Do Coasian Solutions Work in Real Life?

One of my students from the Graduate Certificate in Public Policy – Satish Terala (@satisficed– wrote a rejoinder to my Pragati blog post on why I should get compensated by my neighbour who is building a house. While he is sympathetic to my cause, he believes that the trade will not actually takes place. His post follows:

Anupam Manur in his post “Dealing With Construction in Your Neighborhood” sets up an interesting problem – construction activity in his neighbourhood undertaken by his neighbour is disturbing the peace and tranquility of his life. Anupam then rightly concludes that his neighbour’s actions are imposing a negative externality on him (actually the entire neighbourhood) and then invokes the Coase Theorem to solve for it. The solution would involve the offending party (his neighbour) paying Anupam a certain amount. Anupam would then promptly buy a new pair of heavy duty earbuds, soundproofs his house and perhaps gets some extra cleaning help.

Sounds simple enough. But why did that not happen in this case. I would surmise that getting his neighbour to understand the economics of externalities and Coase theorem is still not going to help matters here. Why is it that then perfectly rational actors fail to trade even when there are gains to be had by doing so. The answer to this comes from another equally important but not as famous theorem called the Myerson-Satterthwaite theorem.

In presence of private information about the value of certain good (Anupam’s peace and tranquility) to the buyer and the seller, Myerson-Satterthwaite theorem says that no mechanism exists that guarantees that a trade will always happen. The problem here is that of information-asymmetry. In a Coasian world, all information about the externality is public and bargaining will ensure that an efficient outcome for both parties is reached.

In Myerson-Satterthwaite’s world, people’s valuation of the good are private i.e. the buyer only has a vague sense of the what the seller is willing to accept and similarly the seller only has a notion of what the buyer is willing to pay (for the math inclined: buyers view of sellers cost is uniformly distributed on the interval [0,1] and vice versa). This private information induces sellers to act as if the costs of their goods are higher than they actually are and similarly for the buyer to act as if good is of lesser value than their private valuation of it. The theorem then shows that the gains of trade are not sufficient enough for either of the players to honestly reveal their costs and values. This implies that no fool proof mechanism can be designed that guarantees a trade will happen even when there is a price that would be agreeable to both parties.

Turns out that worst case scenario is the case of a single buyer and a single seller. As the number of buyers and sellers increase, these informational problems disappear and markets become ‘efficient’.

So Anupam might then just be better off buying those heavy-duty earbuds himself; Coase is not going to help him much in this case.

Note: While I highlight only the applicability of M-S theorem in case bargaining does occur, there are many other reasons why bargaining might not even occur. Social norms, inability to assign the responsibility of the externality, hold out problems and other issues often have large transaction costs dissuading the participants from even bargaining in the first place.

Satish is a technology professional based out of Boston. He has degrees from UC Berkeley and University of Toronto in ‘doing marginally useful things’. He still hopes to finish his GCPP – some day.