The Coase Theorem in Land Use

On a recent post about property rights in the land market, commenter David Sucher brought up the issue of transaction costs. He commented here and at his blog City Comforts:

The “least intrusive means” should be always kept in mind. The only issue for me is the huge transaction costs which, I believe, make private agreements for land use quite impossible. The very reason we have government is because “voluntary private contracts” are too complex. We got rid of tort law (as to land use) because it was much easier to have uniform area-wide regulations.

While David brings up very valid points, I think that economist Ronald Coase offered a persuasive argument against these area-wide regulations. The Coase Theorem, which interestingly, I don’t think we’ve written about in depth here, addresses this issue of transaction costs. In 1960, Coase published his most famous paper, “The Problem of Social Cost,” exploring a common problem for city dwellers: annoyance at their neighbors’ behavior.

Coase uses as an example a confectioner whose business is adjacent to a doctors office. The confectioner uses loud machinery which causes vibrations next door and bothers the doctor. We can imagine a variety of solutions to this problem: the doctor could sound proof his office, the confectioner could upgrade to quieter machinery, one of them could move his business, the confectioner could compensate the doctor for the bother, or the doctor could pay the confectioner to stop making noise during his business hours. Assigning property rights would help any of these solutions emerge; if the confectioner has a right to make noise, the responsibility lies with the doctor to remedy the situation (or learn to live with the noise) or the reverse if the doctor has a right to quiet.

In a standard Micro 101 class, in my experience, the Coase Theorem is taught as follows. In a world of zero transactions costs, the efficient outcome will prevail regardless of which way the property rights are assigned. If the confectioner would stop making noise (by any of the above methods) for $20,000 and the doctor values his quiet at $30,000, the two will work out a contract to stop the noise. This is often followed by the conclusion 1) it doesn’t matter how we assign property rights, or 2) we don’t live in a world of zero transaction costs, so the Coase Theorem is merely theoretical, not relevant to the real world.

I learned a more nuanced version from Russ Roberts who emphasizes that transaction costs are never zero because people are not all-knowing robots. He also explains that “it takes two to have an externality.” In other words, a skyscraper with no setback and no parking doesn’t create any externalities if its nearnest neighbors are miles away. This is a silly example but gets to the issue of why externalities don’t exist without at least two conflicting parties. In a city with millions of people, though, we can clearly see that transaction costs for a skyscraper developer to negotiate with each person individually for the views that his building blocks would be ridiculous.

David Friedman writes about the Coase Theorem in a similar vein. His whole paper is informative, but I quote at length here the sections that I think are most relevant to land use:

The Coasian answer to this set of problems is that the law should define property in such a way as to minimize the costs associated with the sorts of incompatible uses we have been discussing–factories and recording studios, or steel mills and resorts. The first step in doing so is to try to define rights in such a way that, if right A is of most value to someone who also holds right B, they come in the same bundle. The right to decide what happens two feet above a piece of land is of most value to the person who also holds the right to use the land itself, so it is sensible to include both of the them in the bundle of rights we call “ownership of land.” [Blogger’s Note: Couldn’t be more different than the way property rights assigned through zoning.] On the other hand, the right to decide who flies a mile above a piece of land is of no special value to the owner of the land, hence there is no good reason to include it in the bundle.

If, when general legal rules were established, we somehow knew, for all cases, what rights belonged together, the argument of the previous paragraph would be sufficient to tell us how property rights ought to be defined. But that is very unlikely to be the case. In many situations a right, such as the right not to have noises of more than X decibels made over a particular piece of property, may be of substantial value to two or more parties–the owner of the property and the owner of the adjacent factory in my earlier example, for instance. There is no general legal rule that will always assign the right one.

In this case, the argument underlying the Coase Theorem comes into play. If we assign the right initially to the wrong person, the right person, the one to whom it is of most value, can still buy it. So one of the considerations in the initial definition of property rights is doing it in such a way as to minimize the transaction costs associated with fixing, via private contracts, any initially inefficient definition.

[….]

Part of what Coase showed was that, for some problems, there is no legal rule that will generate a fully efficient solution. He thus anticipated public choice economists, such as James Buchanan (another Nobel winner), in arguing that the real choice was not between an inefficient market and an efficient government solution, but rather among a variety of inefficient alternatives, private and governmental. In Coase’s words: “All solutions have costs and there is no reason to suppose that government regulation is called for simply because the problem is not well handled by the market or the firm.”

David Sucher is certainly right that all voluntary contracts have transactions costs, but if we are seeking a system to minimize transaction costs in land use, it’s not clear to me that zoning achieves this. In DC, for example, where almost all development requires a variance, developers must spend huge sums of money on legal fees to earn the right to build. Furthermore, as Friedman explains we should seek property rights that allow for improvements toward efficiency over time, and zoning essentially prevents this in many cases.