While reading articles today (NYT, WSJ,…) about Ronald Coase, who died yesterday at the age of 102, I am reminded about how much I have enjoyed over the years explaining his famous ideas to beginning students in my Economics 1 lectures. To explain his ideas about how private remedies can resolve externalities,  I usually use a skit. It’s kind of gimmicky, but it works, and students remember it.

Here is how it goes. In the middle of a lecture on externalities, the lecture hall is suddenly jolted by the loud blasts of a rock music coming through the overhead sound system. I act as surprised as the students, and, with the music still blasting, I walk off- stage and out the door to investigate. Then, while I’m still off-stage and out of sight, the music stops, and I can be heard having a heated conversation with someone.

I then come back on stage to explain to the class what is going on. I say that there is a music appreciation class in the same building—on the History of Rock and Roll—and the music professor needs to play the music very loud, spilling over to our auditorium.  Yes, it’s an externality—sound pollution.  The music class must listen to the music but that interferes with our lecture.

What can we do?  Using “centralized command and control methods” you might want me to ask the president of the university to prohibit loud noise during class time. But that would severely impinge on the music class, and the president of the university could instead say, “Too bad, Taylor, rock music is no less important than economics,” and tell us to move to an inconvenient remote location.

But then I say I have worked out a better solution—a “private remedy.” I explain that the music professor and I have worked out a deal.  The music class will only play loud music at the start and end of the class period. That way we can walk (or dance!) in and out of the class each day to the music with the understanding that we can have the lecture time largely uninterrupted.  I then explain, mentioning the music class teacher’s rights to use the room, that in order to get this deal I had to promise the music teacher $500 per day. I did not think that would be a problem because with 500 students in our class that is only $1 a day from each student.  I then ask for a show of hands of those willing pay $1 a day. Usually only a few students agree. Perhaps the others are expecting a free ride, but in any case we are beginning to see some problems that private remedy needs to overcome.

By this time everybody gets the point of the silly skit, and there is time to talk more seriously about the issues, including the issue of property rights which determine who has the right to pollute or infringe on whom. Does the music class have the right to use loud music, or does the economics class have the right to peace and quiet? The property rights will determine who actually pays for the adjustment that remedies the externality.

And even if property rights are well defined, for a private agreement like this, transaction costs associated with the agreement must be small compared to the costs of the externality itself. As Coase put it,

in order to carry out a market transaction, it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on. These operations are often extremely costly.

And as the class vote suggests, free-rider problems can also prevent a private agreement from taking place.

So when transaction costs are high or free-rider problems exist, a private remedy may not work. Then, as Coase put it,

Instead of instituting a legal system of rights which can be modified by transactions on the market, the government may impose regulations which state what people must or must not do and which have to be obeyed.