Thursday, April 9, 2009

Econ 101: The Coase Theorem and the White Stag Sign

Ronald Coase won the Nobel prize in 1991 for his work in understanding the role of property rights in efficient market outcomes. Stealing a page from Bob Frank at Cornell, it is easiest to understand the Coase Theorem by simple example. Suppose two people share an apartment, Jacob and Chuck. The only problem is that Jacob likes to smoke and Chuck is disturbed by smoke. It is worth \$150 to Jacob to be able to smoke in his apartment and it is worth \$200 to Chuck to live in a place without cigarette smoke.

There are two ways to get the efficient outcome, which is to not have any smoking (because collectively they are \$50 better off with this outcome than the other). We could give Chuck the right to live without smoke, or we could give Jacob the right to smoke. Say what? The first is obvious but what about the second?

Think about what would happen in the second case: Chuck would offer Jacob some amount of money between \$150 and \$200 (let's say \$175) to not smoke inside and Jacob would accept. No smoke would happen and this outcome would be efficient. Why? Well, Chuck is \$25 better off paying \$175 and not having smoke and Jacob is \$25 better off not smoking but collecting \$175. So they recover the \$50 in surplus. The second case is worse for Chuck and better for Jacob relative to the first, but both are efficient.

This is the essence of Coase. As long as negotiations are costless and property right are well defined, an efficient outcome occurs no matter which party has the property rights.

What does this have to do with the White Stag sign? Well suppose that the sign with UofO on it benefits the UofO a sum of \$100. But such a sign would negatively impact Portland residents collectively a sum of \$200. The efficient outcome is for the sign not to read UofO. If UofO did not have the right to change the sign, problem solved. If the UofO had the right to put whatever it wanted there, residents could offer a sum of more than \$100 not to. The problem is it is hard to negotiate such a transaction - it is not costless. Residents would have to come together and propose a deal with UofO and this takes time, effort and resources - all real costs. In the end then, this would not happen and an inefficient outcome would occur.

This is precisely why we have rules and regulations governing such large public displays. In the case of situations where it is hard to negotiate laws are written to impose the burden on the lowest cost participant.

As Frank says: "It is often impractical to negotiate solutions to the problems created by externalities. Hospital patients, for example, are unable to negotiate with passing motorists about not blowing their horns. In such cases, the law tries to impose the burden of adjustment on the party that can accomplish it at lowest cost. Not blowing his horn is a cost to the motorist, but a benefit to the patient. Because peace and quiet is especially valuable for hospital patients, the law prohibits horn blowing in the vicinity of hospitals. "

This is also why I supported Commissioner Leonard's exercise of authority on behalf of Portlanders. Essentially what he did was to assert the appropriate property rights and this led to negotiation on behalf of Portland residents and what is a reasonably efficient outcome.

1 comment:

Jacob Grier said...

If the UofO had the right to put whatever it wanted there, residents could offer a sum of more than \$100 not to. The problem is it is hard to negotiate such a transaction - it is not costless. Residents would have to come together and propose a deal with UofO and this takes time, effort and resources - all real costs. In the end then, this would not happen and an inefficient outcome would occur.

Residents don't have to come together to do this. They have elected representatives with control of tax revenues to act on their behalf. That's precisely what Randy Leonard did before bringing eminent domain into the equation: He made an offer on behalf of the city to lease the sign and U of O rejected it. Yes, making this offer takes time, effort, and resources, but it's still an ordinary economic transaction.

You could make the argument that Leonard underestimated the value of the sign to Portlanders and should have offered more. But assuming he made a reasonable estimate, the Coase theorem has been applied here and came out in favor of letting U of O change the text.