A Quick Retort for the Coase Theorem

07Feb07

Most anyone involved in a discussion about the economics of commons will run into the Coase Theorem at some point. Often, it is offered as proof that market forces will generate optimal protections for the environment without any need for action by government. If you find yourself in that situation, here is a quick retort to the Coase Theorem.

First, some background: when Coase was awarded the Nobel prize in economics, two works were cited: “The Nature of the Firm” and “The Problem of Social Costs.” Both of them have to do with transaction costs. I can illustrate the idea of transaction costs with one quick example. When you buy a television set, the money you give to the store is the market cost. The time you spend reading Consumer Reports to decide which TV to buy, the time you spend looking at advertisements and websites finding out where you can get the lowest price, the time you spend in showrooms looking at different models, and then (possibly) the time you have to spend trying to get the store or the manufacturer to honor their warranty; all of that constitutes the transaction costs of buying the TV. None of it shows up on your credit card bill as part of the cost of a TV, but it is a very real cost nonetheless.

In “The Nature of the Firm” Coase argued that the primary reason that corporations exist is to hold down transaction costs. Shopping in the marketplace for workers and supplies every time it needs a report made or a unit of product turned out would add huge costs, transaction costs, to the cost of doing business. By locking down workers and supplies into a quasi-permanent bureacracy called a corporation, the enterprise can avoid what would otherwise be an endless drain of market transaction costs, spent on constantly negotiating with vendors for everything.

Some years later, in “The Problem of Social Cost,” Coase said that transaction costs are really the only thing that prevents market forces from doing a perfect job of dealing with the problem of externalities. By way of illustration, he postulated a world where bargaining with other people and reaching mutually-profitable agreements with them could happen instantly and without effort: a world with zero transaction costs. In this world, Coase hypothesized, any problems we inflicted on each other could be resolved through instantaneous, effortlessly-reached private agreements to compensate each other, without any need for government intervention. It’s sort of like the time in grade school science class when the teacher explains that, if it weren’t for gravity, you could throw a baseball to the Moon. The point of the two stories, that of Coase and that of the teacher, is to make you more aware of an omnipresent phenomena that shapes the way the world is. The point is not to suggest that you can really throw a baseball to the Moon.

But when right-wingers bring up “the Coase theorem” that is usually what they’re suggesting. More specifically, they argue that instead of passing or enforcing environmental regulations, we should be trying to re-organize the legal system in such a way that transaction costs will be reduced sufficently to allow private bargaining to handle pollution and externality problems. Sometimes they even skip that step and simply assert that private bargaining can handle the problem right. Period.

And that brings me to the retort. First, you have to remind the speaker that Coasian bargaining can only replace regulation if transaction costs are low. Then you remind them that Coase also pointed to the existence of business corporations as testimony to the current extent and signficance of transaction costs. Then you can bring it home:

“When transaction costs in society have sunk to the point where IBM and Exxon elect to stop functioning as bureacracies, and simply dissolve into seamless webs of discrete, market transactions, at that point I will agree that transaction costs are probably low enough to let us dispense with government environmental regulation. And when that moment comes, I’d like you to hand me that baseball over there, because there’s something I’ve been wanting to try since grade school.”

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