The Story So Far
We have two posts so far in this series. In the first one, I have tried to explain the nature of the problem regarding the argument between the Southern states and the Union government. In the second post, I have tried to fit the problem into a framework borrowed from international macroeconomics. In this, the third and final post in this series, I’ll focus on attempts to resolve the problem.
Let’s begin!
Say Hello To The Coase Theorem
What is the Coase Theorem? Here’s an old EFE post with a useful set of links that’ll help you learn about it.
But here’s the basic set-up:
- There are externalities in life, and that is just a fact.
- These externalities are a problem, because the resulting benefits (or costs, if it is a negative externality) may not have been accounted for in the original transaction. (Should you pay for the marginally better lungs that you have as a consequence of the Metro having been built in your city? How much should you pay? To whom should you pay, when should you pay, and how often should you pay? Should the payment change over time?)
- So who pays for these unintended costs or benefits? How do we resolve this issue?
And here’s the central idea in the Coase theorem:
If the parties involved in this problem can negotiate between themselves without much hassle, they’ll probably be able to reach an efficient solution regarding these externalities, regardless of initial property rights.
This idea, by the way – that of the Coase Theorem, that is – is one of the most important ideas in economics. It is beyond this particular blogpost to speak about all that needs to be discussed when it comes to the Coase Theorem, and I am not joking when I say that a lifetime may not be enough. But a good place to begin would be this video and the ones after it over on MRU.
Another Way To Think About the Coase Theorem
But there is another way to think about the Coase Theorem. Here’s an alternate definition of the Coase Theorem:
More often than not, transaction costs are so high that an efficient solution regarding externalities is not attainable in practice.
This definition is both more dismal and more realistic (and hey, maybe correlation is causation in this case). Think about the Metro example I cited up above. No one’s ever heard of the citizens of any city queing up to pay their Clean Lung fees to the local transport authorities. And the reason we haven’t seen this is precisely because answering all those questions I raised above involves very, very high transaction costs. It is cheaper, in fact, to not try and collect the fees!
Viewed in this (admittedly rather pessimistic) fashion, the Coase Theorem tells us why we seem to reach agreements on complicated issues ever so rarely – it’s because transaction costs are so damn high.
And I fear that is what Ronald Coase would have said as regards our not-so-little problem that we’ve been talking about. He would have said that the transaction costs are so high that an efficient solution is not going to be possible.
In what follows, I am going to try and break down two things:
- Why is the Coase Theorem a good way to try and think through this issue?
- Why does the Coase theorem imply that an efficient solution isn’t possible?
Why is the Coase Theorem a good way to try and think through this issue?
Think of India’s federal set-up, back when we first went around establishing it, as a trade between the Union government and the states. The Union government in effect said to the states that hey, come along with us, we’ll create a new nation. And oh, by the way, come along with us means give up on certain things. Such as, say, the ability to raise your own army. But don’t worry, we’ll raise it for you. In return for you giving up some of your rights, we’ll give you security, loads of funds, take over some of your administrative headaches, and leave you free to administer your state as you see fit. This is a huge oversimplification, of course, but bear in mind that this is a blog post.
So that was the deal between the states and the Union government. But then externalities came along. The unintended consequences of (eventually wildly) differing birth rates across states in our country, and of different economic growth rates of these states created economic and political imbalances. The Southern states eventually had fewer people, but greater economic output.
And so the southern states face the negative externality of their northern neighbors being economic laggards, and population leaders. As a consequence, southern states end up contributing more to the Union government’s coffers, but get lesser in return when it comes to horizontal devolution – and in the delimitation exercise, will get lesser political representation than they currently have to boot.
Why does the Coase theorem imply that an efficient solution isn’t possible?
Because if you agree that transaction costs are an impediment to an efficient solution most of the times, this situation becomes a canonical example!
Which are the two parties involved here? State governments in the south, and the union government. Throw in the Downs’ paradox for good measure during both the state and the Lok Sabha elections, add some Rodrik-Alesina type political economy ideas as garnish, and you have the perfect non-starter.
So a double helping of doom and gloom all round, then?
Well, no.
Better decentralization, better vertical devolution of funds, and a meaningful implementation of the 73rd, but especially the 74th Amendment would all be good ways to tackle the problem. There would still be no guarantee of a workable solution, because this is a truly wicked problem – but these would be a good start.
But I’m cynical enough to say they’re all exceedingly unlikely, at least in the short run. And this goes without saying: I hope I’m wrong!
But between them, Bob and Ronald do help us understand what the problem is, and why there likely is no easily implementable short term fix.
Over the next two to three years, we will be living in interesting times.
EconForEverybody 