Argument against the Coase Theorem

[Bones]

I know that a lot of economists have issues with the "Coase Theorem" either because it has unrealistic assumptions or is ambiguous, but I do not think I've seen this argument against it yet. I'd like to know what you think.

Background

From Wikipedia, of course:

“
In law and economics, the Coase theorem, attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that when trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasian bargaining.
...

For example, two property owners own land on a mountain-side. Property Owner #1's land is upstream from Owner #2 and there is significant, damaging run-off from Owner #1's land to Owner #2's land. Four scenarios are considered:
1. If a cause of action exists (i.e. #2 could sue #1 for damages and win) and the property damage equals $100 while the cost of building a wall to stop the run-off equals $50, the wall will probably exist. Owner #1 will build the wall, or pay Owner #2 between $1 and $50 to tolerate the run-off.
2. If a cause of action exists and the damage equals $50 while the cost of a wall is $100, the wall will not exist. Owner #2 may sue, win the case and the court will order Owner #1 to pay #2 $50. This is cheaper than actually building the wall. Courts rarely order persons to do or not do actions: they prefer monetary awards.
3. If a cause of action does not exist, and the damage equals $100 while the cost of the wall equals $50, the wall will exist. Even though #2 cannot win the lawsuit, he or she will still pay #1 some amount between $51 and $99 to build the wall.
4. If a cause of action does not exist, and the damage equals $50 while the wall will cost $100, the wall will not exist. #2 cannot win the lawsuit and the economic realities of trying to get the wall built are prohibitive.
”

I am making the argument that example 3 is not necessarily true, and bargaining under the Coase theorem may not lead to the most efficient outcome.
In example 3, if you assume:

1. Owner #1 has a neighbor, #3, who has the ability to cause run-off that would not be stopped by the wall that may be built to stop #1’s runoff.

2. If Owner #3 causes runoff it would result in the same $100 worth of damage to #2

3. The cost of building a wall to prevent #3’s potential runoff is $51.

Then if #2 knows that #3 may decide to utilize the ability to cause runoff and decides not to build a wall, however, #3 does not utilize the ability to cause runoff, then $100 worth of damage will be caused that could have been prevented at a cost of $50.

On the other hand, if #2 builds a wall to prevent runoff from #1, then #3 utilizes its ability to cause runoff, #2 will build an additional $51 wall to prevent the $100 runoff. In this case, you would have $101 worth of wall to prevent $100 worth of runoff.

I’m thinking that this may be beyond the scope of the “Coase Theorem.”

[vertigo]

This is not a topic I know much about but I wonder if the whole issue is too vague to be meaningful. I mean, the theorem says that an efficient outcome will ALWAYS come about, but I here I give counterexamples:

A: there is benefit to causing run-off for neighbour #1. Now neighbour #2 must pay #1 the difference, plus some profit. Only if #2's gain plus incentivizing profit plus wall cost is cheap enough will the wall be built. In fact, #1 can now refuse to build a wall on principle, preferring monthly installments to avoiding run-off.

B: causing run-off or not is cost-neutral for neighbour #1. There is an economic case for him to cause run-off anyway, to charge #1 for the service of avoiding run-off.

So I don't know what is meant by "efficient outcome". The outcome can only be seen to be efficient from the point of view of neighbour #1, insofar as run-off is economically useful, and if leveraged can derive profit.

I am making the argument that example 3 is not necessarily true, and bargaining under the Coase theorem may not lead to the most efficient outcome.

On the one hand, one could count the damage twice because there are two sources of run-off and building a wall can only counter one source. Each wall is preventing $100 of damage, so $200 of damage is being prevented by the two walls.

On the other hand, building only one wall adds no protection. It is only the second wall that protects against run-off. So the first wall is preventing no damage whatsoever; only $100 of damage is being prevented by both walls.

The second analysis seems more sensible. One should view both walls together as one remedy and add up the costs.

If, after the first wall is built, #3 starts producing run-off, there is damage being done anew and the situation can be viewed on its own as another instance of the same problem, that $100 damage is being caused and a wall is needed. But clearly there is interaction between the two cases because the previous wall has been neutralized, and whatever it cost has now been lost. So I think more than $100 dollars damage has been done by this second neighbour. It is now worth more than $100 dollars to neighbour #2 to build the next wall because he already has the other wall. Building the second wall is an easier decision.

But if both produce run-off simultaneously then building two walls is one remedy and the costs will be added and weighed against the $100 dollars. So it may happen that building two walls is not worthwhile but building a second is, for the same damage amount.

On the other hand, the court system may not agree that the damage is the same; it is perhaps different damage to the same value and the original wall is still preventing the run-off it was intended to prevent. It has therefore not been neutralized, it is effective (but not economically effective). This is a political matter though, although relevant.

[Bones]

I think that I overlooked a basic point in analyzing whether or not this example contradicts the Coase Theorem: If cause of action did exist, would the two possible outcomes be as likely?

So, the situation would be the same as in example 1, except with the additional three assumptions I added.

In this case #1 would pay to build a wall worth $50 to prevent causing damages and being sued for $100, assuming runoff was unavoidable. Now, if #3 decides to cause a runoff, he will also build a wall, while if he does not decide to cause a runoff, there will, of course, be no second wall. This is the same result as if #2 decides to build a wall at first:

“On the other hand, if #2 builds a wall to prevent runoff from #1, then #3 utilizes its ability to cause runoff, #2 will build an additional $51 dollar wall to prevent the $100 runoff.”

However, I do not see how it is likely that no wall would exist:

“Then if #2 knows that #3 may decide to utilize the ability to cause runoff and decides not to build a wall...”

So, if this is the case, since the outcome without the cause to action, no wall, differs from the outcome with a cause to action, a wall, the Coase theorem does not hold.

An additional assumption, that I may have needed to add would be: There is only $100 worth of damage possible, and all $100 damage would result when any runoff hit #2's property.

I think that efficiency is not so much about the money, but whether or not the walls exist.

[vertigo]

Oh, so the theorem is saying that suing for damages, if free and efficient, would suffice to force the aggressor to pay for the wall to be built. The free and efficient court system would perfectly transport the cost of the run-off to the creator of the run-off, a feedback loop that would prevent damage.

But courts are costly and inefficient, so it applies only for the insanely rich.

[Bones]

Yeah, the assumption transaction costs do not exist is what that so many economists find so unrealistic. With regards to this, even Coase stated, "It would not seem worthwhile to spend much time investigating the properties of such a world. What my argument does suggest is the need to introduce positive transaction costs explicitly into economic analysis so that we can study the world that exists."

Of course, a person who has his right to grow a tomato plant on his property and does, but then subsequently has the plant destroyed by the pollution from a neighboring power plant, will not make the rational decision to pay the court costs to sue the power plant for the loss of value of the tomato plant in real life. But in the world under the Coase theorem, the tomato plant owner would instantaneously receive the value of the tomato plant from the corporation without any effort whatsoever. Despite the ridiculousness of this assumption, it does not negate the theorem. However, in my example, perhaps you could include the fact that the one person doesn't know what the third party is going to do as a transaction cost of information that cannot exist in the Coase theorem. However, if that is the case then the theorem may simply be: if A is more valuable than B, then A is more valuable than B. And I would not think that any economist would think that that theorem adds much value at all.

Anyway, I found this paper that discusses other situations where the existence of third parties may undermine the theorem if you are interested http://www.springerlink.com/content/v34 ... lltext.pdf.

[vertigo]

Nah, it's okay. Economics is not my thing. I can't follow your argument. When there is not a cause for action there is not a wall, isn't that just what Coase says?

[Bones]

No, I don't think so, but that's cool. Thanks for following as long as you could.

[Hierophant]

Seems to me like the argument as presented is irrelevant to real life. In real life, force enters the picture. It can cost less for a big corporation to finance this or that political bid, and get a law passed or favors pulled, than for them to clean a river they've polluted. It also ignores the need to "keep face" and keep away from any legal responsibilities.

[Bones]

Yeah, I agree that my argument is irrelevant to real life, since it is against the Coase theorem that has assumptions that do not exist in real life. However, I think that the argument is relevant against the Coase theorem. But I guess that my argument would be mute to anyone who already deems the Coase theorem irrelevant. I guess I'm looking for any "David Friedman's" here to argue with.

[Bones]

I think I meant "moot" not "mute."

[Veritas]

1. Its a Tautology.

2. Enforcement of property rights brings cost, and sometimes these costs can be huge.