Megan McArdle, in a debate about land use regulations, plays the libertarians' ultimate trump card:

[T]hen we got into noise pollution, and he demanded to know if I thought people should be allowed to play loud music in their houses, if you can hear it. Not deafening music, which I would be against; just loud. I pointed out that as long as the transaction costs for side deals are relatively low, which they should be in the kind of leafy, large suburb we were discussing, it didn't really matter whether he had the right to play music, or I have the right to enjoy silence; the Coase Theorem dictates that we will end up with preference maximization.
The Coase theorem "dictates"? Actually, the Coase theorem dictates absolutely nothing. The Coase theorem has made enormous contributions to economics, but its net contribution is diminished every time someone applies it to the real world. I literally cringed when I saw McArdle invoke the Coase theorem as the basis for her argument. It's a neat trick, and a lot of libertarians I know use it, but it betrays a fundamental misunderstanding of the Coase theorem. Not only should the Coase theorem never be applied to the real world, but it was not intended to ever be applied to the real world. In his seminal article establishing the Coase theorem (The Problem of Social Cost), Ronald Coase made this clear:
The argument has proceeded up to this point on the assumption that there were no costs involved in carrying out market transactions. This is, of course, a very unrealistic assumption.
Coase never argued that the results reached under the Coase theorem would have any relevance to the real world. After 20 years of people abusing his thoerem, Coase again stated in no uncertain terms that his theorem was not intended to, and should never, be applied to the real world and treated as determinative:
[W]hile considerations of what would happen in a world of zero transaction costs can give us valuable insights, these insights are, in my view, without value except as steps on the way to the analysis of the real world of positive transaction costs.
So if you invoke the Coase theorem as the basis for your argument, your argument is by definition wrong. Please, end the scourge of Coase Theorem Abuse! UPDATE: Megan McArdle responds in the comments:
I actually agree with you, sort of ish, but by that point in the argument, we were so far into theoretical la la land that you'll have to trust me that zero transactions costs were among the more realistic assumptions being made.
Okay, I trust you. And I should have noted that relying on Coasean bargaining is probably more realistic than relying on Tieboutian sorting, which your friend seemed to do. But some transaction costs are so distortionary that the Coase theorem is inapprorpiate even as a starting point. This is especially true for a lot of land use issues, where transaction costs are extremely high. Government capture is so widespread in land use that Coasean bargaining is the exception rather than the rule. In fact, last year I had a client tell me that she would have approached her neighbor about resolving their land use dispute privately, but she didn't think the contract would hold up in court! It's important to remember that homeowners don't make their decisions on land use issues based solely -- or even predominantly -- on their subjective valuations. Most homeowners care first and foremost about maintaining the resale value of their house, because the higher the market value of their house, the more equity they have to borrow against. So homeowners make land use decisions based on what they think prospective homebuyers' preferences are. Prospective homebuyers, in turn, also take the future resale value of houses into consideration when buying a house. And so on, and so on, in a self-reinforcing cycle. A much better starting point for modeling land use is probably an anticommons. As Ed Glaeser has noted, there has been a "dramatic increase" in the number of land use regulations over the past 30 years (though I would trace the rise of land use regulations further back than that, as William Fischel has done). The complex web of land use regulations has essentially given every resident de facto veto power over every other resident's land use. You can imagine how useful the Coase theorem is under that allocation of property rights.


Jane said...

I actually agree with you, sort of ish, but by that point in the argument, we were so far into theoretical la la land that you'll have to trust me that zero transactions costs were among the more realistic assumptions being made.

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