Hi everybody, welcome back. At last we'll identify our elderly court observer, Ron, as the eminent economist Ronald H. Coase of the University of Chicago. Retired now for some years but I'm delighted to say still alive and recently celebrated his one hundred and second birthday. Coase made the argument that I've just summarized in the previous lecture, in a very famous 1960 scholarly article called the Problem Of Social Cost, which since 1960 has become one of the most cited articles ever written in the discipline of economics. Nowhere in this article does Coase use the phrase Coase Theorem. That phrase comes from the thousands of people who have puzzled over the result that is suggested by the earlier lecture, and has been formalized as it were, or summarized in a statement. A statement that summarizes the example that we've just given and has been given the name by Coase's successors the Coase Theorem. So what I would like to do is to parse out the Coase theorem, explain it in full in this lecture, and at the end suggest an extremely important qualification and hidden assumption that lies at the base of the argument that we've just. So let's begin to talk about the Coase theorem by beginning with a phrase, a qualification if you will. If the costs of bargaining are low, You'll recall that in the example that we just developed. The example of Hamilton and Jefferson. The property right in question, the right to test sirens in Rachel's alcove. Moved to the higher valuing owner no matter which of them won the case. That is no matter which of them was the initial recipient of the property right at the end of the court case given by the judge. But in both cases, if the judge did not intitially give the property right to the higher valuing owner, then a transaction, an exchange was required in order to move the property right from the lower valuing owner to the higher valuing owner. So a critical condition Of the Coase theorem, of the result that we've just begun to suggest, is that bargaining between the parties be sufficiently costless so that property rights can be transferred by exchange among the various parties without the costs of doing business with one another eating up all of the gains of trade. You recall that in the trade between Hamilton and Jefferson over the property right. When a trade could be made, both of them wound up better off at the end of the trade than when they began. The qualification that bargaining costs must be low simply means that the costs of actually completing the transaction that moves the property right from the lower to the higher valuing owner must be sufficiently small That they don't overwhelm the benefits that each trader will receive by participating in the exchange. So this suggests that we introduce a new category, a new idea. And that idea is the notion of transactions. Transaction costs are the frictions that impede free exchange. Whatever it is that stands in the way of people like Hamilton and Jefferson being able to do business over the transfer of property rights. These costs of doing business arise in a number of different ways. It's not always easy to now what you want. That is to say, in our example, it's not always easy for Hamilton or Jefferson to know exactly what the value to them of their quiver of property rights is. Sometimes this is easy sometimes it isn't easy. And, when it isn't easy it's costly to determine what one wants. This is what advertisers try to take advantage of by trying to persuade us that we want something that we didn't know we wanted before we heard the advertisement. Once we know what we want, and indeed know what we have to trade in exchange to get what we want. Then our problem becomes finding potential trading partners. Who is it out there in the universe who has what we want and is willing to accept what we have in exchange for it? Sometimes it's easy to find potential trading partners. Sometimes it's very hard to find potential trading partners. And sometimes there are many, many trading partners, and one finds it difficult to find the best trading partner, the one who's willing to offer the most favorable terms of trade. Once one knows what one has and what one wants, and once one has discovered some potential trading partners, then the terms of trade have to be negotiated. We had Hamilton and Jefferson sell a property right between them for $300, and we simply arrived at this figure rather easily. Easily. In the real world of course there'd be some negotiating. Hamilton would faint, Jefferson would parry. They would reveal little bits of information. They'd try to hide little bits of information about what they had and what they wanted. And sometimes it's costly, it takes time, it takes effort. Sometimes it uses resources to ultimately determine what the price of those property rights is going to be. Finally, there's what might be called shipping and handling. And that is the costs of physically completing the transfer of goods from 1 individual to the next. Again, sometimes this is very easy. If all we're transferring is an arrow with a tag on it. Then physically consummating the transfer or goods can be expected to be cheap and easy. That if we're selling 1,000 bushels of grain or 4,000 automobiles, it's not easy to move the goods from one place to another to complete the exchange. All of these are sources of transactions cost Transaction costs frustrate free exchange. Anti-transaction costs are sufficiently high. The result that we've seen in the previous lecture will not obtain, and the Coase therem will be rendered false. So the very first qualification in the statement of the cospherim, is that the costs of bargaining must be low, so that the transactions that move goods from lower to higher value in owners, can take place freely and easily. If the costs of bargaining are low, as we've seen, property rights will ultimately come to be held by their highest, highest value in owners. And we saw this on both sides, in the two examples that we saw in the last lecture. In the first example, when Jefferson was the higher valuing owner of the property right, he wound up with the property right no matter who was awarded the right in the court case itself. Similarly when we made Hamilton the higher value in owner of the property right, then no matter who got the property right originally, Hamilton the higher valuing owner would wind up eventually, whether a transaction was needed or not. So when property rights are in fact held by their highest valuing owners. Unsurprisingly the total value of all property rights will be maxmized. That is, if every property right is producing the maximum value that it possibly can by being in the hands of it's highest valuing owner. Then the sum of all of those values will be as high as it can possibly be, and the total value of all property rights will be maximized. When property rights are all in the hands of their highest-valuing owners, economists say that those property rights have been allocated efficiently. There is no wastage of anything if property rights have been allocated efficiently. Notice in our earlier example using the original numbers, if sirens were not tested then the total value of the two properties was $2,200, but if sirens were tested the total value of the two properties was $2,500. Notice that there are not more or less property rights in the two situations. The only thing that differs is whether Hamilton or Jefferson owns the property right to test those sirens. If Hamilton ends up with the property right, as the lower valuing owner. And the total value of the two properties is $2,200, then there's a wastage. By simply moving the property right from Hamilton to Jefferson, not creating any more property, but simply moving existing property from one holder to another. The total value of the two properties can be increased from $2,200 to $2,500. More total economic value has been squeezed from the same property rights when Jefferson holds That property right to test the sirens then would be the case if Hamilton held that right. Hence, property rights are allocated efficiently No value is wasted when the property rights are in the hands of their highest valuing owner. And this will happen, as we've seen, regardless of how the property rights are initially allocated. If the law allocates the property right initially to the higher valuing owner, then no transaction is needed to achieve an efficient allocation of property rights. The judge has already allocated property rights efficiently by giving the property right initially to the higher valuing owner. If not that is if the judge has given the property right initially to a lower valuing owner. Then free exchange if the costs of bargaining are low, will ultimately move that property right from the hands of the lower valuing owner to the hands of the higher valuing owner. But how this maximized value is distributed as we've seen, depends on how the rights are initially allocated by the court, that is, on who wins the case that initially allocates the property rights. Right. As we've seen in our earlier example, if Hamilton wins the case, the $2,500 dollar total value is divided up with Hamilton getting $1,300, Jefferson getting $1,200. But if Jefferson brings the case that same $2,500 value created by Jefferson's ownership of the property and testing of the sirens, that $2,500 is divided differently. Hamilton is now worth only $1,000 and Jefferson is worth $1,500. So there's the theorem. If the costs of bargaining are low, property rights will ultimately come to be held by their highest valuing owners. Or to say the same thing, property rights will be allocated efficiently, regardless of how rights are initially allocated. But how this maximized value is distributed depends on who wins the case, who it is that gets that property right initially. But there's a very important qualification to the Coase Theorem which is not obvious from what we've been saying up until this point. Let's go back to that second example that we had in the previous, the previous lecture. That is, let's assume that Jefferson can earn $500 of profit by testing the sirens, increasing the value of his house from a thousand to 1500, but if he does sell, he will decrease the value of Hamilton's house to Hamilton by $600. From $1,200 to $600. So Paul Hamilton has the right, then as we've seen, he will sell it for less than $600, because if Jefferson has the right, Jefferson will use that right to impulse a $600 cost on Hamilton. To avoid that $600 cost, Hamilton, if he has the right, will refuse to sell the right for less than $600, and he is the higher valuing owner in this example. But if the court initially gives the right to Jefferson Then the Coase Theorem says that efficiency will be achieved only if Hamilton is able to buy the right from Jefferson. And in our example, we assumed Hamilton could do this by coming up with $550 in cold cash to pay for the property right that Jefferson had, and that Hamilton wanted. And claim to value more than Jefferson. So, if Hamilton doesn't have the right, he has to raise at least $500 in cash in order to buy that right. What if he doesn't have the money? And what if he can't get the money? Doesn't have any access to the money. What happens then? Well, suppose he has $200 . And that's all that he has in cash. But he says if he didn't have the right, that he'd pay $599 if he had to, if only he had the $599. So, we have a Hamilton, now, in this altered example, who, if he owns the property right initially, will not sell it for less than $600 But if he doesn't have the property right initially, he can only raise $200 maximum, to purchase that right. And as we've seen, $200 was not enough to pry the right from the hands of Jefferson. In this case, one of two things must be the case. Either the theorem fails, since Hamilton is the higher valuing owner when he has the right, but not the higher valuing owner when he doesn't have the right, and thus the total value of the rights does indeed depend on their initial placement. If Hamilton doesn't have the cash to buy the. The, the property right from Jefferson even though he claims to value it at $600, then in fact it does depend, does matter who gets the right. Hamilton won't be able to buy the right and he won't sell the right if he's given it initially. The alternative is that we simply assume that this problem will never arise. That is, we might assume that each party to the transaction, the potential transactions at stake in the example, has access to enough money to make whatever purchases of property rights. They feel, the need to do, that is to say we'll assume this situation away by assuming that in this case Hamilton will always have at least six hundred in cash that will enable him to make this purchase. And so the result, if he has that $600 in cash that he is the higher valuing owner no matter how the case is initially decided, and he will wind up with the right. So, we can summarize this important qualification in three propositions. The first of them is the utility. And economic value are not the same thing. Right at the beginning of the course I introduced Jeremy Bentham, the father of this philosophy of utilitarianism, who argued that social policy ought to be made and that property rights ought to be allocated so as to produce the greatest happiness possible, the greatest utility possible. As we've seen in the Coase Theorem, this is not what is being maximized in the dealings between Hamilton and Jeffesrson. As the qualification example suggests, Hamilton may get a lot of disutility from the testing of those sirens. But he may not be able to back up the preferences he has about siren testing with money. So what's being maximized in the Coase Theorem situation is not the sum of the utilities of Hamilton and Jefferson, but the sum of the economic value of their quivers of property right. An economic value is not simply how much somebody wants something. It is preference backed by money. That is, the only values that count in the Coase theorem argument are those values that... So reported valuer can back up with cash to manifest that value in an exchange. And therefore, of course, how much economic value a person can derive for experience from a particular property right depends on how much money they have. And so economic value is strongly conditioned by the distribution of wealth of across individuals. And in our latest example, Hamilton being poor is unable to back his preference against siren testing by money and therefore the exchange system will simply not register their preference. Finally, the Coase Theorem is there for, not about utility maximization, but it's in fact about the maximization of value. We'll talk a little bit more about qualifications to the Coase Theorem in the next lecture.