Frank on Coase

quotes economics transaction costs externalities

23 Apr 2014

Robert Frank on Coase:

Coase’s famous example in the “Federal Communications Commission” article published in 1959 involved a doctor and a confectioner, a candy-maker. The confectioner was first on the scene. He had machinery that made candy in his orders. The doctor opened an office in the same building. They co-existed without incident for many years. Then the doctor built a new examination room adjacent to the candy maker’s machinery, and he found that the vibrations and noise prevented him from doing his work properly. And so he sought a court injunction trying to prevent the confectioner from making the noise that was interfering with his work. And in fact he prevailed in the court decision. Coase said: Wait a minute; where did the presumption come from that the doctor has the right to a noise-free environment? It does seem that the confectioner is harming the doctor; that’s clear enough. But what if we tell the confectioner, no, you can’t do what you are doing? Then we’re harming him. So, no matter whether you turn left or you turn right in a case like that you are going to cause harm. Coase’s insight, and I think it’s the real, enduring insight he had, was that it’s in the interests of both parties, the doctor and the confectioner, to solve this mutual problem that they have, namely that their two activities aren’t compatible fully with one another, to solve that problem in the least costly way. Any other way of proceeding would leave open the possibility of making both parties better off. So, who is the guilty party? That’s the wrong question to ask. The question is how can this problem be solved in the cheapest way? And there, Coase saw that the law made no difference if they could talk to each other. And that’s what I think the people who don’t like government regulation in general saw as an idea to celebrate: Look, if the doctor could talk to the confectioner then they could reach an agreement even if the confectioner were not held liable for the noise damage. If it were cheaper for the confectioner to solve the problem, say by putting sound-proofing on his machine, than it would be for the doctor to move to a new location, if that were the best option for him, then the doctor could pay the confectioner to install the sound-proofing. If it were cheaper for the doctor to move, then the doctor could move. So without any attempt for the government to get involved, the problem would be resolved efficiently–that is to say, the cheapest solution would be adopted by the two parties.

So, Coase was very clear in his piece, and if you read the broader context of his earlier work it’s even more clear, that he did not believe that in general people could reach easy solutions through private negotiation about such problems. His very first work conducted when he was a young man on a visit to the United States from England was a detailed study of why we have firms in the first place. Why don’t we just do everything through individual contracts in the spot market? It’s because all the contracts you’d have to write would be so cumbersome to negotiate that it’s just much cheaper to have a firm organize them all internally and then give you a final product that you can buy. So he saw that negotiation was very impractical much of the time. And he sought to understand institutions, laws, social norms, all manner of institutional arrangements as attempts to economize on negotiation costs, making negotiation unnecessary. And what that means here is if you are thinking about how to define rights, who should have the right, the doctor to a quiet environment or the confectioner to make noise as he pleases? Well, you’ve just got to see what agreement they would have reached if they had been free to negotiate with one another, and then have the law try to set up property rights so as to steer them to that agreement. So in this interesting example that he offered, if it had been cheaper for the doctor to move and they can’t negotiate, then having the confectioner not be liable for noise damage results in the efficient solution–the doctor would have every incentive just to move on his own and that’s the cheapest solution. If the cheaper solution were for the confectioner to install soundproofing, however, then you would want to have the law say he’s liable for damages because now it’s not practical for the two to negotiate; the doctor can’t bribe him to install soundproofing and he’d had to move as the best solution available to him. If the law makes the doctor [confectioner?–Econlib Ed.] liable for noise damage then he will install the soundproofing because it’s cheaper to do that than to pay the damage that the noise would cost. So that’s the Coase insight, I think in its simplest and most general form. Laws and regulations, property rights, all such things should be designed in such a way to mimic the agreements that free people would have reached in their own interest had negotiation been practical.

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