Coase Theory Works
- Posted by Jeff Carter
- on October 10th, 2012
Ronald Coase proposed a controversial theory back in the late 1950′s. A group of Chicago economics professors discounted it at first. As is typical at the university, they tore into the theory. They ripped it apart. However, Friedman and the Chicago Boys came around and embraced the theory. Coase won the Nobel Prize for Economics.
Here is the essence of Coase:
“The Coase Theorem holds that, regardless of the initial allocation of property rights and choice of remedial protection, the market will determine ultimate allocations of legal entitlements, based on their relative value to different parties.”
That short statement has massive implications. Many refuse to believe it. But, in the real world, we see that behavior does follow the Coase dictums. Time and time again, we see practical evidence of Coase. Yet, few really internalize and believe it.
Here is an academic representation of Coase taken from this source:
Economists before Coase of virtually all political persuasions had accepted British economist Arthur Pigou’s idea that if, say, a cattle rancher’s cows destroy his neighboring farmer’s crops, the government should stop the rancher from letting his cattle roam free or should at least tax him for doing so. Otherwise, believed economists, the cattle would continue to destroy crops because the rancher would have no incentive to stop them.
But Coase challenged the accepted view. He pointed out that if the rancher had no legal liability for destroying the farmer’s crops, and if transaction costs were zero, the farmer could come to a mutually beneficial agreement with the rancher under which the farmer paid the rancher to cut back on his herd of cattle. This would happen, argued Coase, if the damage from additional cattle exceeded the rancher’s net returns on these cattle. If, for example, the rancher’s net return on a steer was two dollars, then the rancher would accept some amount over two dollars to give up the additional steer. If the steer was doing three dollars’ worth of harm to the crops, then the farmer would be willing to pay the rancher up to three dollars to get rid of the steer. A mutually beneficial bargain would be struck.
Coase considered what would happen if the courts made the rancher liable for the damage caused by his steers. Economists had thought that the number of steers raised by the rancher would be affected. But Coase showed that the only thing affected would be the wealth of the rancher and the farmer; the number of cattle and the amount of crop damage, he showed, would be the same. In the above example, the farmer would insist that the rancher pay at least three dollars for the right to have the extra steer roaming free. But because the extra steer was worth only two dollars to the rancher, he would be willing to pay only up to two dollars. Therefore, the steer would not be raised, the same outcome as when the rancher was not liable.
This insight was stunning. It meant that the case for government intervention was weaker than economists had thought.
Let me repeat, “The case for government intervention was weaker”. Let that sink in.
It’s not just America, it’s human behavior everywhere. Iceland was in a world of hurt in 2008. The financial crisis just about ruined them. Instead of bailing out their banks, and propping up companies, they let them go under. It looked grim. Today’s WSJ has an article that says:
But in the past couple of years, Iceland has staged a recovery of a sort. Unemployment is down to nearly 5%, although work-force participation isn’t what it was in the boom years, and there’s been some emigration from the population of 320,000. After shrinking 6.6% in 2009 and 4% in 2010, Iceland’s economy grew 2.6% last year and could hit 3% this year.
The rebound is in no small part thanks to the business that has been the island’s mainstay for a millennium—fishing. Fish account for more than 40% of Iceland’s total exports.
Of course, a new left wing government decided to fight the real world benefits of following Coase theorem and you can guess the outcome. Instead of trying to increase efficiency, production, and raise the standards of living for all Icelanders, they are pointlessly arguing about how to divide the pie. Instead of creating a bigger pie, they are eating the pie that’s there and nothing will be left to fight over except the crumbs. Shouldn’t we try to create more pies? Bigger pies? This should remind you of other debates we are having in the US today.
Coase extends to everything. All the major issues of our time can be solved correctly if we apply Coaseian principles and stop worrying about who gets what, or who has what. Instead of lecturing about transfers of wealth, wouldn’t it be better to enact policies that allowed for more creation of wealth?
thanks for the link Daily Crux.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
Jeffrey Carter is an angel investor and independent trader. He specializes in turning concepts into profits. He co-founded Hyde Park Angels one of the most active angel groups in the United States in April of 2007. He previously served on the Chicago Mercantile Exchange Board of Directors. He has done market commentary for (More...)
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