One of the fundamental problems with neo-classical economics is its lack of reality. In university students are taught theories that bare little similarity with the real world. I have learned a lot about economics and society during my time in university, unfortunately very little of that happened in the classroom. So I will run a series of posts where I challenge mainstream economics and debunk the unrealistic theories. Myself and my classmates are well able to explain abstract theories but can say little about the state of the economy or what to do about the recession. First up is the Coase Theorem, a particularly ridiculous theory that only an economist could take seriously.
(My textbook is Microeconomics (4th ed) by Jeffrey Perloff and Principles Of Economics by Robert Frank and Ben Bernanke. I’ll use my lecture notes to show that I’m not debating a straw man.)
The theory was developed by Ronald Coase in two economic papers, “The Nature Of The Firm” (1937) and “The Problem Of Social Cost” (1960). He saw it as an example of a world of zero transactions, something he admitted was quite unrealistic. Despite having the theorem named after him, Coase disliked it himself, which should be a warning about its robustness. Coase won the Economics (fake) Nobel Prize partly for this work, which is part of the reason the Economics Nobel Prize isn’t held in high regard. Free marketers have taken the theorem further than Coase ever intended and took it further than he envisioned.
The Coase Theorem holds that disputes can be solved not by the government or use of courts but by bargaining on the free market. It is portrayed as an alternative to rigid and blanket government regulations or pollution taxes which are described as inefficient. It is argued that if both parties have established property rights and there are no transactions costs then the free market will lead to the most efficient outcome. It is drawn in response to market failures in the case of pollution where people suffer
I’ll use an example from my textbook. Imagine there is a chemical company (called Abercrombie) and a fisherman (called Fitch). The chemical company wants to dump its chemicals unfiltered into the lake, whereas the fisherman obviously doesn’t want that. If there are no property rights, then the chemical firm will dump the toxic chemicals and the fisherman will lose business. The obvious (and realistic) solution is for the government to intervene and prevent chemicals from being dumped without a filter. However, this is where the Coase Theorem comes in.
Free marketers hate even the thought of government so they use the Coase Theorem as a free market alternative. This estimates how much each firm values the use of the lake and then allows them to bargain over whether or not to install a filter. Let’s say both sides would gain £100 per day if a filter is installed. However if the filter isn’t installed then the chemical company makes £130 per day while the fisherman makes only £50. The fisherman will then pay the chemical company £40 to install the filter, making him better by £50 (net gain £10) and the chemical company better by a net gain of £10. Therefore everyone is better off thanks to the free market.
Then there are some hypothetical numbers thrown at you to imply that if the government got involved by imposing a pollution tax or forcing the chemical company to install a filter, this would be inefficient and make everyone worse off. Moral of the story is that the free market can solve our problems without pesky government interference. What is interesting is that there is little difference between how the Coase Theorem is explained in 1st year and in final year. It doesn’t begin simple before adding complicated details, it literally is that simple.
Obviously there are a host of problems with this theorem. Why should fishermen pay for the right not to lose their livelihood? Isn’t that extortion? Won’t this lead to moral hazard where companies have an incentive to threaten to pollute the lake unless they receive a bribe? This could also work in result with people pretending to be fishermen in order to claim compensation for “lost earnings”.
Second of all, what about the people who don’t have an economic stake in the lake but still use it? For example what if I enjoy swimming or water sports in the lake? Seeing as I don’t derive any economic benefit from this, how do I pay off the chemical company? What about the marine life? What if a deal is reached that is economically efficient but involves the death of all life in the lake? If the lake is reduced to a toxic pit, in what sense is this efficient? What if the bargaining is not between equals, but between impoverished fishermen and a giant multinational?
The theorem doesn’t hold well even on its own ground, but it collapses if you take it elsewhere. What if instead of one fisherman, there were hundreds? How do we efficiently bargain then? What if there aren’t clear property rights or they are impossible to implement?What if instead of a lake we are dealing with the Atlantic Ocean? What about toxins in the air, how can they be divided into property rights?
The theory is based on the assumption that people have perfect information about the world. It is assumed that everyone knows the cost and benefit of every action to everyone else. The whole theorem is based on the assumption that we can easily measure the costs and benefits of an action, yet in the real world we don’t. It is near impossible to put a monetary figure on the effect of chemicals on a lake and harder still to measure how much this will cost all the people who use the lake. There are many chemicals whose effects are unknown and far too many actions to make a reasonable estimate.What if instead it was a factory emitting toxins into the atmosphere? How do you measure the effect it will have on millions of people in many countries? How do you separate it from the other toxins in the air? Suggesting that people can simply sit down with a major factory (who has every interest not to comply) and measure the costs of the pollution and then bribe it to stop is too absurd to be taken seriously.
The Coase Theorem is supposed to show how the free market can operated without the need for government intervention. Instead it only shows what desperate lengths and unrealistic assumptions neo-classical economics will go to in defence of the market. It is an example of the kind of absurdities students waste their time on rather than learning how the economy really works. It truly is a bunch of “neo-classical mumbo-jumbo”. At the end of the discussion on the Coase Theorem my textbook (Perloff 2007:619) notes that: “For these reasons, Coasian bargaining is likely to occur in relatively few situations.” Then why bother mentioning it?