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The Coase Theorem and Governance

Governance via externality pricing
Here we’ll explore a way to frame the problem of governance as just “pricing externalities”. This is a tempting framing because it makes defining “good governance” comparably much easier 1) whether or not something is an externality is much closer to an objective question and 2) there are theoretical methods to pricing externalities in Pareto Optimal ways, like Coasian Bargaining which we will explore.

The canonical story of externality pricing is that of the farmers and the Dutch waterworks. This is a true story about farmers in the Netherlands that were using fertilizers and pesticides on their crops in order to increase the size of their harvest. This worked great for them, but the chemicals they put in their soil leached into the waterways to the detriment of the people that lived downstream. In response, the Dutch waterworks (the public organization encharged with maintaining clean water) had to work much harder to filter chemicals out of the water than they used to because of the increase in usage of pesticides and fertilizers.

At this point, they could have gone to the local government and asked them to pass a law, for example, limiting the amount of fertilizer the farmers were allowed to use. However, legal limitations are notorious for creating deadweight loss, and are slow and expensive to implement and enforce. As an alternative to legislative governance the Dutch waterworks opted for economic governance: they offered to pay the farmers in exchange for using less fertilizer. This strategy of paying someone who causes externalities so that they’ll do less of it is called Coasian Bargaining after Ronald Coase who first proposed it in 1960 and for which he later won the Nobel Prize in Economics.

Originally, Coase wrote his famous paper, , as a follow up to a previous paper he had written encouraging the nascent Federal Communication Commission to adopt ownership rights for radio waves (). He had noticed corruption and inefficiency in how those rights were awarded by the agency, and argued that an economic system would do a better job allocating those rights (both more efficient and more just). In the end they listened to him, switching to the broadcast rights model we know today. At the prodding of a colleague, Coase wrote a follow up paper that would treat the problem of efficient allocation of goods more generically; rather than focusing on a single instance of inefficiency — as in The Federal Communications Commission — he would review the general mechanisms by which markets in the presence of ownership rights would have the ability to self-regulate so as to find optimal economic output. The mechanism by which this could be achieved, Coase argued, was not a legal process, but rather an economic interaction that came to be known as Coasian Bargaining: pay the person who is doing things you don’t like in exchange for them not doing it.

The principle behind Coasian Bargaining is that if the value of the pesticides and fertilizers to the farmers is $5 per harvest, then the Dutch waterworks should be able to pay them about $5 per harvest in exchange for them not using those chemicals. That money is coming from the community that lives downstream, they’re paying, through their taxes, to have cleaner water. If the community doesn’t value clean water at $5 per harvest then they won’t reach a deal where the farmers avoid chemicals.

However, in practice Coasian Bargaining doesn’t work. In fact, this canonical case of the Dutch waterworks and the farmers is exactly an instance where Coasian Bargaining failed: in the real world the waterworks was unable to negotiate a deal with the farmers because the farmers could hide the true value of the use of chemicals and because they weren’t required to reach a deal. These are the two main problems with Coasian Bargaining:
The Hidden Information Problem
The Hold Out Problem

Since the waterworks didn’t know the value of the chemicals to the farmers, the farmers can always plausibly increase the fee they want the waterworks to pay them. Furthermore, since agreeing to a contract is voluntary, the farmers don’t ever have to make a deal. These two problems conspire to always make it optimal for the farmers to inflate the amount of remuneration they demand from the waterworks. In fact, there’s a general theorem, the Meyerson-Satterthwaite Theorem, that predicts that all voluntary markets will suffer from buyers that signal they undervalue a good and sellers that inflate their prices, especially when there are only a few buyers and sellers as is the case here.

The Hidden Information Problem shows up in a second way here: even if the waterworks had come to an agreement with the farmers, how would they ensure the farmers actually reduced their usage of chemicals? Sure, they could measure the water for the chemicals, but it would be hard to attribute it to individuals in the group. This gives each farmer an individual incentive to defect, continue to use the chemicals, and even if the whole group loses out on the payment, at least they still got the benefit of the chemical usage. Since all the farmers know that the payment will go away if any one of them defects, and since they all know that defecting will be the best strategy if any of the others defects, their best move is to defect themselves, so they most likely do. If there was a way of attributing defection to a particular farmer then it would be possible to avoid this issue, but who is using fertilizer and how much is hidden.

There are other problems with Coasian Bargaining which are closer to ethical than to economic:
Coasian Bargaining favors the externalizer (in this case, the farmers)
It may also incent players to create externalities so they can be paid to stop creating them

By favoring the farmer (because they’ll be the ones receiving the payment) it creates an economic situation where even if that farmer’s land could be used profitably for something other than farming, the farmer won’t want to leave because they’re now getting paid to not use chemicals. For example, if the farmer normally would use fertilizer on her crops and earn $7 profit per year, but has now reached an agreement whereby the waterworks has agreed to pay her $5 to not use fertilizer, which reduces her profit from the annual harvest to only $2, the farmer is not unhappy and is still whole because the waterworks has compensated for the loss. However, what happens if along comes an alternative energy company which would like buy her land to install solar panels? The energy company expects to earn $5 per year on the solar panels. Normally, if the farmer were growing with fertilizer the value of the land would be higher for her than for the energy company, and so she would not sell. If the farmer didn’t use fertilizer and didn’t have the subsidy from the waterworks then she would sell, because the land to her would only be worth $2 per year, whereas the land to the energy company would be worth $5 per year. However, in this instance she won’t sell because the subsidy from the waterworks keeps the value of the land to her at a profit of $7 per year. If the energy company were to buy the land, the waterworks would no longer have to pay $5 per year to the farmer, but the farmer won’t sell because of the $5 per year the waterworks is paying.
The most efficient solution to this problem would be for the energy company, not the farmer, to own the land, where a total of $7 of profits would be created with no costs for the local populous, however the community is now stuck with a solution where only $2 of profits are created per year, and which cost $5 per year to avoid externalities. In fact, the only way the energy company would be willing to purchase the land from the farmer is if they could get the waterworks to pay them an additional >$2 per year. To achieve this the waterworks might even threaten to release chemicals into the water just like the farmers if the waterworks didn’t agree to pay. A new deal could be reached where the energy company is earning >$7 per year, >$2 of which is paid by the waterworks in exchange for them agreeing not to release chemicals into the water which they had no intention of doing anyway. This does make things more efficient: more goods are created and for lower costs to the waterworks, >$2 instead of $5. Notice that in order to make the transaction, the energy company had to know to make a deal with the waterworks. If there had been multiple waterworks, or subsidies coming from many different places this would have made the transaction much harder to complete because of coordination costs. In this way, the bargain struck by the waterworks increases the floor price that any alternative service must supersede, and complicates the negotiation process. Ultimately, the value of this transaction has accrued to the farmer, the polluter!, her land was purchased at a higher price than it otherwise would have thanks to a subsidy from the waterworks. In fact, if she had managed to pollute more the waterworks would have been willing to pay more she would have earned even more money on the sale.

Technically, the fact that the externalizer gets richer and that there’s an incentive to create more externalities is not a problem. What Coase would predict is that this will cause the citizens of the town to move away (because of the pollution or the costs of minimizing pollution) which would reduce the subsidy for the farmers, which would cause them to go back to using pesticides and fertilizers. And now the externality is “gone” because no one is hurt anymore by the chemicals. This is technically Pareto optimal — meaning the best possible economic arrangement. However, it feels completely wrong. If I walk around town with a hammer threatening to break the windows of everyone who doesn’t give me $5 then the optimal move from the perspective of Coasian Bargaining is to pay me not to start swinging. It’s reminiscent of mobs charging local stores for “protection”, but then attacking them if they miss a payment. Even if this is optimally efficient from a microeconomics perspective, it’s clearly inefficient from a more macro perspective. Ironically, or perhaps predictably, more windows will be broken in the world where you pay people not to break windows.

These are the perverse incentives created by Coasian Bargaining. However, it turns out that the mechanism can be salvaged. The trick is that instead of paying the farmers to not pollute, charge the polluting farmers by paying them with negative money. Initially, this might not seem like a new idea. It sounds very similar to Pigouvian Taxation, which is also a way of charging a fee to polluters, and which predates Coasian Bargaining. However, Pigouvian Taxation has the problem that as part of disincenting polluters it creates revenue for the taxing government. Surprisingly, this revenue can be problematic because it can create an incentive landscape where the taxing government actually relies on the polluter as a source of income. This can then become a moral hazard when the disincentives to polluters create alternative products come along that are profitable and don’t have externalities (e.g. solar panels instead of wheat) and displace the government’s very important source of revenue. In this way, the government can end up with an incentive to simultaneously protect the polluting industry against competition while taxing it for its pollution. Negative money does not suffer from this issue. One way to conceive of negative money is as a fine that’s levied against the polluters, but the revenue from that fine must be immediately destroyed so that it cannot be spent. This is impossible to do with most fiat money because there are laws against destroying money, however, it’s totally fine to do with cryptocurrencies, and burning a token is a common operation as part of a broader tokenomic system. This is not the only way of implementing negative money, so I’ll refer to the specific mechanism of putting negative money into the polluters account as “disbursing” the polluter’s account. This creates Disbursive Coasian Bargaining.

The great thing about Disbursive Coasian Bargaining is that it solves our two problems from above:
It directly disincents creating negative externalities because they’re now expensive to create
It disfavors the externalizer. Now negative value accrues to the polluter in exchange for creating negative externalities

However, to really fix Coasian Bargaining you must solve the Hold Out Problem and the Hidden Information Problem. Disbursive Coasian Bargaining doesn’t directly do this but it gives us new tools in that design process.
If it’s possible to directly disburse an account (perhaps enabled by a certain type of token whose value can be remotely changed by a governance process) then there is no Hold Out Problem because the agreement is now non-voluntary.
If it were possible for polluters to mitigate the size of the disbursement by providing more information then there would be an incentive for providing new information. This could be the start of solving the Hidden Information Problem.

The questions would then become:
What kind of governance mechanism can be trusted to infer what would be valuable information in the pursuit of an accurate estimate of a polluter’s contribution to a negative externality?
Why would anyone voluntarily sign up to be governed by this economic system if it could be disbursive toward them?
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