The Coase Theorem, Applied to Markets and Government.

• Author: Holcombe, Randall G.
• Position: Essay

The Coase theorem, as commonly understood, says that in the absence of transaction costs, the allocation of resources is independent of the assignment of property rights--or, restated in more descriptive terms, in the absence of transaction costs, resources are allocated to their highest-valued uses. (1) The logic of the Coase theorem is especially straightforward in this second variant. If there are no transaction costs, people who value resources the most will engage in mutually advantageous exchange to maximize the value of resources under their control. This holds true in political transactions as well as in market transactions. In the political marketplace, some people are in a low-transaction-cost group and can bargain with each other to produce policy outcomes that maximize the value of resources to those in the group. Most people face high transaction costs in the political marketplace and are unable to participate in those transactions. Policies implemented by those in the low-transaction-cost group--the people who design public policy--are not necessarily the ones that maximize the value of resources to those in the high-transaction-cost group.

A transaction-cost approach to public-policy analysis shows why some are systematically able to enact policies that benefit themselves, often at the expense of others. Public-choice theories of rent seeking, regulatory capture, and interest-group politics describe situations in which some are able to use the political system to generate benefits for themselves, but by imposing costs on others that result in an inefficient allocation of resources. Those others are prevented by high transaction costs from bargaining to mitigate the costs imposed on them. The lesson of the Coase theorem is not that resources are allocated to their highest-valued uses but rather that when they are not so allocated, the reason is that transaction costs stand in the way. (2)

The implications of the Coase theorem apply to government allocation of resources just as they do to the market allocation of resources, but market versus government outcomes often differ because markets allocate resources through mutually advantageous exchange, whereas governments allocate resources by a political decisionmaking process in which the resource-allocation decisions made by the small group of people who design public policies apply to everyone. The very nature of government allows some to impose costs on others.

The Coase theorem offers a good framework for analyzing the nature of these costs and by extension offers some insights about the operation of political systems. In particular, it provides an economic foundation for the elite theory that has been developed by social scientists for more than a century and integrates elite theory into the public-choice framework. A transaction-cost approach to public-policy analysis shows why some--the elite--are systematically able to enact policies that benefit themselves, often at the expense of others. In the context of the Coase theorem, the elite are those who face low transaction costs in the negotiations that determine public policy and so are able to bargain among themselves to maximize the value of public policies to members of the low-transaction-cost group.

Public choice has sometimes been described as analyzing politics as exchange. Exchange can take place only when transaction costs are low enough to allow people to bargain with each other. In politics, some people face low transaction costs and can bargain with each other to design public policy. Other people are excluded from the exchanges that produce public policy because they face high transaction costs. Transaction costs separate the elite from the masses. The Coase theorem provides an economic foundation for the elite theory that has been a part of sociology and political science for more than a century.

The Coase Theorem, Applied to Markets

Resources are allocated in markets through voluntary exchanges that occur when all parties view the exchange as mutually advantageous. The assumption when analyzing market exchange is that property rights are well defined and effectively enforced, so exchange takes place when all parties to the transaction value what each party receives in the exchange more highly than what each party gives up. This section assumes there are no externalities, which follows from the assumption that property rights are well defined and effectively enforced. (3)

In the absence of transaction costs, resources are allocated to their highest-valued uses because those who value resources most highly buy them. If the transaction costs for a particular exchange are higher than the gains from trade, the transaction will not occur. Although markets may not allocate resources to their highest-valued uses if transaction costs are too high, market exchanges do not result in resources being allocated to lower-valued uses. High transaction costs can prevent mutually beneficial exchanges from taking place, but potentially advantageous exchanges that are prevented because of high transaction costs do not impose costs on anyone. They simply preserve the status quo. When markets are complete, market transactions are always welfare enhancing, even though transaction costs prevent some transactions from occurring when the transaction cost is greater than the gain from trade.

Externalities

Externalities exist because transaction costs prevent some people from negotiating with others to mitigate the effects of actions taken by those others. One of Coase's (1960) points was that if transaction costs are absent, those who bear external costs can bargain with those creating these costs to internalize the externality. Internalization means that resources formerly allocated externally to the market system are now allocated internally to the market system because the recipients of externalities bargain with those who create them. Internalization occurs when transaction costs are low enough to allow the parties to bargain. (4)

Externalities exist because some people in a low-transaction-cost group bargain for their mutual benefit and as a by-product generate costs or benefits external to the market that affect others outside the low-transaction-cost group. Those others face high transaction costs and are not in a position to bargain to internalize the externalities. For externalities to exist, some people must be in a low-transaction-cost group to create them, and other people must be in a high-transaction-cost group and prevented by transaction costs from internalizing them. Consider the classic example of air pollution. Some people, such as steel producers and steel purchasers, participate in the market for steel because they face low transaction costs and are able to bargain to their mutual advantage. People who breathe the air pollution from steel mills are in a high-transaction-cost group and are unable to effectively bargain to reduce the amount of pollution they experience.

The Coase theorem divides people into two groups. Some are in a low-transaction-cost group and can engage in mutually advantageous exchange that maximizes the benefit of their transactions to those in their group. Others are in a high-transaction-cost group and are prevented by transaction costs from bargaining with those in the low-transaction-cost group. Those in the high-transaction-cost group can find themselves bearing costs imposed on them as a by-product die transactions of those in the low-transaction-cost group.

The Coase Theorem, Applied to Government

The Coase theorem applies the same way to government. Some people engage in political exchanges to make public policy. They are in the low-transaction-cost group. Other people are outside the policy-making arena and have no say in the design of public policy. They are in the high-transaction-cost group and must comply with the policies created by the low-transaction-cost group. Following the Coase theorem, those in the low-transaction-cost group who make public policy will bargain to produce public policies that maximize the value of those policies to those in the bargaining group. They are analogous to the steel producers and the steel purchasers. Those in the high-transaction-cost group often bear costs as a result of policies produced by those in the low-transaction-cost group. They are analogous to those who suffer the air pollution created by the steel mills. Just as in markets, those in the high-transaction-cost group bear the external costs of exchanges made by those in the low-transaction-cost group.

Consider the costs imposed on third parties via rent seeking, as described by Gordon Tullock (1967) and Anne Krueger (1974). Those in the low-transaction-cost group are able to compete for rents, which impose costs on the general public. Tariffs and monopolies benefit those who are protected by trade barriers and monopoly privileges, which raise prices and impose costs on those in the high-transaction-cost group, who are unable to bargain with policy makers. Douglass North (1990) clearly recognizes cases like this as the result of transaction costs that prevent political bargaining. As Mancur Olson (1965) describes, smaller groups are able to organize more effectively precisely because they have lower transaction costs and so are able to use the political process to generate gains for themselves at the expense of the general public. Similarly, George Stigler's (1971) regulatory capture works only because of the low transaction costs between the regulators and the regulated firms. Public-choice theory often describes how some can use the political process to impose costs on others.

The public-choice literature essentially stops at die point where these various theories explain how some people use the force of government to impose costs on others. Applying the Coase theorem, it is easy to see that those who are able to design policies for their...