Aesop Econ: The Charcoal-Burner and the Fuller

My Amazon Kindle app came with a free copy of Aesop’s Fables (translation by George Fyler Townsend), which I began reading a few days ago. Aside from being charmed by their brevity and deceptive simplicity, I was also struck by how many of the stories involved economic concepts -- some obviously, others subtly. So I thought it might be fun to do a series of blog posts analyzing Aesop’s Fables from an economic perspective.

To start, here’s a fable called “The Charcoal-Burner and the Fuller.”

A CHARCOAL-BURNER carried on his trade in his own house. One day he met a friend, a Fuller, and entreated him to come and live with him, saying that they should be far better neighbors and that their housekeeping expenses would be lessened. The Fuller replied, “The arrangement is impossible as far as I am concerned, for whatever I should whiten, you would immediately blacken again with your charcoal.”

Like will draw like.

This is a story about negative externalities. Were the charcoal-burner and fuller to move in together, the charcoal-burner’s trade would impose unwanted costs on the fuller’s. How might this problem be addressed?

In a traditional Pigovian analysis of the situation, the coal-burning’s harmful side effects might be regarded as justifying a correction. Perhaps the government ought to impose a tax on burning charcoal; the optimal tax would be set equal to the marginal external cost in terms of blackened garments. That would induce the charcoal-burner to consider the full costs of his choices, and therefore to reduce his charcoal-burning to the efficient level.

But Aesop’s story presages a more sophisticated Coasean analysis. As Ronald Coase observed, externalities are reciprocal in nature. To permit the burning of coal would harm the fuller -- but to restrict the burning of coal would harm the coal-burner. The presence of both activities is necessary for the externality to exist. And this draws our attention to the possibility of averting the harm by means other than reducing coal-burning. According to the least-cost avoider principle, an externality should be reduced or prevented by the party who can do so at the lowest cost. In the case at hand, the fuller can avoid the externality by not moving in with the charcoal-burner in the first place.

In most modern externality analysis, the story begins with two parties or activities that are already in conflict. But Aesop properly chooses to start his story before the conflict comes to be. Moreover, Aesop (like Coase) reminds us that externality problems can, at least sometimes, be solved or avoided by the interested parties themselves.

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The Fundamental Transformation in Breaking Dawn

If you’re on Team Edward, you might think the fundamental transformation in Twilight: Breaking Dawn is a person getting turned into a vampire. Or if you’re on Team Jacob, you might think it’s a boy morphing into a wolf. But if you’re an economist, it’s the conversion of undifferentiated assets into relationship-specific assets.

That came out more boring than I planned. But it’s true! On Deadline Hollywood, Nikke Finke reports that several supporting actors played hardball during negotiations for the final installments of the Twilight series:

Really, my eyes glazed over at the recent ruckus that those secondary actors were demanding as much as $4 million each to do the 4th and 5th installments of the Twilight Saga. ... I’m all for higher pay for thesps, and Summit has tons of cash to spread around. But in this case Summit gave these actors their big break, and offered them 10 times what they’d made in the first movie, and could have replaced every one of them with hungry unknowns had it not been for the execs’ fears of offending fans.

We’ve seen this happen before, of course, most notably when the six leads on Friends wangled $1 million each per episode in their final season. In economics jargon, stories like these illustrate what Oliver Williamson dubbed the fundamental transformation (see p. 176).

When an organization (such as a firm) acquires new assets (such as employees), those assets are typically undifferentiated at the outset. The firm has many other equally suitable options, and thus the potential employees have limited bargaining power. But after they join the organization, they undergo a transformation. They gain value to the organization that they lack outside of it, and thus they’re no longer undifferentiated from all the other options. Now there’s more room for bargaining, and the parties may try to claim a larger share of the gains from continuing the relationship. That’s just what the Twilight supporting actors have done.

What’s less obvious is the symmetry of the situation. The owner of the relationship-specific asset can threaten to hold-up the process, but so can the buyer. Say having the specific actor from previous installments of a series is worth $5 million to the studio. Meanwhile, the actor’s best alternative movie offer is $1 million. Then there’s a $4 million pie to be cut, and an offer of $3 million would exactly split the gains from trade. But the studio may hold-up the process by refusing to pay a dime over $2 million, while the actor may threaten to walk for anything less than $4 million. Both parties stand to lose if they walk away, which is why they usually end up settling somewhere in the middle (often with the final number undisclosed to the public). But every now and then, the deal falls through -- especially when the parties disagree about how valuable that relationship-specific asset really is.

Human assets aren’t the only assets subject to the fundamental transformation. To take another example from the movie business, the selection and creation of sets transforms undifferentiated assets (apartments, furniture, lumber, etc.) into relationship-specific assets. And in some cases -- for instance, a private home rented as a location -- the same problems can arise. But for physical assets, there’s often a simple solution: buy the asset outright. That solution is not available for human assets... although some would argue the old studio system came close.

(For another application of the fundamental transformation, see here. Cross-posted at ThinkMarkets.)

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Peer Production and Transaction Costs

The concept of peer production is hardly new to me. Wikipedia and Linux, the most visible examples of peer production, long ago convinced me that intellectual products can be produced by means of a distributed network of individuals working largely without supervision or central control.

But until a couple of weeks ago, when I finally listened to Clay Shirky’s interview on EconTalk (recorded over a year ago), I had a difficult time fitting peer production into my mental models. It’s not that I didn’t understand peer production; it’s that I couldn’t quite integrate it with what I already knew about typical modes of production. Shirky, by invoking the work of Ronald Coase, finally let me put it together.

(Disclaimer: The following doesn’t necessarily represent Shirky’s view; it’s just my take on what he said. Also, I have not read Yochai Benkler's work on this subject. Finally, my conclusions will probably be obvious to some readers -- but to compensate, I promise an example drawn from my work on Fringe!)

The first step is to uncover an assumption hidden in most models of labor supply. The “typical” labor supply curve looks something like Figure 1. This curve represents an individual’s willingness to supply labor. As the figure shows, the individual won’t supply any labor until offered a wage that exceeds some minimum, denoted w_o and dubbed the “reservation wage.” This reflects the notion that exerting effort is inherently unpleasant.

But what if labor is not inherently unpleasant? Then the labor supply could look something like Figure 2. Here, we see that even at a wage of zero, the individual willingly supplies some amount of labor. This is obviously true for a variety of activities; I blog for free, for instance. Denote this minimum L_o and dub it the “free labor supply.”

But that’s not the end of the story. Most worthwhile projects will require more labor than any one individual will provide for free. To complete these projects without paying wages, you need to assemble the free supply of many, many individuals. Prior to the modern information age, this certainly happened; think barn-raisings and charity projects. To do it, however, you usually had to get people together in the same place, requiring both transportation and physical space. Information technology has dramatically reduced these transaction costs -- specifically, the costs of coordinating team production. It’s now possible to assemble the free labor supply of thousands of people at much lower cost than before.

Thinking of peer production in this way helps to understand its limits. What kind of projects can be done by this method, and which can’t? First, we need to have the kind of project for which people have labor supply curves like Figure 2 -- that is, for which people willingly supply free labor.

Second, the project’s other transaction costs must be sufficiently low. Coordination costs include not just drawing laborers together (physically or virtually), but also making sure their separate efforts mesh properly. The pieces have to fit, so to speak. And this puts a premium on modularity -- the capacity of a task to be broken up into pieces that can function, at least to some degree, on their own. Wikipedia is a nice example: an error or conflict within a single entry (say, Walmart) does not inhibit ongoing work on another entry (say, Target or quantum field theory). I don’t know enough about software programming to give examples there, but my understanding is that it has similarly modular features.

Not every project is of this nature. To take an example from my current livelihood: it’s awfully difficult to write a script in a distributed fashion. Anyone who’s read the results of a tandem writing assignment knows this. Every now and then, time constraints in the Fringe writing office will require us to “gang-bang” a script (yes, that’s actually what we call it): acts and scenes must be divvied up among all the writers to get the script written faster. But this only works because a detailed overall outline has already been written, either by an individual or by a group working in concert.

Moreover, once the individual pieces have been stitched together, the combined script is typically a hairy mess. The tone is inconsistent; some bits of necessary information have been duplicated across scenes; other necessary components have fallen through the cracks. To make the script coherent, a single writer or pair of writers (usually the writer(s) of record on the episode) must go through the script revising, reworking, and rewriting substantially. As Warren Buffett wryly notes, you can’t make a baby in one month by getting nine women pregnant; the same is true of a script. In some cases, I’ve seen a gang-banged script take longer to write than a regular script.

To summarize, peer production works because information technology has reduced the transaction costs that previously had prevented the coordination of large amounts of free labor provided by many individuals. Thus, low transaction costs are the key to peer production. But some kinds of transaction costs remain high, especially for projects that cannot easily be made modular; for those projects, peer production is still not a viable option.

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An Economic Puzzle: Fixed Prices with Variable Unit Sizes

I’ve finally succeeded in inserting the code to make post extensions work (with the help of Hackosphere), so this seems like a good time to pose an economic puzzle I’ve been thinking about.

In the absence of price controls, most goods and services respond to changes in conditions with changes in price, while the size of each unit remains fixed. If grain gets more expensive, for instance, the price of bread rises while the size of loaf stays the same. But can you think of any goods or services for which the price remains fixed while the amount per unit changes, even when the prices are free to fluctuate? I can think of two or three. Can you guess what they are, and can you come up with any others?

The example I had in mind was marijuana. Though I have zero personal experience with buying weed, I’ve seen the transactions take place, and some friends (you know who you are!) have confirmed my observation. Marijuana is typically sold in amounts designated by price, such as the well-known nickel bags ($5) and dime bags ($10), as well as larger $50 or $100 bags. If there’s a change in supply conditions, like the cost of growing weed, it is apparently reflected in the quantity per bag. Likewise, if you’re buying better quality weed, that will be reflected in a smaller volume in the bag, not a higher price. You don’t see bags of weed with prices like $19.95.

And there’s a natural economic explanation, courtesy of Ronald Coase: transaction costs. An illicit market puts a premium on fast and discreet transactions, because longer transactions increase the chance of getting busted. Nobody wants to take the time to make change, and that makes it desirable to have prices easily represented by one or two bills.

This explanation suggests a second example, with which I’ve had even less experience: prostitution. I don’t know for sure, but I’d be willing to bet that prostitutes always price their services in denominations of at least $20, and probably $100. The reason is the same: minimizing the time involved in making the transaction. I can’t imagine there are any hookers who charge $349/hour.

And the topic of sex suggests a third example, this one legal, but still characterized by high transaction costs: lap dances in a strip club, which seem to be priced in $10s and $20s. In that context, nobody wants to spend time fumbling with change, especially since (a) the dancers don’t usually have pockets and (b) the cash mostly comes straight from the ATM, which dispenses cash in $20s or higher.

Am I missing any other examples? And do they all have the feature of high transaction costs?

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Dan Klein on Coercion

Dan Klein has an excellent essay at Cato Unbound arguing (inter alia) that the distinction between coercion and voluntary agreement should occupy a central place in economic analysis:

Now, you might be muttering, “Yeah, whatever, but I’m interested in economics. I don’t care to ponder semantic issues about moral and political terminology. Let’s leave that to the philosophers.”

Hold on. We need the distinction between voluntary and coercive action to give meaning to “the free market.” We need it to identify an “intervention.” We need it to measure “economic freedom.” We use it to categorize classes of action, to identify and define industries, to formulate theoretical parallels between one industry and another, and between one polity and another. We use it to formulate reform proposals. Our theories about human interaction make key distinctions based on whether the interaction is voluntary. We generally assume that the individual is bettering his situation in voluntary interaction, but we don’t make the same assumptions in coerced interaction. The distinction between voluntary and coercive is built into many of the key analytic distinctions we use in economics. So it is important that we know what we mean by it.

The danger, as Klein acknowledges, is that focusing on coercion versus voluntarism might encourage more ideological – and thus less analytical – analysis. But the solution is to recognize forthrightly that “coercive” does not equal “always wrong.” It should be perfectly acceptable and comprehensible for an economist, even a libertarian one, to say of a particular policy that it is “coercive but still desirable on net.” For libertarian economists, such cases will be few; for other economists, they might be numerous. But at least we’d be on the same semantic page.

I strongly agree with the overall point, but I think Klein exaggerates the sharpness of the concept of coercion. He defines coercion as “when someone brings physical aggression or threat thereof to your property,” and he defines property as “your stuff, including your person.” Klein admits to the existence of holes and gray areas, but still says “the basic ideas of tangible property, ownership, and consent are cogent and apply so widely that we may think of the exceptions as exceptions.”

Okay, maybe I’m just arguing over how large those holes and gray areas are. But the problem, as I see it, is that many disputes concern exactly what your property is to begin with. Let’s take what Klein regards as one of the few cases where coercion by private actors is routinely tolerated: “loud Harley-Davidsons.” Is this example so obvious? Yes, the Harleys impose noise pollution on nearby homes; this is a kind of negative externality. But as Ronald Coase observed, externalities are reciprocal in nature. To side with the motorcyclists is to harm the home owners – but to side with the homeowners is to harm the motorcyclists. The real question is, what does your home ownership really include? A right to absolute silence? Surely not. But then how many decibels is too much? Does it matter if the motorcyclists had been cycling in your area long before the homes were built? (Or for a more contentious example, does it matter if the airport was built before the nearby homes were constructed under its flight path?) The issue here is not one of coercion versus voluntarism, but of establishing initial property rights.

Klein may have intended the Harley example as a jest. But his more serious example of grazing rights in Montana, where the presumption is that others’ cattle may graze on your land unless you specifically fence them out, suffers from a similar problem. The question again is what rights you really possess in what is otherwise your land. Just as it’s not obvious that you have a right to absolute silence in your home, it’s not obvious you have an absolute right not to have others' animals wander across your yard. Even outside Montana, you don’t need permission in advance to possess animals that might escape and do damage to someone else’s assets – you merely have to pay for any damage after the fact. In other words, land is protected against trespass by animals with a liability rule rather than a property rule. Is Klein saying that all liability rules constitute a form of coercion? If so, that would mean almost the entirety of tort law is an exercise in coercion – which would seriously damage his claim that institutionalized coercion by private parties is “almost never tolerated.”

For these reasons, I would restrict the term “coercion” to two types of cases: (a) Where there is general agreement on initial property rights, and then some action (public or private) takes away those property rights and transfers them to someone else. (b) Where there is general agreement on initial property rights, and then some action (public or private) prevents the owners of those rights from voluntarily transferring them.

This more restrictive definition of coercion would not rob it of all meaning. Taxation clearly falls within category (a), since there is general agreement that your income (or whatever else is being taxed) is indeed yours to begin with, even if it “becomes” the government’s. The minimum wage – Klein’s starting point in this discussion – would clearly fall in category (b), since there is general agreement that workers own their labor and employers own their money and their businesses, yet the law prevents these parties from making voluntary exchanges at mutually agreeable prices. Most of the policies that Klein lists, from drug prohibition to FDA regulations to gun control, would fall into either (a) or (b) or both. And, as Klein indicates, recognizing these as forms of coercion does not necessarily mean opposing them.

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I Can't Live (With or Without You)

Last night’s episode of Grey’s Anatomy almost – but not quite – raised a fascinating philosophical and economic problem. A pair of conjoined twins were planning to have a separation operation. The surgery involved a considerable risk of death to both twins. One of them actually wanted to get separated; the other agreed only because “I don’t want to be attached to someone who doesn’t want to be attached to me.” But what if the second twin had not agreed? Would one twin’s consent have been sufficient, or would both twins’ consent have been required?

Put differently, the question is what kind of property the twins have in their shared body parts: a commons (joint rights of use, only one party’s consent is required) or anti-commons (joints rights of exclusion, both parties’ consent is required)? Both regimes have their problems. Commons property encourages externalities – in this case, imposing a risk of death on an unwilling party. Anti-commons encourages hold-outs – in this case, a refusal to allow someone who really wants out to leave.

The Coase Theorem would suggest that it really doesn’t matter, so long as transaction costs are low. Suppose the gain from separation to twin #1 exceeds the loss (in risk of death) to twin #2, meaning it’s efficient to separate. Under commons, twin #1 simply demands the separation; under anti-commons, twin #1 pays twin #2 enough to make the risk worth his while. On the other hand, suppose the loss (in risk of death) exceeds the gain from separation, so it’s efficient to stay together. Under anti-commons, twin #2 will simply refuse to allow the surgery; under commons, twin #2 will pay twin #1 enough to induce him to stay.

However, the existence of a bilateral monopoly (one buyer, one seller) means the transaction costs could actually be high, thus stymieing the necessary Coasean bargains. We might hope that two people literally joined at the hip would be able to bargain effectively. But that might not be the case when one twin is unhappy enough to want to leave. If we assume transaction costs are prohibitive (not necessarily a good assumption), we should choose the property regime that generates the least expected losses in the absence of a bargain, which in this case would appear to be the anti-commons. Under anti-commons, the worst loss is continuing an unhappy coexistence; under commons, the worst loss is an uncompensated risk of death.

(I'm still thinking about whether this conclusion is consistent with my intuitive reaction to Judith Jarvis Thomson's parable about a person who wakes up attached to a brilliant but ailing concert violinist, which is to say to hell with the violinist.)

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The Coasean Blues

The weirdest thing about Douglas Baird's podcast of "Coase's Journey" (aside from the disturbing news that I, along with most of the economics profession, have been pronouncing 'Coase' incorrectly for all these years) is what you'll find out if you drop the MP3 file into iTunes. The lecture's genre classification? Blues.

This iTunes revelation, along with my co-blogger’s past efforts, has inspired me. And so I present “The Coasean Blues.” Imagine, if you will, the voice of an aging African-American man accompanied by harmonica and blues guitar. (Pay close attention and you might even learn the corrected pronunciation of Coase.)

The Coasean Blues

I got up this morning and tripped without warning
On the works of a fella named Coase.
He’s got a model and theorem for folks that’ll hear ’em,
And my problem he hit on the nose.

My good neighbors and I got an airport nearby,
The planes wake us again and again.
We could pay them all right, to fly less at night,
If free-riders would only chip in!

The state’s got a buy-way of building a highway
That’ll go through your grandmother’s claim
So would she have sold out, or been a real hold-out?
We don’t know ’cause of em’nent domain!

Yeah you pick and you choose... your property rules;
And if you pick wrong... you’ll be singing the blues.

If you think that Pigou knew the right thing to do,
You’d best be moseyin’ through.
You’ll be sheddin’ a tear if you’re standin’ round here
While I’m singin’ the Coasean Blues.

You can hire an agent to work in your basement
But you know there’s a possible cost:
That dude could be shirkin’ yet oughta be workin’
If you don’t hire monitors, boss!

You can bring on a man to run your food stand,
But your firm could be courtin’ a loss.
’Cause that helpful young man might come up with a plan
To abscond with your so-special sauce!

Yeah you pick and you choose... the markets you use;
And if you pick wrong... you’ll be singing the blues.

I know that one day if my tears go away
Then my cheeks’ll be rosy in hue
But 'til that fine day comes to pass I must say,
I’ll be singin’ the Coasean Blues.

That fella named Coase really knows all the woes
That cause jurists and firms just to quake.
We hang on the cross of a transaction cost
That’ll mess up the deals we could make.

Yeah you pick and choose... institutions to use;
And if you pick wrong... it’s the Coasean blues.

[Update: I've edited the post to fix the meter in one line.]

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Coase's Toilet

About a year ago, I linked Gil Milbauer’s analysis of toilet seat norms. Specifically, Gil addresses the eternal question of who should raise or lower the toilet seat and when. As I said then, Gil’s logic is absolutely correct and strongly supports the CWN (“Change When Needed”) rule over the AD (“Always Down”) rule. Why? Gil presents the math, but really the names say it all. The AD rule requires toilet-seat adjustments in some cases where they are unnecessary (between two consecutive male urinations). The CWN avoids such unnecessary adjustments, thereby minimizing the total seat-adjustment burden.

Now I find – via Marginal Revolution – another mathematical analysis of toilet-seat norms. The calculations are similar, and author Richard Harter agrees with Gil about how to minimize the burden: “It is readily seen that ... the joint total cost is optimized by strategy J” (strategy J is equivalent to Gil’s CWN). But, Richard says, this strategy is “suspect” because men have a selfish interest in advancing it. The CWN rule involves more seat-adjustment by women, whether compared to the AD rule (which puts all the burden on men) or living alone (where there is no such burden). Women will therefore strongly resist the CWN rule.

Richard’s conclusion is that “there is an inherent conflict of interest which can be resolved by [an] equity solution.” His proposed solution involves dividing the increased seat-adjustment burden (which results from choosing to cohabit) between the man and woman. But this equitable arrangement is inefficient, at least until the disutility of relationship discord is taken into account.

While Richard’s analysis is correct as far as it goes, it suffers from a shortage of imagination. The seat-adjustment issue is a kind of externality problem, and like many such problems, it is susceptible to a Coasean solution. As Ronald Coase observed, we can reach efficient outcomes through voluntary transactions so long as the parties are free to bargain. In this case, let’s suppose Richard’s equitable solution defines the initial allocation of duties. Then both parties can be made better off if they switch to the CWN rule and the man gives the woman some form of compensation – perhaps more frequent gifts, extra foot rubs, or straight-up cash payments.

So why doesn’t this actually happen? Well, maybe it does with some couples. But one condition of the Coase Theorem is that initial property rights must be well defined, or else bargains will be difficult to reach. In the seat-adjustment problem, men and women are still fighting about the initial rights allocation. Thus, Richard’s analysis could still be useful, not for establishing the correct final seat-adjustment rule, but for establishing a viable initial rule as the baseline for bargaining.

[An addendum: Some women seem to think the AD rule is better simply because it avoids the “Midnight Surprise” problem of sitting down and plopping one’s rear in the water. I find this unconvincing. Are women blindly backing up to the toilet before sitting? All it takes is a quick glance. Men, too, are potentially subject to the Midnight Surprise when doing operation #2, but I’ve never heard a man complain about it. That’s because men don’t assume the seat will be down. After becoming accustomed to the CWN rule, women wouldn’t assume that either. In any case, the MS doesn’t vitiate the Coasean argument. Start with Richard’s equity solution, which involves seat-down in the evening already, and then let the negotiations begin. If the disutility of a potential MS is large enough to make CWN inefficient, then the bargain won’t occur.]

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A Matter of Coase

Will, an avowed non-utilitarian, sure does make a lot of compelling utilitarian arguments. In his latest flaying of Richard Layard (a hedonic utilitarian who assuredly deserves the flaying), Will deploys a fascinating corollary to the Coase Theorem that has implications far beyond his debate with Layard.

Layard has devised a new kind of negative externality argument. He observes that inequality of status makes many people – specifically, envious people – unhappy. As a result, any productive effort to improve one’s position creates a negative externality by reducing the relative status, and thus happiness, of others. Using standard Pigovian logic, Layard concludes that we ought to discourage (e.g., tax) productive effort in order to correct the externality.

Of course, Pigovian externality theory is almost 50 years out of date. Will brings to bear Ronald Coase’s “least-cost avoider principle,” which says that when parties A and B can both take actions to avoid a harm, efficiency dictates that whoever who can reduce the harm at the lowest cost should do so. For example, if an airport imposes noise pollution on nearby residents, the airport should relocate or restrict flights if and only if that’s cheaper than the residents moving away or installing sound-insulation. Will combines this insight with the observation that people can overcome their envy via sublimation or learning of new preferences. As Will puts it, “If you changing your preference is cheaper than taxing me, then you ought to change your preference.”

This reasoning opens a mighty interesting can of worms (and I mean that in a good way). In the traditional Coasean approach, preferences of agents are taken as given, and the only question is whose actions can reduce harm at lowest cost (keeping in mind that all harm is relative to the parties’ preferences). But if actions can change preferences, it follows that changing preferences may in some instances be the least-cost means of reducing harm. This is true even for less exotic forms of externality than Layard’s status-externality. Take the airport noise externality. Maybe the least costly solution is for people to start enjoying the sight and sound of airplanes. Or consider the visual externality created by a factory that obscures the view of a nearby mountain. Perhaps the least costly solution is for people to stop caring so much about natural scenery and learn, Rand-like, to appreciate the man-made beauty of mortar, block, and glass decorated with thousands of electric lights.

As Will’s post indicates, this approach also provides a ready-made response to anti-utilitarian arguments of the “what if lots of people have really monstrous preferences” variety. Consider a Southern town where lots of bigoted white people would be supremely satisfied if a black person were lynched. The Coasean answer: maybe they should just stop being bigoted! (This answer seems especially compelling if we take a multi-generational point of view.) Does an externality arise from people envying others? The Coasean answer: maybe they should stop being so envious!

Clever statists might seize on Will’s Coasean Corollary to justify some scary policy ideas. For example, a Marxist might claim the CC indicates people should stop being greedy and transform themselves – or be transformed by state power – into altruists. But remember, the CC doesn’t mean that preference change is always the preferred alternative, nor does it mean that only one party’s preferences can change. Preferences are malleable, but not infinitely so. Some preferences can change easily within a single person’s lifetime, others can change over generations, and yet others may be so built-in to human nature that changing them is essentially impossible. The Coasean argument is sensitive to the costliness of the actions involved.

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Cream Mixing (or, The Fable of the B's, C's, and D's)

Alex expands on the point I made below, that public schools also “cream skim” by creating Honors tracks and magnet schools. Among other things, Alex notes:

More generally, the argument in the peer-effects literature is that we shouldn't let smart kids escape the public school system because their presence gives dumb kids a positive externality. I detest this argument. Children are not pawns to be moved about to satisfy the desires of some grand master. A decent school system treats children as ends in themselves.

Characterizing the benefit of smart kids to dumb kids as a “positive externality” raises an interesting point. Let’s suppose it’s true that the presence of smart kids really does improve the educational performance of the dumb kids. The primary lesson of the Coase Theorem is that externalities can often be internalized through market transactions. Thus, to use one famous example, the fact that honey bees provide positive externalities to apple orchards (by pollinating apple blossoms) does not mean there will necessarily be an inefficiently low level of beekeeping. Why not? Because the owners of apple orchards can pay the beekeepers to release bees in their orchards. And indeed, this is exactly what happens, according to a 1973 article (“The Fable of the Bees”) by Steven Cheung.

What is the analogous arrangement in schooling? Scholarships, of course. Lower-ranked colleges regularly make sweet offers to good students to lure them away from higher-ranked schools, because such students are likely to raise the school’s prestige and make larger contributions as alumni. The non-scholarship students benefit from both effects. If it’s really the case that smart students create positive “peer effects” externalities, there’s every reason to believe that private schools in a voucher system would find ways to achieve the optimal mix. And they would do so without treating the best students as merely means to an end, because they would have to reward such students for their beneficial choices.

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Ashton, Demi, and Coase

One implication of the Coase Theorem is that assets will tend to get allocated to their highest-valued uses, regardless of who owns them initially, as long as trade is possible. Thus, for example, it is unlikely that the introduction of free agency in sports leagues results in a different allocation of players among teams than would result under a pure draft system. Suppose that player X would bring more added revenue to Team A than to Team B. Under a pure draft, if player X is “owned” by Team B, Team A will end up buying the player (because A is willing to offer more than the minimum B will accept). Under free agency, the player owns himself, and Team A will win the bidding war. Either way, player X winds up playing for Team A.

This particular economic principle came to mind, believe it or not, when I read this Slate article on celebrity dating. The article observes that when movie stars were effectively “owned” by their studios, the studios regularly tried to arrange romantic relationships – real and faux – for their stars, in a fashion designed to increase studio profits. For example, actors would sometimes be told to dump unknown girlfriends and trade up to celebrity girlfriends. Now stars are free agents, but the romantic game is pretty much the same. These days, the actors do the dumping and trading up on their own:

But celebrity romance has not changed radically, because celebrities have become so savvy about their own images that they do what the bosses used to. "Movie stars have unconsciously become their own publicists. It is an instinctive skill. They don't need publicists to tell them what boyfriends and girlfriends are good for their career," says Paramount producer Lynda Obst.

In other words, assets – in this case, celebrities – will tend to be used in a fashion that maximizes their value, regardless of initial ownership. It’s the Coase Theorem at work.

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