The Coase Theorem and behavioural psychology
Keywords: Coase theorem; endowment effect; behavioural psychology
The Coase theorem is not consistent with two behavioural psychology observations: people are subject to an endowment effect, and some goods are bound up with individual and group identity. Therefore, initial assignment of property rights for some goods may therefore have significant effects for allocative efficiency.
The Coase theorem (Coase 1960, Stigler 1966) contends that when trade in an externality is possible and there are no transaction costs, bargaining will lead to efficient outcomes regardless of initial property rights allocation. So, radio spectrum or water rights allocation will be efficient regardless of in whom initial property rights are vested. Of course, the absence (or near absence) of transaction costs is a restrictive assumption that limits the theorem’s real world application. However the theorem is a corrective to views that Pigouvian taxation and other government interventions are always needed to address externalities.
This note argues that the Coase theorem is inconsistent with two behavioural psychology observations. Firstly, people are subject to an endowment effect, with associated loss aversion and status quo bias. Secondly, many individuals and groups conflate their identity with that of property. These properties are therefore non-market goods – that is goods that may be valued but will not be priced since they are not offered for trade, or at least will be tradeable only in very restrictive circumstances.
2. The Coase theorem and the endowment effect
Behavioural psychology argues that people are subject to an endowment effect, placing higher value on a good possessed compared to one they may aspire to. The endowment effect is a specific form (linked to ownership) of the status quo bias. It is distinct from but associated with loss aversion, where people place greater weight on losses than gains (Kahneman et al 1990). These factors violate the orthodox assumption that willingness to pay for a good is equal to willingness to accept compensation for being deprived of it.
The Coase theorem argues that initial property rights assignment does not matter to efficient resource allocation assuming individuals can bargain and transact at no cost. However, if the marginal rate of substitution between two goods is subject to an endowment effect then an individual with an initial rights endowment will be more likely to retain it. In effect, the endowment effect makes trade less likely, as well as reducing gains from trade. Notably however, the endowment effect is especially important for goods that have a personal psychological dimension. It relates less, if at all, to many goods that are impersonal and abstract.
3. Conflation of individual and group identity with property
The (at least stylized) orthodox economic assumption is that anything that is scarce (material goods, water, biodiversity, amenities) ultimately has a value. For such valuable goods markets should be created to discover a price, and trade then allows resources to flow to their highest valued use. Where transaction costs are excessive regulation or voluntary action may substitute for price. The above theory assumes that all goods can be placed in a market framework and be priced and traded. However, behavioural psychology suggests that many valuable goods fall outside a market framework. That is, it may be possible and appropriate to place an economic value on them but not to put a price on them, because a price implies willingness to trade.
Valued but unpriced and untraded “goods” include objects bound up with self-identity, civil society, amenity values, democratic votes, rights enforcement, and intergenerational cultural goods. People do not sell their voting rights nor are they comfortable with the costing out of rights enforcement. The administration of justice is subject to cost constraints but is not treated as a market tradeable good. Properties conflated with individual self-identity are commonly not traded even when they are valuable – for example wedding rings, family heirlooms and the iconic family bach. The psychology associated with intergenerational cultural goods and with cultural heritage more generally suggests that individuals feel part of something wider than themselves that endures beyond them. Therefore some “goods” cannot easily be disposed of in a trade that maximizes utility only for individuals living today.
Property can be bound up with group as well as individual identity, as illustrated in recent debate over the foreshore and seabed and the very concept of mana whenua itself. Ledgerwood et al (2007) argue that group identity can be a goal towards which group members strive using material symbols of that identity. The value placed on a property is influenced by the extent to which it is symbolic of group identity, and by whether perceived threats to that property conflate with threats to a group. Any such threat then strengthens oppositional identity, with implications for intergroup conflict.
Such conflict has been a recurring theme in New Zealand history in relation to Maori conflict with the Crown, and peoples’ attitudes to amenity values and public land.
When a public good is at risk of loss, there may be extraordinarily high demand for compensation (Rowe et al 1980). This and the arguments above should be borne in mind when governments consider the balance between public and private rights over, for example, the conservation estate.
Coase, R. (1960): The Problem of Social Cost. Journal of Law and Economics 3 (1), 1-44.
Kahneman, D.; Knetsch, J.; Thaler, R. (1990): Experimental tests of the endowment effect and the Coase Theorem. The Journal of Political Economy 98 (6), 1325-1348.
Ledgerwood, A.; Liviatan, I. Carnevale, P. (2007): Group-identity completion and the symbolic value of property. Psychological Science 18 (10), 873-878.
Rowe, R.; d’Arge, R.; Brookshire, D. (1980): An experiment on the economic value of visibility. Journal of Environmental Economics and Management 7, 1-19.
Stigler, G. (1966). The Theory of Price. 3rd edition. New York: McMillan.