Examples of the Coase Theorem

As the railroad example illustrates, most real-world externality settings do not have low transaction costs, which suggests that the Coase Theorem, like the perfectly competitive market, represents an important benchmark but has little practical relevance. While this is largely true, there are some notable ex- amples of the Coase Theorem in action. We provide four in this section.

Example 1: Pollution Rights. Pollution represents the prototypical example

of an externality that results in market failure. Historically, pollution control in the United States has therefore been conducted by means of direct regula- tion—so-called command and control. Recently, however, economists have urged the creation of tradable pollution rights in the hope that Coasian bar- gaining among polluters will result in an efficient allocation of these rights (Tietenberg 1985). Such a program was in fact established for the control of sulphur dioxide emissions (the cause of acid rain) as part of the Clean Air Act of 1990. To date, the program has proven quite effective in reducing emis-

sions, thus demonstrating its superiority over traditional methods for con- trolling pollution (Schmalensee et al. 1998).

Tradable permits work because they involve bargaining among a small number of polluters. Polluters and victims can also trade rights to pollute, but transaction costs usually preclude this (see the discussion of the Boomer case below). In one interesting case, however, an electric generating plant in Cheshire, Ohio, recently completed a deal with 221 nearby residents in which the residents sold their houses to the plant and signed pledges not to sue for damages in return for $20 million.14_{Although highly unusual, this cases pro-}

vides a striking illustration of how Coasian bargaining can internalize ex- ternalities, even in a large-numbers case, without the need for government intervention.

Example 2: The Reserve Clause in Major League Baseball. Prior to 1976,

professional baseball players were contractually bound to the team that drafted them. Under this “reserve system,” owners could automatically renew a player’s contract and could trade or sell the player at will, but players did not have the right to negotiate with other teams. Their only alternative to negoti- ating with the owner was to threaten not to play. The decision of an arbitra- tor’s panel in 1976, however, introduced a limited form of free agency into major league baseball whereby players with a minimum amount of major league experience could negotiate with other teams.

Owners had justified the reserve system by arguing that it was essential to maintain competitive balance in the league. Under free agency, they argued, the richest teams would end up with the best players. In contrast, economists have argued that free agency should not change the distribution of player tal- ent. To see why, note that under free agency, players would move to the team that placed the highest value on their services, whereas under the reserve sys- tem, owners would sell (or trade) players to the team that placed the highest value on their services. The only difference between the two systems is who owns property rights in the players’ services: under the reserve system it is owners, whereas under free agency it is players. Thus, the Coase Theorem im- plies that free agency should not change the distribution of talent, only the distribution of wealth.15

It is possible to test this proposition by looking at the records of major league teams before and after the onset of free agency. Table 6.1 looks at two measures of competitive balance for both the American and National Leagues during fourteen years before (1963 –1976) and fourteen years after (1977– 1990) free agency (Quirk and Fort 1992).16_{The first measure is the average}

range of winning percentages (that is, the average of the difference between the teams with the highest and lowest winning percentages), and the second is the average standard deviation of winning percentages. Both measures in-

TABLE6.1 Impact of Free Agency on Competitive

Balance in Major League Baseball

Pre-free Post-free agency agency (1963 –1976) (1977–1990) Average range of winning percentage American League .241 .249 National League .251 .211

Average standard deviation of winning percentage

American League .071 .070

National League .066 .064

SOURCE: Quirk and Fort (1992, 285).

dicate that no significant change occurred in the competitive balance of either league as a result of free agency. There is little doubt, however, that it has shifted the distribution of wealth toward players.

Example 3: Order Without Law. Robert Ellickson (1991) provides an inter-

esting illustration of the Coase Theorem in action in his case study of how residents in a rural county of California deal with the problem of straying cattle. Prior to 1945, most of the county in question was “open range.” That is, cattle ranchers were not liable for damages caused by straying cattle. In 1945, however, the county enacted a “closed range” statute in some areas, making ranchers strictly liable for cattle damage. This regime change offered a unique opportunity, in the context of Coase’s own example, to evaluate the impact of a change in property rights on the allocation of resources.17

Ellickson found that neighbors were in fact strongly inclined to cooperate with one another to resolve their disputes. In this sense, the parties achieved the outcome predicted by the Coase Theorem, namely, a mutually beneficial outcome without the need for government intervention. Surprisingly, though, they did not reach this outcome by bargaining from established legal rules. In- stead, they did it “by developing and enforcing adaptive norms of neighbor- liness that trump legal entitlements” (Ellickson 1991, 4). This finding shows that, in some circumstances, even the minimalist role of government implied by the Coase Theorem—namely, to define rights as a background for bargain- ing and to enforce any reallocations—is not necessary to achieve an efficient outcome. Although we saw that property rights similarly emerged without government intervention in mining, that was a prelude to formal government enforcement, rather than a substitute.

Example 4: Experimental Evidence for the Coase Theorem. A final example

man and Spitzer (1982) report the results of a set of controlled experiments that tested the predictions of the Coase Theorem in two- and three-person in- teractions. In each experiment, the parties made pseudoproduction decisions that affected each other’s payoffs (as in externality cases), and they were al- lowed to bargain over the outcome and division of the proceeds. The results turned out to be efficient in 89.5 percent of the experiments, providing clear support for the Coase Theorem in small numbers (that is, low transaction cost) settings.