(This essay was published in Hong Kong Economic Journal on 23 October 2013)
Professor Ronald Coase, who spent most of his academic career at the University of Chicago as a professor of economics in the Law School, died on 2 September 2013 at the age of 102 in Chicago. He was the oldest living Nobel laureate. Coase is best known for two papers. The first paper entitled “The Nature of the Firm” was published in 1937, and the second, “The Theory of Social Cost” was published in 1960. The impact of these two papers was profound because they reoriented the work of economists, political scientists, historians, and legal scholars in a fundamental way. Few individuals have published so little, yet influenced so many, and in such an enduring way. There is little doubt that his influence will continue to grow long after his passing.
“The Nature of the Firm,” offered groundbreaking insights into why firms exist and established the field of transaction cost economics. Coase showed why typing services, telephone answering services, and other clerical services are not outsourced through the market, but instead managed internally within a firm by hiring secretaries. He identified differences in transaction costs as the crucial factor in determining how clerical services are arranged. If certain tasks were cheaper to organize through the market then the firm would outsource them. Activities that are costly to outsource would be organized within the firm.
More importantly, Coase also explained why transaction costs are the raison d’être for the existence of firms in the first place. He offered a new way of thinking about how firms are organized, how they evolve, and why the boundary between firm and market can shift. Transaction costs have become the foundation of a new economic theory of institutions and institutional change – economic, legal, and political.
Professor Steven Cheung, using Coase’s idea, predicted in his book Will China Go Capitalist that the capitalist market economic system would replace the socialist command economic system because it would significantly reduce the transaction cost of organizing economic activity. Noted US columnist George F Will wrote in The Dispatch on 7 December 1991, “The Cold War is over and the University of Chicago won it,” as tribute to the ideas of the Chicago School of Economics to which Coase made seminal contributions. In both instances Coase’s original idea of the relative efficiency of the firm versus the market was extended to the economy as a whole and became a theory of institutional change.
Why Paying Polluters Can Work
Coase’s other paper, “The Theory of Social Cost,” is widely considered to be the seminal work in the field of law and economics and the economic theory of institutions and institutional change. It sets out what is now known as the Coase Theorem, which holds that people who place the highest value on a good or service will get to use it. This is of course what markets normally do. Markets allocate the use of goods and services through mutually voluntary exchange to those individuals who are willing to offer the highest payment for their use. Coase’s path breaking idea was in showing that markets might still function even in situations when they are believed to be dysfunctional. For example, when there are externalities (like sound pollution), common property resources (like preserving country parks), or public goods (like lighthouses).
The Coase Theorem can be illustrated with a simple example. Cars produce pollution and impose a disutility or cost on victims. In deciding whether to purchase a car a prospective owner often takes into consideration only the utility he derives from driving, but not the disutility borne by the victims. As a consequence there will be too many cars on the road.
The standard solution before Coase’s work on social cost was to tax the car owner for the pollution caused by driving. The optimal amount of tax would be the amount that would be sufficient to compensate the victims for their loss. This is the “polluter pays principle.” Arthur Cecil Pigou, who was Professor of Economics at Cambridge University, proposed it in 1920 in his book The Economics of Welfare. This tax came to be known as the Pigouvian tax and continues to inform many policy advocates and policy makers on how to deal with vehicle pollution, as well as numerous other forms of negative externalities.
Pigou’s idea is straightforward: if each car on the road produces $5 of disutility to each victim, and assuming there are 100 victims, then the government should tax each car owner $500 and arrange to compensate each victim $5 for every car that is on the road. Since the cost of owning a car is now $500 more expensive, only owners who derive more than this amount of utility from driving will wish to own one. If only 10 out of 20 prospective car owners can derive more than $500 in utility from driving, then there would only be 10 cars on the road; this is the optimal number of cars.
Coase made the following proposition: if the 100 victims got together and paid every car owner $500 to not drive, then the 10 prospective owners would be willing to accept this offer. The victims would be willing to share the $5 cost per car because this is their disutility from suffering the pollution. Coase thus raised the theoretical possibility that the role of government in enacting Pigouvian taxes might not be needed to solve the problem of negative externalities as was usually assumed. It was possible for victims to compensate polluters to stop polluting.
Coase’s insight is that the amount of pollution does not depend on whether government imposes a tax on car owners or whether victims voluntarily choose to compensate prospective car owners for not driving. The total pollution damage in either case equals the amount produced by 10 cars or $5000 worth.
The Coase Theorem assumed that the transaction cost incurred by the 100 victims in organizing themselves to compensate prospective drivers would be the same as that incurred by government to impose a tax on producers and distribute compensation to the victims.
If the transaction cost was different, then society should choose the approach with the lower cost. If it were cheaper for government to identify the 100 victims and ascertain their disutility, then it would be economically efficient to adopt Pigouvian taxes. If it were cheaper for victims to organize themselves, then society should let the market address this problem. Coase Theorem treats car owners and victims symmetrically. Whether it is more efficient for society to make the polluter pay or let the victims pay off the polluters depends on which is more costly to arrange.
The idea that victims should compensate polluters may sound odd and morally offensive to many people. But this apparent oddness disappears if one sees that in some situations it may be a far cheaper option. If we insist on making polluters pay then society will have to bear a higher cost when a less costly option is available.
Coase’s insight is particularly profound because it describes how real societies actually solve problems. Research in law and economics and the economic theory of institutions has shown that in the long-term societies choose solutions that tend to minimize transaction costs. The ideas contained in “The Theory of Social Cost” therefore lead back to Coase’s first paper on “The Nature of the Firm”. When it is cheaper to outsource you outsource, when it is more expensive to outsource you manage internally. Firms are alternatives to the market in the same way that markets are alternatives to the firm. The most efficient institution is selected to organize a task.
Light Pollution or High Rents
Hong Kong is believed to be the world’s worst city for light pollution, with levels in Tsim Sha Tsui reportedly up to 1,200 times brighter than a normal dark sky. The government is currently consulting the public on whether a law or regulation should be passed to mandate that neon lights should be switched off after say midnight. It is claimed that these very bright lights cause insomnia and interrupted sleep to those who live in their vicinity. Many have to draw thick curtains to block out these lights before they go to sleep. What can Coase’s reasoning offer on this issue?
Let us identify the stakeholders and affected parties. First there are the tenants who live in affected domestic premises. Second, there are the landlords who own these domestic premises. Third, there are the landlords who own the wall space that they rent out for the signs with neon lights. Fourth, there are the shopkeepers who put up the neon lights. Fifth, there are the landlords who rent out the shops. Sixth, there are various other stakeholders, for example, the “Pearl of the Orient Fan Club” and the “Dark Sky Lobby.”
The stated purpose of a new law or regulation is to help the tenants who suffer from light pollution. The perpetrators of light pollution are presumed to be the shopkeepers who put up the neon lights. What will be the effects of a new law or regulation?
At present shopkeepers are allowed to rent wall space to erect and switch on neon lights with few restrictions. Landlords can lease out wall space with few restrictions as to when the neon lights have to be switched off. Business neon lights and domestic premises are in closest proximity in the old city neighborhoods where zoning allows mixed occupancies to co-exist. So if business neon lights have been blazing for a long time, it is obvious that residents will have suffered from insomnia and interrupted sleep for many years. Those who are unable to adjust to the neon lights and can afford to move out would have already done so. Those who stayed are those who were unable to afford to move. It would be logical to presume that these victims have been compensated for damage through paying lower rents. Landlords of these domestic premises would have lowered rents sufficiently to keep these tenants from moving out.
If a new law or regulation takes effect, and neon lights are now switched off around midnight, what would happen to rents for these now “improved” domestic premises? Landlords would raise rents because there is now less need to compensate victims for insomnia and interrupted sleep. Landlords who rent out wall space to shopkeepers may suffer a loss of rental income if shopkeepers lose sales as a result of reduced neon light driven business promotion, but the magnitude of this effect is not known. Landlords of the shopkeepers may also suffer a loss of income if business drops, but the size of this effect is also not known.
It appears that everybody loses except the landlords of the domestic premises. Tenants may also lose because the improved sleep quality is unlikely to be able to compensate for the resulting higher rents. Demand for these domestic premises will rise because they now provide an improved night-time environment. Some existing tenants who cannot afford the higher rents will move to other less convenient locations.
What is not well appreciated is that some tenants who live in neon lit neighborhoods often work late shifts and sleep during the day. Many of these are often low-income households. There is an inherent compatibility between such tenants and neon-lit neighborhoods. Of course not all tenants in these neighborhoods work late shifts and they have a reason to complain about brightly lit neon lights after midnight. What they will soon appreciate is that the low rents they currently pay are a form of implicit compensation for suffering from light pollution – a compensation that landlords would withdraw should the new law or regulation come into effect. Will they really be better off?
Very often those who advocate a “lights out” law or regulation have little understanding of how real markets work to solve incompatible uses of resources. They still live in a Pigouvian world of control and punitive measures that Coase debunked in 1960.
Land Conversion for a Good Cause
From time to time we have heard calls to develop a small portion of country parks to accommodate housing and other uses that the people of Hong Kong deem valuable. Opponents are adamant that no part of the park should be developed. They argue that any change in the use of the parks, currently protected by law, might trigger a slide down a slippery slope that could lead eventually to losses these advocates do not want to see happen.
Many parcels of land in Hong Kong were granted to various non-profit charity organizations (often under a trust) for conducting their activities. When the land was initially granted it was at below market terms. The premises built were often low rises with dedicated purposes. Over time the activities of these organizations grew and at the same time the value of the land they were granted appreciated significantly. Some of these organizations have since expanded. Their land has been redeveloped and even partly converted to a different use. The government has received compensation for this and the organizations may be collecting income from the converted land to support their activities. These converted uses may be for commercial or residential purposes. One of the earliest conversions was the southern campus of La Salle College into Beverly Villa (碧華花園).
This process is a wonderful example of Coase Theorem in action. The market facilitates the conversion of land use to make it available to people who place the highest value on its use. For this to happen such land must, first, be in the hands of an individual or a legal entity, and second, such conversion must be allowed. Hong Kong is blessed with legal and administrative rules that allow such conversions to take place for otherwise the use of land would be permanently locked into a lower valued use to society’s detriment.
Land in country parks is public land designated for non-development park purposes. Since no individual or legal entity owns it, any change to its use is a political process requiring legislative change. A market solution is not available. The question is, can the political legislative process determine the optimal use of the land? This is seriously in doubt because advocates against development are making a bid for preserving land in the country park without committing any money. It is therefore not possible to determine how much they value the land for conservation.
To begin with the political process represents overwhelmingly the interests of the organized public and their advocates rather than the interests of each individual or household. The interests of those who have yet to be born are certainly not represented through the political process. At best they have to rely on present day advocates to speak for them. But then how are we to verify whether their interests have been correctly represented?
Contrary to what many people think, the market and property rights can represent the interests of the future generation even before they are born. An individual has a strong incentive to enhance the value of the land he owns for self-use or as a bequest to others. A legal entity that owns land has an interest in ensuring its value is maximized in order to sustain and advance its objectives. These objectives may be for profit, but they may also be for educational, religious, social, humanitarian, conservationist or environmental purposes. The incentive to put valuable resources to their highest valued use is what drives the market process forward and provides Coase-like solutions.
How to Value the Worth of Conservation
In the absence of any real ownership of land in the country park, everybody is representing the interests of everyone else. So how do we know what is the value of the country park conversion? A survey conducted between August and October 2009 questioned 613 people who were asked if they would be willing to pay an annual fee to enhance the conservation and educational elements of the parks and how much they would like to pay if they could choose. The results were published in the International Journal of Sustainable Development and World Ecology. Most were willing to give HK$95 to HK$133 a year. Only six per cent said they would not pay. The respondents were randomly selected from visitors to Pok Fu Lam, Shing Mun and Clear Water Bay country parks. Their household incomes ranged from HK$10,000 to more than HK$40,000 a month.
So let us take the highest valued payment of $133 a year. This amount in perpetuity discounted at 3% yields a present value of $4,433. In 2011 there were 13.5 million recorded visits. Let us assume all these visitors are from Hong Kong and this means everyone in the territory visited on average twice a year. Multiplying the two yields a total sum of $29.9 billion. How much residential space will this amount pay for? Assuming a plot ratio of 4 and a price of $7,500 per square foot it would pay for the development of 0.1 sq. km. of land, which is only 0.044% of country parkland. Under these very generous assumptions one would not conclude that the country park loving public places a very high value on it compared to other users who want land for residential development.
Of course, one should not believe the results of one survey alone. But the only way we will really find out what is the true value of the country parks is to inject a small portion of its land, say less than 1%, into 10 separate trusts with full ownership and conversion rights. Let us assume these trusts are established to promote conservation and environmental causes.
These trustees now have the responsibility to properly utilize the land put under their management to promote the cause of conservation as best as they can. They may then realize that converting a portion of the land into commercial and residential use would raise so much money to support conservation causes that allowing land in the country park to be converted into other uses may well be a better choice. La Salle College saw the conversion of its south campus into residences was a better way of supporting education. Coase would see putting land into trusteeship as a more efficient institutional arrangement to promote public interest than leaving it under public ownership. Society will then have real accountability in the ownership of a very scarce resource – developable land.
Land is the next most valuable resource in Hong Kong after its people. The idea of rigidly designating some 40% of the land in Hong Kong for conservation that disallows any other form of development under public ownership protected by law is a totalitarian act of heinous proportions. It cannot be an efficient use of land and it limits the liberty of individuals to make better choices affecting their own lives. Changing land in the country park into a form of trustee ownership liberates the hegemonic public control of such large quantities of land. Individuals cannot compete against the tyrannies of organized political groups when political processes determine the use of public land.