An Economic Theorem: Application, Implication, and Fallacies

Kwan Wan Hong ponders whether economics works in the real world.

A synergy between law and economics that is often overlooked is the application of the Coase theorem. The Coase thorem, referred to by some as a ‘theoretical curiosity’, is an economic explanation of achieving equilibrium between two parties with contesting interests.

Some modules in law school might have introduced this theorem in the laws of land, rights and property, while economics students will have come across it in public sector economics and environmental economics. More interestingly, the real life application of this theorem has far reaching implications in policy making that is worth a ponder — implications that lead to notions of soul searching for the socioeconomic welfare.

The theorem

Say that there is a single quantity ‘good’ that is demanded by two different parties, Party A and Party B. The acquisition of this ‘good’ — be it a consumer product, service or even something of a more abstract form, the right or claim to something — is through monetary means. That is, the party that pays the highest price gets the good. Thus far, this implies a somewhat zero-sum game between Party A and Party B for the acquisition of the good.

This common intuition is given a twist by Ronald Coase, a Nobel Prize winning economist. He theorised that regardless of which party the good is bestowed ownership at first (this is an important starting point of the framework), the final outcome of who gets hold of the good — the equilibrium — will be the same. This is to say that Party A and Party B will ‘fight it out’ through monetary payment to one another to acquire the good. Whoever values the good most will be willing to pay the price to acquire the good.

Let’s take pollution as an example. Say that the good defined here is ‘the right to pollute and otherwise, the right to clean air’. Party A is the factory (that pollutes) and Party B is the residents (that want no pollution). The market contested between both parties is ‘the right to clean/dirty the air’.

Say that Party A values the good (to pollute) more than Party B (do not want pollution). Assuming that at the starting point, Party B was given this good (the right to clean air), through some means (just assume for a moment). Party A will be willing to offer a price to Party B to buy this good (right to pollution) over. This price tag X has to be accepted by both parties, for Party A must at most value the good (right to pollute) at price X, and for Party B (the demand for clean air) to at least value the monetary gain of X (compensation for the polluted air) for the transaction to take place.

Conversely, if Party A is first given the ownership of the good (factory can pollute), and that Party B values the good more than Party A does (the residents value clean air more than the factory values the right to pollute), Party B will pay the price of Y (there is no reason for the price to be X, given different circumstances) to buy the good over from Party A (residents will pay the factory for it to not pollute).

So therefore, the essence of the Coase theorem is as such — it matters not how the good is distributed initially. The equilibrium will always be that both parties will come to a compromise through monetary means that leads to the ownership of the good at the hand of the party that is most willing to value it highest.

This equilibrium is of efficient economic outcome in terms of resource allocation. This is a win-win situation. In the former example, Party A gets the good that he/she is willing to pay for and Party B is compensated at the level that satisfies him/her.

For the Coase theorem to hold true, a caveat must be understood. The Coase theorem holds a strong assumption that there is no (insignificant, at least) transaction costs between Party A and Party B. That is the cost of logistics, liaising, monitoring and such is negligible for both parties to be able to strike up the deal. This assumption is the cornerstone to the theorem. If there is a substantial transaction cost to be incurred, the required effort to overcome this cost would render the actual transaction too troublesome to be undertaken. No deal or transaction will be able to take place.

Application

As a theoretical framework, its workflow is as such:

  1. Observe a case of a contested right to ownership.
  2. Identify the parties with respective interests to the claim.
  3. It matters not which party is awarded the right.
  4. The parties will mediate the ownership dispute between themselves through monetary means.
  5. Everyone is satisfied and compensated.

In the economics of analysis of law, the Coase theorem is referred to in the literature of resolving legal matters of land and property rights. The implication is that the law has only to rightly define the scope of legal grounds and rights.

To illustrate using an example of water pollution, say that the factory wants to acquire the right to pollute but the law and community as a whole fail to identify and acknowledge that the residents affected by that particular polluted river has the right to clean water. There might even be parties affected by the water pollution but they are in the dark. How then does the factory know who exactly to deal and negotiate with for the case of water pollution without the proper legislature?

Having achieved a rightly defined scope, the arising disputes can then be settled through the free market framework of the theorem (assuming no transaction cost incurred).

Now that we have an appreciation of the framework, I cannot help but to ponder that this theorem can be modelled after many issues of contention.

Implication

The elegance of this equilibrium appears to provide for a universal solution to conflicts. Free market is the answer to all socioeconomic woes and contention — ammunition for the war chest of the staunch capitalist. Policy deliberation and decision making are, by theory, made obsolete. Money makes the world go round. Demand and supply is the way to go for maximising utility and keeping everyone satisfied.

Fallacies

If only the framework of this theorem was as formidable as the model’s underlying assumptions.

The assumption of ‘no transaction cost’ in the theorem is the model’s Achilles’ heel. How can there not be costs incurred to mediate and coordinate the discussion to agree on a price for transaction? In reality, there are often always more than two parties that lay claim. To navigate and fumble through to come up with a unanimous agreement is a nightmare.

Take diplomacy for a case in point. Tension is growing in the East China Sea territories as China flexes its muscles to test its maritime boundaries to the anger and retaliation of neighboring countries. By the Coase theorem, this can be resolved by economic means. Pay the highest price to acquire the contested borders! Yet the reality reflects the fallacy of Coase. The transaction costs not taken into account by the Coase theorem are the associated political costs to diplomatic disputes (nations’ reputations, credibility of threats). Even after a price is tabulated for, it might be a price too high to pay, and perhaps not worth the island.

In essence, unless applied to a euphoric ideal world of no transaction cost, the theorem crumbles on its own for being unrealistic.

Despite the theorem’s fallacy, its reasoning contributes to yet more questions raised with no answers in sight. Although the application of the Coase theorem appears benign in civil matters, the same application in criminal cases opens a Pandora’s box. It will imply a demand-supply market for justice in court. ‘Innocence’ and ‘guilt’ can be traded with the court.

The theorem is not at fault here. It is the application of the framework that yields disturbing distortion to the sanctity of not only the law, but that of morality and ethics.

Herein lies the philosophical question of the boundaries between economics of pricing and morality. Economics is good when left to its own devices and the realm of fiscal, monetary policies, interest rates and balance of payments. A crossover to matters that ought to have been priceless, that of justice, morality and nature will conjure bizarre if not downright disgusting implications. Unfortunately, these circumstances have in many ways permeated into the nuances and nooks of the socioeconomic fabric.

From life insurance, surrogate mothers, selling of citizenships, black market for human organs to the world’s oldest profession, prostitution, there is a price tag attached to each. “Whoever said that money can’t buy happiness, simply didn’t know where to go shopping” does not sound so witty now.

In dealing with this appalling notion of attaching a price on the priceless, we are already exploring the philosophical realms of ethics. To complicate things even more, we not only have to consider the rights and wrongs but also the just and unjust of the mechanism that keeps the world go round — free market pricing.

Very often it is the case of economic models to assume no inequality to construct a framework. Assuming no instances of inequality, the good is bought by the demand that is most willing to pay the highest price, and it is for the supply side to strive for highest sale price. This assumption is at fault for in the real world of economics, the 1% versus the 99% distorts the credibility of many economic models.

Referring to the Coase theorem example, say Party B values the good more so than Party A but inequality has it that Party A has all the money and Party B just a pittance. How then can an efficient allocation of resources, a prized equilibrium of economics, take place? There are desires and conspicuous consumption that the rich take for granted that are so desperately essential to the poor. The Coase theorem is rendered a laughing stock placed in such a context.

Most certainly, this is a complicated matter that warrants a much closer inspection into the elements and variables, not one that can be achieved through a few paragraphs. A good book that delves deeply into this conundrum of the price of everything is “What Money Can’t Buy” by Harvard professor, Michael Sandel.

As much as I enjoy economics, within the nooks and crannies of this discipline lie the fallacies of the free market — its preposterous assumptions and the unscrupulous applications. Am I calling for an outright rejection of economic methods then? Definitely not, it would be equally ridiculous to do so.

To furnish this article with more depth, at this juncture, I provide for an opportunity for a defending argument for the economics discipline. In the academia and applied economics, economists indeed have the quantitative skills to literally compute a numerical value for such ‘goods’ that we take to be priceless. Economists build on decades-old theoretical mathematics workhorses and advanced techniques to perform cost benefit analysis on matters that seem impossible to quantify. Following the argument of this article thus far, it is this notion that we should reject — putting a price on pricelessness.

But before we jump to conclusions and criticise these exercises as cold blooded, one should understand that one of the current empirical application of such analysis is on environmental issues, such as the decision to locate the site for contentious infrastructure such as nuclear reactors, waste disposals, and rare earth plants. Economists are often roped in to provide insights from a market oriented perspective, using economic cost benefit analysis to weigh the cost of community’s displeasure against the commercial benefit of a controversial plant. And in this instance, I must come to the defence of economics. It is better to work with known calculated risks than to deal in an oblivion of uncertainties. Such calculations, hedonistic as the may seem, provide for a more substantial bigger picture.

Yet, the free market economics serves its purpose. The invisible hand can only guide us thus far. It is worth pondering the philosophical curiosity of price in everyday life and everything of existence — the crossover of free market price into the priceless.

“Life is hard. Knowledge is scarce. Grow up and admit you can’t extract policy from a couple of lines on a blackboard” — a wise comment by a professor of economics, Deirdre McCloskey.

This leads to a soul searching opportunity — where do we seek a holistic solution to socioeconomic issues? Where do we draw the line? Do we use the tools of economics, politics, and spirituality or a somewhat hybrid framework?

And what then does it make us as an individual, as a society, and as a nation? “What then and how?” — that is the question.


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Posts by Wan Hong

Economics is undeniably important, but it is cold & difficult & best left to those who are at home in abstruse realms of thought.

Posted on 4 March 2014. You can follow any responses to this entry through the RSS 2.0.

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