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The Coase Theorem

    As a colleague once said to me, “There’s a good reason why Coase called his article ‘The Problem of Social Cost’.” The reason is that, as Coase realized, there are no easy answers to instances where individuals impose costs on each other.

    The Coase Theorem (a term coined by George Stigler) is simply the idea that when parties can make deals with one another easily, then externalities can be bargained away. The extent to which parties can bargain with each other is determined by what economists call transaction costs. Transaction costs are the costs of making an economic exchange: these are the costs associated with finding people with whom to bargain, coming to an agreement, and enforcing that agreement. Many people have criticised Coase on the basis that the real world has high transaction costs, meaning that the Coase Theorem is not relevant.

    The irony is that this was Coase’s point all along. Coase’s seminal article ‘The Nature of the Firm’ argues that the reason we have firms is to get over the problem of transaction costs. In making the point that when transaction costs are low, parties can bargain to an efficient outcome, Coase was criticising economists who fail to think carefully about transaction costs. His argument was that many economists who advocate Pigovian taxes (taxes on a polluter) assume that there are no transaction costs; however, if that were the case, then there should be no need for government intervention in the first place.

    What do we do in the world of transaction costs, that is, the world we live in? This is where things get rather difficult. Coase recognized that costs are reciprocal, meaning that while A may impose costs on B, B’s attempt to restrain A’s activity also imposes costs on A. What we really want to know is which party can avoid the problem at the lowest cost. (The other way of expressing this is that the party who most values the right to do something should have that right.) Let us imagine a dispute about noise between an airport and the local residents. Due to transaction costs, it is very unlikely that any efficient bargains can be made between the two sides. However, it is almost certainly the case that by installing double-glazing, homeowners can avoid the problem of noise at a lower cost than the airport can. This means that to reach the solution where the problem of noise is avoided at the lowest cost, the airport should have the entitlement to make noise. This will mean that homeowners will then go ahead and install double-glazing; the problem has been avoided in the cheapest way possible.

    In this instance, a Pigovian tax on the airport is likely to make the situation much worse from an efficiency point of view. In order to bring noise levels down to a similar level as that achieved by installing double-glazing, a large tax would have to be levied on the airport. Many fewer planes would fly, but this solution would come at a great cost. Pigovian taxes only increase efficiency if they are levied on the party that can avoid the problem at the least cost.

    To illustrate, we can imagine another situation where a tyre factory is emitting some smoke that drifts over to a nearby village. At the moment, the factory has the right to pollute. One of the chemicals within the smoke reacts badly with dyes found in clothes, discolouring any washing that is left out. Again, because of transaction costs, no efficient bargain can be reached. However, if the factory were to install a scrubber at the cost of £100 on to their smoke chimney, it would eliminate the discolouring chemical. The factory is clearly the least cost avoider. In this instance, a Pigovian tax on the factory would produce an efficient outcome, as long as it amounted to more than £100. Rather than pay the tax, the factory will install the scrubber. The problem will have been avoided at the lowest cost possible. Both these examples show that who is to ‘blame’ for the existence of a social cost is simply not relevant to an efficient solution to the problem. It is this concern with blame that has led Pigovian solutions astray.

    This means that the mere existence of an externality implies very little about what the government should do. The efficient response to an externality is an empirical matter. In both of the previous examples, the party that can avoid the problem at the lowest cost is obvious. The real world, however, is not nearly as straightforward. For a start, which party can avoid a problem at the least cost is dependent on the technology available at the time. As technology changes, the lowest cost solution may also change. It is also the case that the parties involved may not even know which of them can avoid the problem most easily. It may only be when they start experimenting with different production techniques that they discover potential solutions. This poses a serious problem for the policymaker hoping to reach an efficient outcome.

    Coase is extremely wary of what he calls ‘blackboard economics’, where economists compare the existing distribution of goods with some theoretical optimal. He comments on the use of Pigovian methods: “The Pigovian analysis shows us that it is possible to conceive of better worlds than the one in which we live. But the problem is to devise practical arrangements which will correct defects in one part of the system without causing more serious harms in other parts”. When it comes to dealing with social costs, Coase argues that there are no easy answers. Policymakers need to spend a great deal of time looking at how firms and governments can really deal with harmful effects. Great time and consideration should be taken to chose the least harmful solution.

    As Deirdre McCloskey robustly comments, "Life is hard. Knowledge is scarce. Grow up and admit you can't extract policy from a couple of lines on a blackboard".

    James Hill is a PhD student at King's College London. He is researching the question of whether inequality is an externality that should be removed by government.

    James is a PhD student at King's College London. He is researching the question of whether inequality is an externality that should be removed by government.

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