From the Perfect to the Imperfect
5. Coase's second theorem

So does ownership solve the problem of externalities? Is Coase's First Theorem a decisive argument in favor of capitalism?

Well, no. The Theorem has two provisos - markets need to be competitive and deals need to be easy to make - both of which are serious caveats. When markets are not competitive, market adjustments may be less than smooth, and perfect and efficient outcomes may not come about. Another important obstacle is the cost of transacting, the so-called transaction costs:

Transaction costs are the costs of doing business in a market.

These costs include the costs that people incur before they are able to make deals. Think of the costs of going to the shop or the costs of searching for the best price in town. They furthermore include the costs of assigning and enforcing property rights. Think of the costs of registering and checking clams to ownership (of land, houses, patents, etc) as well as the costs of the courts, the police and lawyers that get involved whenever property rights are disputed or violated.

Coase was in particular struck by the obstacle of transaction costs. Pondering their impact he came to his Second Theorem:

Coase's Second Theorem states that when deals are difficult and costly (high transaction costs) the assignment of property rights does matter for efficiency; further research is needed to determine which assignment is best on efficiency grounds.

Gone is the magical world of Coase's First Theorem when efficiency was guaranteed no matter how property rights are distributed. We are back to the real world where hard work is required to achieve the most efficient outcomes.

Coase's argument for his second theorem is again relatively simple. Say the right to the air is awarded to the neighbors of the factory. So the neighbor could charge the factory for pollution. But what if the neighbors cannot agree on the proper charge? One possible outcome may be that a coalition of angry neighbors elects a hard-nosed city council which decides to forbid any pollution whatsoever. The factory has to close, harming consumers and workers alike. Alternatively, if the factory got the rights then the citizens have to get together to determine what to pay the factory to reduce its pollution. Getting people to agree to pay may be even a more cumbersome and costly affair than getting agreement to have another pay. They may fail to reach agreement, duping those who are really bothered by the pollution.

This is the moment to call in researcher economists to determine which case would produce the most efficient outcome.

Paul: So why not have the government regulate the amount of pollution?

McCloskey: That's what usually gets done. Coase's Theorems, however, alert us to the importance of markets. It's best to let the markets work to determine how much cereal gets produced and how clean the air will be.

Paul: Not when transaction costs are high.

Ziliak: I agree to a large extent with Deirdre. That's still no reason to think that governments do better. Do you really think that governments can figure out all effects of its regulations? Surely not. There are too many bad and stupid regulations around to show you that governments can produce terrible outcomes. It's best to let the markets do their job when possible.

Klamer: The alternative is to improve the government. A better government with better people will not allow stupid regulations and will abolish them when they are on the books.

McCloskey: You try.

Ziliak: This is not to say that markets are a bad idea. On several occasions governments have set up markets in which they put up for sale rights to pollute. The highest bidders gained the right to pollute to a certain amount. These cases show that we need a strong and inventive government. . . .

McCloskey: I agree. We need a good government to determine and enforce property rights. One reason why Russia has such trouble adjusting to a market economy was the uncertainty about property rights. People were not sure whether they owned their property afraid that the government would step in any moment to assign their property to someone else. Such uncertainty is terrible for business.

Ziliak: But look at the history. When George Bush, Sr. signed into the law the Clean Air Act he enabled for the first time in United States history the formal auction of rights to pollute sulfur dioxide-a major negative byproduct of burning coal. The three or four largest offenders of sulfur dioxide pollution-steel companies in the Midwest-bought up more than 90% of the shares! Initially, after the Clean Air Act, total emissions increased.

Klamer: A pity. But not unexpected by anyone thinking carefully about incentives.

Property rights during the California Gold Rush
In the early days of the California Gold Rush it was impossible to keep people in the gold fields as policemen and judges. The government would send such people to the fields and they would promptly resign to become miners. They made more money mining than policing. How then were the property rights of the Forty-Niners enforced? By an elaborate system of private courts, set up by the miners themselves. The miners made up property law as they went along and enforced it with rapid justice, administered by the miners themselves in democratic councils and backed up by their collective gun power. One might as well call the miner's council a "government." It fulfilled the basic duty of government - the protection of the commonwealth, that is, of the property of its citizens.

High transaction costs can account for the many avoidances of markets in a modern market economy. As Coase pointed out, they can explain the existence of firms. If transaction costs were to be zero all around, there would be no firms at all. People would be hired on a daily basis in open markets. Secretaries, marketing managers, cleaners, and supervisors would be selling their services to the highest bidders. In reality the costs of doing so would be prohibitive. Recruitment of personnel is costly. That's why it is more efficient to work with contracts and to organize a variety of transactions to circumvent market-type deals. That's why there are bosses telling employees what to do, instead of markets that let things work out in a voluntarily interplay of demand and supply forces. Surely, when producers of cars want to speed up the production process they could raise wages and salaries to get more efficient workers and managers on the market place. In practice it has proven more efficient to have such organizational and legal arrangements that producers can simply order managers in workers to change their ways to be more productive.

Maria: If transaction costs are high, why have markets at all?

Ziliak: Transaction costs are often quite low. It does not take too much for you to satisfy your hunger tonight. All you need to do is go to some kind of market place and buy yourself some food. There's no need for some authority to arrange our meals for us. Voluntary transactions work better.

Rodney: I'm glad it's arranged for me in my dorm. No market deals there. You just eat what they serve!

Ziliak: Yet you chose to stay in the dorm. But you're right, choosing to stay in the dorm is choosing to avoid some market-type of interactions that you would have to engage in if you were to live on your own. Ever realized that the dorm replicates in this respect the situation at home? There, too, you were protected from the market.

Maria: So why not avoid markets altogether?

McCloskey: The thought alone makes me shudder. It would be a terrible idea if only because with the markets you throw out a magnificent information system.

Maria: How so?

McCloskey: Let's explain.