The Coase Theorem and the Theory of the State

Read this original piece of literature written by James M. Buchanan, who explains the Coase Theory.

1. Introduction - The Coase Theorem and the Theory of the State

Things were really quite simple in the post-Pigovian world of microeconomic policy, a world characterized by possible divergences between private and social marginal cost (or product). The classically nefarious factory might be observed to spew its smoke on the neighboring housewife's laundry, and in so doing impose costs that were not reckoned in its presumed strict profit-maximizing calculus. The remedy seemed straightforward. The "government" should impose a corrective tax on the factory owner, related directly to the smoke-generating output (or, if required, a particular input) and measured by the marginal external or spillover cost. Through this device the firm would be forced to make its decisions on the basis of a"socially correct" comparison of costs and revenues. Its profit-mazimizing objective should then lead it to results that would be "socially optimal".

Things have not seemed nearly so simple since R. H. Coasepresented his analysis of social cost. Coase's central insight lay in his recognition that there are two sides to any potential economic interdependence, two parties to any potential exchange, and that this insures at least some pressure toward fully voluntary and freely negotiated agreements. Moreover, such agreements tend to insure the attainment of efficiency without the necessity of governmental intervention beyond the initial definition of rights and the enforcement of contracts. Applied to the example in hand, if the damage to the housewife's laundry exceeds in value the benefits that the firm derives from allowing its stacks to smoke, a range of mutual gain exists, and utility and profit-maximizing behavior on the part of the two parties involved will result in at least some reduction in the observed level of smoke damage, a reduction that can be taken to be efficient in terms of total product value. No governmental remedy may be called for at all, and indeed Coase argued that attempted correction by government might create inefficiency. Such intervention might forestall or distort the negotiations between the affected parties. As a further aspect of his analysis, Coase advanced the theorem on allocational neutrality that now bears his name. This states that under idealized conditions when transactions costs are absent and where income-effect feedbacks are not relevant, the allocational results of voluntarily negotiated agreements will be invariant over differing assignments of property rights among the parties to the interaction.

Much of the discussion since 1960 has involved the limitations of this theorem in the presence of positive transactions costs. In this setting, differing assignments of rights may affect allocative outcomes. Furthermore, the transactions costs barrier to voluntarily negotiated agreements that can be classified as tolerably efficient may be all but prohibitive in some situations, notably those that may require simultaneous agreement among many parties. The generalized transactions costs rubric may be used to array alternative institutional structures, with the implied objective being that of minimizing these costs.

My purpose in this paper is not to elaborate these extensions and/or limitations of the Coase analysis, many of which have become familiar even if an exhaustive taxonomy of cases has not been completed. My purpose is almost the opposite. I want to extend the Coase analysis, within his assumptions of zero transactions costs and insignificant income-effect feedbacks, to differing institutional settings than those that have normally been implicitly assumed in the discussions of the neutrality theorem. This approach leads to the question: Why did Coase suggest that the Pigovian prescriptions might produce inefficient results? Or, to put this somewhat differently, why does the theorem of allocational neutrality stop short at certain ill-defined institutional limits? Why can it not be extended to encompass all possible institutional variations, variations that may be broadly interpreted as differences in the assignments of property rights? What is there in the implied Pigovian institutional framework that might inhibit the voluntary negotiations among parties, always assuming zero transactions costs? If the neutrality theorem holds, why should the political economist be overly concerned about institutional reform, as such?

There is a paradox of sorts here between the theorem of allocational neutrality, interpreted in its most general sense, and Coase'sbasic policy position. One implication of the theorem, so interpreted, would be that the thrust of classical political economy may have been misdirected. Adam Smith's central message points toward institutional reform and reconstruction as means of guaranteeing overall efficiency in resource usage, and, as noted, we can always interpret institutions as embodying specific property rights. Governmental authorities were to be stripped of their traditionally established rights to interfere in the workings of the market economy; or, stated conversely, individual traders were to be granted rights to negotiate on their own terms. The central theorem of classical economies might be summarized as the demonstration of the differences in allocational results under divergent institutional structures. I do not think that Coase would disagree with my statements here, and I think that he shares with me an admiration for Adam Smith and that Coase, too, places Smith's emphasis on institutional-structural reform above the modern policy emphasis on detailed and particularistic manipulation of observed results.

The apparent paradox may be resolved when we take account of the theory of the state or of government that is, perhaps surprisingly, shared by Adam Smith, Pigou, and Coase. My argument proceeds in several steps. First, it is necessary to distinguish carefully between property rights and liability rules. Secondly, I shall demonstrate that governmental or collective action, if conceived in the Wicksellianframework or model, does not modify the applicability of the neutrality theorem. Thirdly, I shall show that government, conceived in a non-Wicksellian model, need not modify the applicability of the theorem, but that, in such case, property rights are explicitly changed with the introduction of governmental action. Finally, I shall suggest that the theory of government decision-making implicit in both classical and neoclassical economics, and carried over in Coase's analysis, offers the source of the seemingly paradoxical limits on the neutrality theorem.

Source: James M. Buchanan,
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