A Freakonomics Contest: The Coase Theorem Online

Freakonomics schwag is up for offer at the end of this post. As such, it may actually be worth slogging through the brief economics lesson that follows.

The Coase Theorem is a somewhat rare species of beast: an economic theory that is both completely counterintuitive and yet often right in practice. The idea is named after Ronald Coase, one of the University of Chicago’s many Nobel Laureate economists. Nearing the age of 100, he may not hear quite as well as he used to, but otherwise he is still going strong, sitting on the Board of Directors of the Becker Center, giving lectures, writing academic articles, and attending the occasional seminar.

The basic idea of the Coase Theorem is that no matter who is assigned property rights, as long as transaction costs are not too high, the efficient outcome will be achieved. In his original article nearly fifty years ago, Coase motivated this idea by writing about the problem of sparks from railroad trains setting wheat fields on fire. We will assume that these fires are very costly, and as such it is best to take action to prevent them from occurring.

Let’s say there are two ways to avoid the risk of fire: adding some attachment to the train that catches the sparks, or having the farmers not plant wheat close to the railroad tracks. The naive view of the problem would be this: if the law dictates that railroads are responsible for the losses to farmers from the fires they start, then the railroad will invest in the spark-catching attachment, since it is a cheaper alternative to paying the farmers if a fire occurs. By this logic, if the law says that the farmers are responsible for the losses, then they will not plant wheat next to the tracks.

The Coase Theorem states that this logic is wrong. Regardless of who is liable, the two parties should bargain to the efficient solution. Let’s say it is cheaper to stop the fires with the attachment. Then even if the railroads don’t have to pay for fire damage, the farmer should offer to pay for the railroad attachment, plus give the railroad a little extra money. The railroad is now better off (it doesn’t mind having the attachment, and it has more money) and the farmer is better off (the attachment was a cheaper alternative than not planting next to the tracks). Everyone is better off, so we expect that this will be the outcome.

The obvious obstacle is what economists call “transaction costs.” If there are many farmers and many railroads, or private information about costs or how much care the parties are taking, bargaining can break down and an inefficient outcome can occur.

With that as background, the actual point of my post relates to how well the Coase Theorem seems to hold in online transactions. My understanding is that more or less anyone can purchase any URL that they want. In that setting, you might expect chaos on the Web, with Web addresses that you would think should belong to one company or organization actually leading somewhere completely different. But the Coase Theorem predicts otherwise: regardless of who originally purchases the right to a URL, ultimately it will end up in the hands of the user who values it most highly. In some cases, when a Web address is really valuable, there may be large transfers of money — according to Forbes, the domain name “Seniors.com” went for $1.8 million at auction.

But there must also be some stark counterexamples in which the Coase Theorem fails. One example is the following: what do you think happens when you enter www.american.com, as I did yesterday, while searching for a plane ticket. American Airlines? Nope — a new magazine that features all sorts of interesting and intelligent stuff, like an article by Alan Krueger about terrorism and a profile of economist Jesse Shapiro. It is hard for me to believe that this URL wouldn’t be more valuable to American Airlines. I’d love to know the story of how it came to be owned by an upstart magazine instead.

So, here is the reader challenge: find the best examples of the Coase Theorem failing on the web. What URLs seem like they should logically take visitors to one place, but in fact lead them somewhere completely different? We’ll give some Freakonomics schwag to the best reader entry.