Growth Part 1: Coase Theorem

Writing posts in parts implies that I have some grand manifesto to expound upon. Nope, not yet. More than anything, the issues I'm dealing with at the moment are causing me some consternation and by breaking them into parts I hope that I can encourage some discussion that will allow them to influence each other and build a very rigorous understanding of the ideas at hand. So... RSVP via twitter or email.  There's a Dilbert in here too. Which is fun and worth reading through to.

Ronald Coase is 102 years old (the picture is obviously not recent) and numbers himself amongst the pantheon of the many Chicago school academic economists to win the Nobel Prize. I keep coming across his work in relation to future economic models as the discussions around the attention economy (more later) and zero-sum growth gain a foothold in the mainstream as potential stumbling blocks for our current model and possible tacks for blame for the unmentionable financial hiccups of the last decade.

His most popular theorem on social transaction costs - later dubbed Coase Theorem - is now a cornerstone of economic theory, and yet it is almost entirely counter-intuitive and anti-classical in the economic sense.  Aaron Levine summarised it thus:
Assuming zero transaction costs and economic rationality, Cease, in his seminal work, demonstrated that the market mechanism is capable of eliminating negative externalities without the necessity of governmentally imposed liability rules.
Which makes almost no sense and so, as with most systems work, requires analogy. The story is that Coase came up with the theorem while working on the problem of radio stations that share the same bandwidth and endlessly squabble over property rights. Regulators find it notoriously difficult to assign radio frequencies to stop stations interfering with each other as their listening base grows and shrinks. Coase realised that without outside influence, this would be a self-regulating system: The radio station that was collecting the most revenue from listeners would have incentive to pay off the radio station receiving less for extra bandwidth. However, the most used analogy is of the wheat farmers and the rail company which I've highly simplified beyond even the original analogy:

A train line runs through a farmers wheat fields. Sparks from the train wheels have the regrettable habit of setting the wheat on fire, damaging the harvest. Suppose that optimally, with a full yield the farmer can make £50,000 per year, with the fire damage he can make £40,000. This happens ever two years, such that over a ten year period where he should make £500,000, he makes £450,000 - a loss of £50,000.

Solution 1 utilises the standard model of a national legal framework and is what we use normally. The farmer sues the train company for damages, costing him legal expenses, time and other nasty transaction costs and the train company has to pay £10,000 to install guards to prevent further damage. Everyone is disgruntled, bitter and unhappy.

Solution 2 is the Coasean solution. The farmer and the rail company strike a deal where he pays them £20,000 to install the £10,000 guards. Now, the train company makes £10,000 profit, giving them incentive, and in four years the farmer has recouped his losses and guaranteed to make a full harvest forever.  Everyone makes money and there are smiles all round.

The point here is that it relies on a fundamental shift in our current economic model and its potentially messy untangling from government frameworks. The parties come to a bargain that is specific and mutually beneficial, circumventing the standardised system in place to deal with such grievances.

As you can see above, this has often led to the model being cynically dubbed a Coasean Bribe since it avoids the infrastructure involved in mitigating transactional relationships (more on this later). Fundamentally it relies on trust - trust that the bargain will be upheld and that the train company will install the guards with the money and not invest it elsewhere. Interestingly, in practical studies, it seems to work. But an economy of trust in non-proximate relationships is nothing new. As monetary theorists and myself are keen to point out, currency is just trust in a nation.

So why is there so much interest in this form of transaction? Essentially, if you look at it hard and squint a bit, it represents an entirely new model for economic growth. Peak Attention pundits (more on this, later - I know) talk, quite flatly about the fact that we, as actors in nations that produce GDP, are running out of time. Our economic activity is almost totally maximised and our economy will not function without growth. A new model is needed that doesn't use growing GDP as a measure of success...