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Friday, November 30, 2007

Coase In Action

Since near the start of the semester, I've been wondering at what point do transaction costs get too high for for the Coase Theorem to work? My thoughts until recently were that this level would be fairly low, not working too far beyond the example of the doctor and the confectioner. But over Thanksgiving dinner (believe it or not) in Aurora, I heard an example that fits this model pretty well.

There was a neighborhood where a developer wanted to construct a three story building, but there was a restriction that nothing higher than two stories could be built. So, in a sense, the developer didn't have the property rights to build. Through the homeowners association, however, the builder was able to negotiate with the people. In the end the homeowners came out with improvements to the neighborhood (new trees, fences, etc.) and the developer, of course, was able to add their third floor.

Looking at the problem initially, it is somewhat easy to guess that the highest valued use is the developer's, as the only apparent reason for this regulation is aesthetics. This is highly normative though, and if the transaction costs did in fact turn out to be too much to overcome, it would be a very difficult decision for a government (e.g. a city council) to make. What is the most valued, the third story or the view? It's very fortunate that the Coase Theorem works at this high of a level.

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