Debunking the Coase Theorem

The famous Coase Theorem says that in the absence of transaction costs the initial allocation of resources does not matter because resources will end up with the users who can use them most efficiently.

To check if this reasoning works, let us carry a thought experiment.

Suppose that all the resources in the zero-transaction cost economy are allocated efficiently, except one plot of land, which is already a very stringent assumption. The owner of the land, John, is the most efficient user, except for just one person, Sam (stringent assumption 2).

John gets from the plot of land $1000 per year. If the title to the land plot were translated to Sam, he would get $2000 per year from it. Assume that these amounts are changeless (stringent assumption 3).

In line with the Coase Theorem, the land plot will be immediately transferred to Sam. But does this conclusion follow from the conditions described?

The first problem is that, since value is subjective, John may value the land plot not because or not just because it brings him money. In such situation the fact that someone may use the land plot more efficiently may just not bother him. Thus, in order to try to save the Coase Theorem, we need to assume that all that agents care about is maximization of monetary income (stringent assumption 4).

But does it save the theorem? Yes, Sam will increase the productivity of the land plot but how much will John value it? In other words, will he ask from Sam $1100 or $5000 or $30000?

Sam may offer John to pay him $1000+ for every year of John’s life remaining. But if we don’t eliminate time preference from the picture, that may not be enough.

Now, suppose that there is no time preference (stringent assumption 5), and John and Sam immediately strike a deal. There is still a problem for the Coase Theorem. For now, the monetary incomes of John and Sam will change. This may change relative prices in the economy and unsettle the rosy picture that had existed prior to the transfer where all other resources in the economy, except John’s land plot, had been efficiently allocated.

And not only has this changed. The increase in the productivity of the land plot by definition means that quantity of at least one good in the economy has increased or a new good has entered the market.

I don’t think that there is a need for carrying the logic further. It is clear that Coase Theorem does not hold even with the most stringent assumptions. And I can’t even think of an assumption that would solve the final problem I mentioned. 

On Intellectual Property and Liberty

On the Equilibrium Conditions

Having read this article by Jorg Guido Hulsmann on realist approach to equilibrium I thought I should analyze one of his main points on an example to see if he is right.


The thesis in question is that both the mainstream economists and even Mises (with his Evenly Rotating Economy construct) have been in error with regard to the conditions that are sufficient for equilibrium to obtain, because for it to obtain it is not sufficient that all conditions cease to change, or that the market agents are omniscient (meaning that they know all the conditions, including the preferences of all other agents). 


To check whether the above statement is true, the following thought experiment is in order.
Imagine an uninhibited island where 6 people find themselves. Three of them decided to become gatherers and gather berries, and three – to become hunters. Suppose also that for some reason the people who are most best suited for hunting are vegetarians.


Suppose that in a given period 3 hunters (A, B and C) caught a small deer which gave them 60 kilos of meat which they divided equally among themselves.


The gatherers have achieved the following results: D - 40 kilos of berries, E - 50 kilos, and F - 100 kilos.


Let us further suppose that the agents are ready to sell their product at following minimum prices (for hunters expressed in kilos of berries per kilos of meat, and vice versa):


Hunters
A 50/20
B 50/20
C 50/20


Gatherers
D 20/40
E 20/50
F 20/30




A price of, say, 50/20, for the purposes of this thought experiment means that the agent wants to sell 20 kilos of meat for a price of no less than 50 kilos of berries.


As follows from the preferences in the table, in this situation equilibrium (i.e. an outcome when all agents would sell as much as they wanted at least at the minimum price) cannot obtain. And even if the agents know each other’s preferences and nothing changes in the following period, equilibrium still won’t obtain, unless the preferences of the agents change.

A simple model of Austrian malinvestment

Assume that a closed economy consists of two individuals – John and Mary.

There are only two goods – potatoes and apples produced by John and Mary, respectively. For simplicity let us assume that in the initial conditions John produces 120 kilos of potatoes per year (10 kilos per month) and Mary the same way produces 120 kilos of apples. John prefers apples to potatoes, while Mary prefers potatoes to apples. So, in the end of each month John gives Mary 10 kilos of potatoes in exchange for an equal amount of apples.

Suppose that in this economy John has an opportunity within a two-year period to increase production of potatoes in the second year to 160 kilos (~12,6 kilos per month) but to create the conditions for that he should reduce production of potatoes in the first year by 24 kilos (2 kilos per month). Assume that this is the only way for John to increase the production of potatoes and that he is not willing to reduce his consumption of apples produced by Mary.

In such conditions the only way for John to increase production of potatoes is to convince Mary not to decrease production of apples despite the fact that she will have to forego part of her consumption of potatoes. In return John would promise Mary that in the following year she would receive from him 32 more kilos of potatoes. John’s profit from this investment project will be 8 kilos of potatoes in the second year.

What will it mean if Mary agrees to the deal? It will mean that her rate of time preference or annual interest rate is less than ~33,3%, that is she prefers 32 kilos of potatoes in the second year to 24 kilos in the first year.

But what if her interest rate is, say, 40% and John, without consulting Mary, mistakenly assumes that it is less than 33,3%?

Then in the first month of the first year he produces 8 kilos of potatoes instead of 10 and starts his investment project. In the end of the month he meets Mary as usual. Mary puts forward her 10 kilos of apples and waits for John to put forward his potatoes. When he does, she notices that the amount of potatoes is lower than she had expected. She asks John about it and he tells her that he decided that she would agree to forego part of her consumption of apples on the aforementioned conditions. In response, Mary tells him that she will not agree to that and for his misconduct she will only give him 8 kilos of apples this month to ensure that he would produce 10 kilos of potatoes in the following month.

Thus, in order to maintain his consumption of apples at the desired level, John will have to abandon his investment project and because of his mistake the economy will lose the value of 2 kilos of potatoes for Mary and the positive difference between the value of 2 kilos of apples for John and Mary.

I believe that, despite being extremely primitive, this model captures the essence of malinvestment conceived by the Austrian theory of business cycle. In the real economy the presence of money and hence credit markets makes it easier for producers to make the right investment decisions. But this only holds in the situation where the amount of credit equals the amount of savings. If the amount of credit exceeds savings, investors may find themselves in the position similar to John’s.

However, the in contrast to the model, the malinvestments will probably not be discovered so fast, and the damage might well be higher.s