Saturday, 9 March 2013

A Brilliant Twist On The Blame Game

Every now and then you'll hear an idea that’s so brilliant, succinct and logical you'll wish you'd have thought of it yourself.  Brilliant ideas like the one I’m now going to tell you about are somewhat paradoxical, because their brilliance usually amounts to an observation that can greatly enrich and inform a large number of people, yet on the other hand one wonders why such an idea wasn’t more obvious before.  The idea I want to tell you about is one I learned in my teens when I was studying economics; it’s called the Coase theorem – and it was conceived by Nobel Prize winner Ronald Coase in 1960.  It is an observation about what economists call ‘externalities’, which are instances of costs imposed on others in an involuntary manner. 

Here’s a typical example – factories used to escape the costs of their own pollution until they began to feel those costs via liability rules, punitive taxes and fines.  The law works this way too – by incentives.  If you cause £100 worth of damage (or the societal equivalent thereof) then you pay £100 worth of restitution (sometimes more, sometimes less), either with a fine, or community service, or a prison sentence.  If a crime that causes society £25 worth of damage suddenly had a punishment worth £1 million (say a life sentence in prison) you’d see a drastic reduction in £25 crimes.  That is the nature of incentives. 

Externalities are based on incentives too, as was most famously written about by English economist Arthur Cecil Pigou with his standard textbook examples of nineteenth century trains that threw off sparks that frequently ignited the crops on neighbouring farms, and of rabbits that would frequently eat the neighbouring lettuce farmers’ goods.  Quite naturally, or so Pigou (and just about everyone else) thought, the railroad owners and farmers with rabbits had to feel the effects of their actions, so recompense was owed to the farmers with the ignited crops and the diminished lettuce supplies.  However, things change when the Coase theorem is brought to bear on the situation.  This is what Ronald Coase theorised:

"Where there are complete competitive markets with no transactions costs, an efficient set of inputs and outputs to and from production-optimal distribution will be selected, regardless of how property rights are divided."

In other words, the Coase theorem asserts that when rights are involved, parties naturally gravitate toward the most efficient and mutually beneficial outcome, with no prior blame or discrimination being automatically assumed.  This dramatically changes the situations above, because Coase was smart enough to enquire as to why the railroad owners and farmers with rabbits were the ones causing inconvenience – why not the farmers with the ignited crops and the diminished lettuce supplies?  When you think about it, it’s obvious; if your trains set fire to my crops then you have imposed a cost on me, but at the same time I have imposed a cost on you by having my crops near your railroad (which may be in the optimal location for transporting commuters from A to B).  Moreover, I may very well use the train myself.  Your rabbits are annoying me by eating my lettuce, but equally my lettuce is annoying you because it is causing your rabbits to eat them, which incurs the cost you are forced to pay me as compensation.  Your nearby power plant burns fossil fuels and pollutes the air I breathe, but you shouldn’t bear all the pollution costs because you supply electricity to many of the places whose products I buy. 

This logic by Coase is so brilliant and simple you’d think it would have been obvious long ago – but it astounded economists of the sixties with its simplicity and scope for wider insight.  Remember Coase isn’t looking to play the blame game; he is looking for an efficient set of inputs and outputs, regardless of how property rights are divided.  In the case of the railroad and the fires he is looking for a solution that benefits both, not who should reimburse who.  If the farmer plants his crops at an optimal distance from the railtrack then both may enjoy the most efficient outcome.  The town has crops and train journeys, and no one is paying financial restitution or looking for ways to sue.  Similarly the rabbit farmer can keep his rabbits in cages or secure ring-fences, the lettuce farmer could grow other things the rabbits won’t eat, or they could split the costs and build an impenetrable fence between their farms. 

How did so many economists and people in litigation miss the simple elegance of the Coase theorem for so long?  I suspect it was because people are perennially too quick to play the blame game – if something happens it must be someone’s fault.  The railroad/crops example shows a new way of looking at the situation; yes, if there were no railroad tracks there would be no crop fires, but equally if there were no crops that were so close to the tracks there would be no crop fires either.  Apply that brilliant twist to the blame game to your everyday social interactions and the chances are you’ll begin to see the world through a new lens.

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