Other people haveexpressedgeneraldisagreements with this post. I find it hard to comment on those since I’m not sure how to interpret the post in the first place. I understand what it’s saying paragraph by paragraph, but I can’t mentally integrate all of it into a set of conclusions that’s nontrivial, accurate, and doesn’t rely on defining connotatively loaded terms like “efficiency” in an unusual way.
Instead, I’m going to take issue with one specific part of the post, the discussion of Coase’s explanation of externalities. From the post:
Coase pointed out that what explained why these exchanges weren’t happening must be to do with some set of costs which prevent exchanges from happening. He called those costs “transaction costs.”
Essentially, the mystery is why people don’t use the price system to internalize externalities. For example, suppose Abe builds a factory next to Barry’s house. On the margin Abe benefits $5, and the pollution from his factory costs Barry $10.
The solution to this is obvious. Barry will pay Abe any amount of money from $5 to $10 to not pollute. Abe will agree to any amount of money over $5 to stop polluting and Barry will agree to pay any amount of money under $10 to prevent the pollution. They’ll both benefit. So how can externalities possibly exist? Economic agents should automatically internalize them.
The only possible real answer, as Coase realized, is that the cost of Abe and Barry using the price system, the transaction cost, must exceed the range of payments they will both agree on.
This is mistaken, because transaction costs are not the only explanation for why two parties can fail to negotiate a mutually beneficial resolution of an externality. Here’s one way that could happen.
Suppose there are no transaction costs at all: Abe & Barry are teleported to the negotiating table and told they’ll both be compensated for whatever time it takes for them to reach an agreement, so negotiating costs them nothing.
Once Abe & Barry have their bearings, Abe realizes he’s probably the only person who knows the precise marginal benefit of the factory to himself, and Barry realizes he’s probably the only person who knows the factory’s exact marginal cost to himself. Abe & Barry, knowing just enough about negotiation to be dangerous, decide to enhance their bargaining strength by exaggerating how good the status quo is for themselves. So Barry complains that the factory’s pollution costs him $5 (instead of $10), and Abe says his factory is worth $10 (instead of $5).
If Abe assumes Barry is being honest, and Barry assumes Abe is being honest, no money changes hands. (Barry thinks Abe will demand at least $10 to close the factory, but sees no point in giving Abe that much, so Barry doesn’t make an offer. And since the original description of the problem implies Barry has no power to have Abe’s factory shut down against Abe’s wishes, Abe has no incentive to compensate Barry.) The factory carries on emitting pollution and the externality remains uncorrected!
More realistically, Abe & Barry will suspect each other of tactical lying. If so, they can’t trust each other’s claims about the factory’s benefit/cost, and so neither has any more information than before they spoke.
To move things forward, Barry might offer Abe some arbitrary sum of money to close the factory, but this might not help. Barry presumably won’t offer ≥$10 because the factory only hurts him to the tune of $10. If Barry offers ≤$5, Abe will refuse, and the status quo will remain. Finally, if Barry offers between $5 and $10, Abe might accept...but Barry will’ve revealed he was originally lying about the factory’s cost to himself, and Abe might hold out in the hope that Barry will then offer a little more. For example, if Barry offers Abe $6, Abe will probably infer that Barry’s suffering at least $6 of loss because of the factory, and most likely even more. At that point Abe might refuse the $6 in the hope that Barry will then offer $7. If Barry does then offer $7, Abe might decide to push his luck again and hold out for $8. This game could well continue until Barry gives up and negotiations break down. (Worse still, if Barry realizes that Abe might hold out like this, Barry can’t even infer a lower bound on how much Abe values the factory. If Barry offers Abe $8 and Abe says no, is it because Abe thinks the factory is worth at least $8 or just because Abe is holding out for more?) If Barry’s offers all fail, the factory will again carry on emitting pollution and the externality will again remain uncorrected.
These concerns are purely tactical and independent of transaction costs. The underlying problem is incomplete information, which opens the door to tactical behaviour that can make Coasian negotiation (and negotiation generally) fail. It follows that when Coasian negotiation fails, the explanation is not always as straightforward as the cumulative transaction costs being too high.
(I don’t care that you didn’t use the standard font, BTW.)
Other people have expressed general disagreements with this post. I find it hard to comment on those since I’m not sure how to interpret the post in the first place. I understand what it’s saying paragraph by paragraph, but I can’t mentally integrate all of it into a set of conclusions that’s nontrivial, accurate, and doesn’t rely on defining connotatively loaded terms like “efficiency” in an unusual way.
Instead, I’m going to take issue with one specific part of the post, the discussion of Coase’s explanation of externalities. From the post:
This is mistaken, because transaction costs are not the only explanation for why two parties can fail to negotiate a mutually beneficial resolution of an externality. Here’s one way that could happen.
Suppose there are no transaction costs at all: Abe & Barry are teleported to the negotiating table and told they’ll both be compensated for whatever time it takes for them to reach an agreement, so negotiating costs them nothing.
Once Abe & Barry have their bearings, Abe realizes he’s probably the only person who knows the precise marginal benefit of the factory to himself, and Barry realizes he’s probably the only person who knows the factory’s exact marginal cost to himself. Abe & Barry, knowing just enough about negotiation to be dangerous, decide to enhance their bargaining strength by exaggerating how good the status quo is for themselves. So Barry complains that the factory’s pollution costs him $5 (instead of $10), and Abe says his factory is worth $10 (instead of $5).
If Abe assumes Barry is being honest, and Barry assumes Abe is being honest, no money changes hands. (Barry thinks Abe will demand at least $10 to close the factory, but sees no point in giving Abe that much, so Barry doesn’t make an offer. And since the original description of the problem implies Barry has no power to have Abe’s factory shut down against Abe’s wishes, Abe has no incentive to compensate Barry.) The factory carries on emitting pollution and the externality remains uncorrected!
More realistically, Abe & Barry will suspect each other of tactical lying. If so, they can’t trust each other’s claims about the factory’s benefit/cost, and so neither has any more information than before they spoke.
To move things forward, Barry might offer Abe some arbitrary sum of money to close the factory, but this might not help. Barry presumably won’t offer ≥$10 because the factory only hurts him to the tune of $10. If Barry offers ≤$5, Abe will refuse, and the status quo will remain. Finally, if Barry offers between $5 and $10, Abe might accept...but Barry will’ve revealed he was originally lying about the factory’s cost to himself, and Abe might hold out in the hope that Barry will then offer a little more. For example, if Barry offers Abe $6, Abe will probably infer that Barry’s suffering at least $6 of loss because of the factory, and most likely even more. At that point Abe might refuse the $6 in the hope that Barry will then offer $7. If Barry does then offer $7, Abe might decide to push his luck again and hold out for $8. This game could well continue until Barry gives up and negotiations break down. (Worse still, if Barry realizes that Abe might hold out like this, Barry can’t even infer a lower bound on how much Abe values the factory. If Barry offers Abe $8 and Abe says no, is it because Abe thinks the factory is worth at least $8 or just because Abe is holding out for more?) If Barry’s offers all fail, the factory will again carry on emitting pollution and the externality will again remain uncorrected.
These concerns are purely tactical and independent of transaction costs. The underlying problem is incomplete information, which opens the door to tactical behaviour that can make Coasian negotiation (and negotiation generally) fail. It follows that when Coasian negotiation fails, the explanation is not always as straightforward as the cumulative transaction costs being too high.
(I don’t care that you didn’t use the standard font, BTW.)