversy with a flippant post on the Coase Theorem. The Coase Theorem states that even in the presence of externalities, the market will reach an efficient solution as long as it’s possible to trade those externalities without transaction costs. Supposedly, this happens regardless of the initial assignment of property rights: it doesn’t matter whether the law gives me the right to peace and quiet, or my neighbor the right to play obnoxious music all day long. As long as we can write a contract about it, we’ll reach the efficient outcome.
This raises some natural questions, as I mentioned in the original post:
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.
These sound like very distorted incentives! How does the Coase Theorem get away with claiming that we’ll reach the “efficient” outcome? (Incidentally, cattle herds were the example in Coase’s original article, The Problem of Social Cost.)
That’s because the Coase Theorem would say that all the farmers, before spending time or money building up the capital in their farms, would have signed contracts with me where I pledged (in exchange for side payments) not to bother them with mutant, crop-destroying cattle.
Of course, there’s still an inefficiency: since I get side payments in exchange for the pledge not to bother people with mutant cattle, I have an incentive to undertake costly investments in socially worthless technologies that threaten cropland (which are necessary to make my threat credible in the first place). How does the Coase Theorem resolve this? Well, I have to sign a contract with every farmer in the world before I spend any time breeding mutant cattle, where I pledge to refrain from developing the technology in the first place (in exchange for further side payments, of course).
But to be in a position to pull off this deal, I have to be a smartass who is able to credibly threaten that he will a develop new technology with the potential to destroy farms across the world. My parents (who will benefit from any wealth I receive) are now inefficiently incentivized to raise a smartass who offers no value to society. The Coase Theorem requires that they sign a contact with farmers across the world while I’m still a baby, pledging to raise a normal human being in exchange for side payments. Of course, this creates an (inefficient) incentive to make a baby who shows even the potential to become an evil rent-seeking mastermind. And so on…
The Coase Theorem is only really “true” in one setting: at the beginning of the universe, everyone who will ever exist gets together and writes a contract that covers every contingency that will ever conceivably occur.
In any other situation, where we negotiate Coasian contracts after economic decisions have already been made, anticipation of the fact that your returns will be bargained away in future contracts makes you less willing to undertake investments in the first place. That’s inefficient. And the Coase Theorem offers no way around it.
Edit: As a link to this post points out, Coase himself might have agreed with the sentiment here: he viewed his result as a consciousness-raising device to emphasize the centrality of transactions costs and noncontractibility, not as some kind of proof that Pigouvian remedies are never necessary. He said as much in his 1990 Nobel lecture: “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.” Unfortunately, I think that the spirit of Coase’s interpretation is often forgotten, and the theorem is taken to imply much more than it can legitimately offer.