Question: Q3. What is Wrong with the Coase Theorem?
Answer:
"we can treat property rights, such as the ownership of a car as being identical to property rights not to have your property damaged by an accidental externality."
This assumption is a highly flawed one.
The negotiation of the terms of a private transaction typically take place prior to the transaction. You want to buy my car. We negotiate and find a price at which we both mutually benefit from the transaction. Then I sign the car over to you.
Payments arising from externalities, on the other hand, are more likely to be negotiated ex post. My rock band holds loud afternoon practices in my garage. Unfortunately you work a job at night and typically sleep at night. My afternoon practices cause you to lack sleep which lead to your poor performance at your job and ultimately to your dismissal.
You seek compensation from me. You tell me that my loud practices cost you your job and you lost $50,000 in wages. I say that the volume of the music at my practices were kept below the maximum sounds levels dictated in the city by-laws and that if you were fired, it was due to your lack of talent.
This is clearly different than the "buying a car" scenario, for a number of reasons:
(a) The negotiation in the car example was ex ante, but the negotiation in my music example is ex post.
(b) Related to (a) - In the car example, you had an incentive to pay me - if you didn't, you wouldn't get the car. In this example I already received the opportunity to play loud music. Even if I privately agree with you that I caused you damages, what incentive (other than my own conscience) do I have to pay you one cent?
(c) The cost of my loud playing is quite uncertain. I say it is $0, you say it is $50,000. How do we accurately put a dollar figure on the damages?
(d) You could sue me in a civil case, but that would be very expensive for you and face a very uncertain outcome due to the uncertainty of what I truly cost you. Now you could argue that in the first example, you could have just stolen the car instead of pay me. But in that case, the issue would be a criminal one and the enforcement costs would be largely paid by the state and not by me.
Due to the ex post nature of externalities, due to the problem of assigning a dollar value to the cost (or benefit) of an externality and due to the much higher enforcement costs (to the individuals) of civil rather than criminal cases, it is clear that externalities are a much different beasts than private economic transactions - and should be treated as such.
Coming Soon: The Coase Theorem Is Based On Absurd Assumptions.
It Treats Externalities The Same As Non-Externalities - But They Are Not
The Coase Theorem is often used in textbooks and by economic conservatives to describe why centralized intervention is unnecessary - that the free market will ensure that, even in the presence of externalities, that social welfare will still be maximized (so long as the Coase assumptions are satisfied). See here for a fairly standard treatment. In What is wrong with the Coase Theorem: Part 1 I suggested this description of the Coase theorem assumes that:"we can treat property rights, such as the ownership of a car as being identical to property rights not to have your property damaged by an accidental externality."
This assumption is a highly flawed one.
The negotiation of the terms of a private transaction typically take place prior to the transaction. You want to buy my car. We negotiate and find a price at which we both mutually benefit from the transaction. Then I sign the car over to you.
Payments arising from externalities, on the other hand, are more likely to be negotiated ex post. My rock band holds loud afternoon practices in my garage. Unfortunately you work a job at night and typically sleep at night. My afternoon practices cause you to lack sleep which lead to your poor performance at your job and ultimately to your dismissal.
You seek compensation from me. You tell me that my loud practices cost you your job and you lost $50,000 in wages. I say that the volume of the music at my practices were kept below the maximum sounds levels dictated in the city by-laws and that if you were fired, it was due to your lack of talent.
This is clearly different than the "buying a car" scenario, for a number of reasons:
(a) The negotiation in the car example was ex ante, but the negotiation in my music example is ex post.
(b) Related to (a) - In the car example, you had an incentive to pay me - if you didn't, you wouldn't get the car. In this example I already received the opportunity to play loud music. Even if I privately agree with you that I caused you damages, what incentive (other than my own conscience) do I have to pay you one cent?
(c) The cost of my loud playing is quite uncertain. I say it is $0, you say it is $50,000. How do we accurately put a dollar figure on the damages?
(d) You could sue me in a civil case, but that would be very expensive for you and face a very uncertain outcome due to the uncertainty of what I truly cost you. Now you could argue that in the first example, you could have just stolen the car instead of pay me. But in that case, the issue would be a criminal one and the enforcement costs would be largely paid by the state and not by me.
Due to the ex post nature of externalities, due to the problem of assigning a dollar value to the cost (or benefit) of an externality and due to the much higher enforcement costs (to the individuals) of civil rather than criminal cases, it is clear that externalities are a much different beasts than private economic transactions - and should be treated as such.
Coming Soon: The Coase Theorem Is Based On Absurd Assumptions.