Feb 9 JDN 2458889
The Coase Theorem states that under perfect property rights, perfect information, perfect contract enforcement, and negligible transaction costs, Pareto efficiency can be achieved even when there are large externalities. It was designed as an argument against Pigovian taxation, which tries to use taxes to create incentives against externalities such as pollution.
The usual argument against the Coase Theorem is that transaction costs are rarely negligible and contracts are often unenforceable, so the Pareto-efficient solution to externalities that it provides is unrealistic. (In fact, Coase himself agreed with this critique, and instead argued that regulation of externalities needs to be done on a case-by-case basis with attention to the detailed context.)
Yet this is not the real problem with the Coase Theorem. The real problem is the criterion of Pareto-efficiency: An arrangement can be Pareto-efficient without being fair, just, or even economically efficient in any real sense.
As a reminder, Pareto efficiency simply says that no person can be made better off without making some other person worse off. It doesn’t say anything about how well off people are relative to one another—inequality—or how they got what they have—justice. It doesn’t even really entail economic efficiency: Supposing that the marginal utility of wealth is always positive, if one man claims all the wealth in the world and lends it out to everyone else at interest, that does seem to be Pareto-efficient—we can’t make anyone else better off without taking something from His Majesty the Supreme Emperor—but it clearly isn’t economically efficient in any desirable sense.
And this is what’s wrong with the Coase Theorem: The kind of Pareto efficiency it generates allows for—indeed, in many cases demands—what we would ordinarily call extortion.
What is extortion, after all?
If a member of the mafia comes to your house and says, “What a nice place you’ve got here; what a shame if anything happened to it!” and then demands you pay him $500 a month, that’s extortion. He has the power to inflict a negative externality on you, and he promises not to as long as you pay him. (Here, the contract enforcement actually comes from the reciprocity in the indefinitely iterated game, and doesn’t require an outside enforcer.)
Extortion is when one party has the power to create a negative externality upon another (e.g. burn your house down, punch you in the face). They make a deal: They won’t create that negative externality, provided that you compensate them (pay them money). Is this Pareto efficient? Absolutely! They’re as well off as they would be if they hurt you, and you’re better off. But is this how we want to run a society? I don’t think so.
In the cyberpunk future in which we now live, there is a market emerging that fits the requirements of the Coase Theorem as well as any which has ever existed; and sure enough, in the absence of adequate regulation it is turning to extortion.
I am referring of course to the market for online advertisements. Perfect property rights? Not quite, but that intellectual property enforcement is very strong. Perfect contract enforcement? Not perfect, but highly reliable, like any mature market in a First World country. Perfect information and negligible transaction costs? As close as humanity has ever come.
What’s the externality? People don’t like seeing ads. Ads are annoying, distracting, and unpleasant. But businesses benefit from showing people ads (or at least think they do), and seek rents by trying to post more ads than their competition. I proposed a Pigouvian solution: Tax advertising.
What’s the Coase solution? Let people pay to skip ads. And indeed there are now sites that do this.
Note that there is a vital difference between this and, say, YouTube Premium. With YouTube Premium, you’re actually paying for the opportunity to use an ad-free version of the service. So instead of advertisers paying Google to run ads on the content you watch, you’re simply paying for the content you watch. That’s great. I have no objection to that. In fact, I strongly prefer it to the ad-supported model. Paying for content makes you the customer. Accepting ads in return for free content makes you the product.
No, I’m talking about businesses posting ads, and then offering you the chance to pay them to get rid of those ads. (Maybe a cut would go to the content provider, but that’s not really important here.) The key is that the people who make the ads get the chance to get revenue from you paying to skip them.
In Coase terms, that sounds great! Instead of me having to put you through a miserable ad that probably won’t lead you to buying anything anyway, you just pay me $0.25 or something directly. I’m better off, you’re better off, everyone’s happy.
But in fact, everyone is not happy, because here’s what I can do: I can go out of my way to make the ads as obnoxious as possible, so that you have no choice but to pay me to skip them. I’m not the first one to make this point: It’s the subject of an SMBC comic and a major plot point in a Black Mirror episode.
This is precisely the same process as extortion: Threaten a negative externality, demand compensation in return for not doing so.
I think what Coase missed in his original argument is that negative externalities aren’t always by-products of otherwise productive activities. We often—nay, usually—have the power to inflict negative externalities upon other people with no productive purpose. If externalities were always by-products, negotiation as Coase imagined it could allow us to achieve the productive benefit without the externality cost. But when externalities can be generated independently, they are a means of extracting rent from those too weak to resist you.
What’s the solution to this problem? It’s boring: We have to tax and regulate externalities after all.