Crying babies and the Coase Theorem

This week in my ECONS102 class, we've been covering externalities. An externality is the uncompensated impact of the actions of one person on the wellbeing of a third party. Externalities can be negative (they make the third party worse off) or positive (they make the third party better off). We call them externalities because they lie outside the decision that created them - that is, some of the costs or benefits are external to the person whose action creates them.

A key part of the topic is understanding the Coase Theorem (named for the late Nobel prize-winner Ronald Coase) - the idea that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (that is, without government intervention). It's an important idea because it is tempting to believe that, whenever there is an externality, it is the government's job to fix it, often through some form of regulation. But the theorem tells us that government intervention isn't always necessary.

The Coase Theorem first requires us to recognise the rights and entitlements associated with an externality. I'll illustrate with the example from this article in the New Zealand Herald last month:

A Sydney mother is "fuming" after receiving an "unbelievable" note about her parenting in her letter box.

The new mum shared a photo of the letter on Facebook, where the next door neighbours complained about her baby crying during the night.

"We would have called you but we are never sure when you are around," the note reads.

"We just wanted to let you know that unfortunately we have had a number of disturbed nights sleep recently due to the thinness of the walls between our units."

The neighbours added while they don't have kids of their own they're sure "it's not at all easy to soothe a crying baby".

"We really would appreciate anything you can do to help us get more sleep, particularly during the early hours," the note reads.

"Thank you for your consideration of this. I am sure we all look forward to more undisturbed nights' sleep."

A crying baby creates a negative externality - they impose a cost on the neighbour, who is losing sleep. How could the two parties negotiate a solution to this problem? It depends on the rights and entitlements.

Both parties have rights here. The neighbour has the right to quiet enjoyment of their home - they shouldn't have to worry about being disturbed at night. The mother has the right to have a baby at home, and babies are known to cry. So, there are competing rights. The bargaining solution will depend on which party has the overriding rights - whose rights are protected more under the law.

Let's work it through from both possible perspectives. First, let's say that the overriding rights belong to the neighbour - their right to quiet enjoyment will be protected. The default solution is that the mother has to quiet the baby in some way (or maybe they have to move somewhere else). The alternative solution is that mother and baby stay, but they agree to pay compensation to the neighbour for the neighbour's loss of sleep. The amount of compensation would have to be at least as much as whatever the neighbour values their sleep at (otherwise they wouldn't agree, and they don't have to, since under the default solution they would get quiet). However, the compensation has to be less than whatever the mother values staying in that home with their baby at (otherwise, mother and baby would be better off moving, rather than paying the compensation).

Now let's look at it the other way. Let's say that the overriding rights belong to the mother - her right to have her baby at that home will be protected. Now, the default solution is that the neighbour has to put up with the crying (or maybe they have to move somewhere else). The alternative solution is that mother and baby move away, but are paid compensation by the neighbour in order to do so. In this case, the amount of compensation would have to be at least as much as whatever the mother values living in that house with her baby at (otherwise they wouldn't agree, and they don't have to, since under the default solution the neighbour just has to put up with the crying). However, the compensation has to be less than whatever the neighbour values their lost sleep at (otherwise, they would be better off moving or putting up with the crying, rather than paying the compensation).

The Coase Theorem tells us how a bargaining solution could arise when there is an externality problem. However, it requires both parties to reach an agreement. In this case, given that the mother is already "fuming" about the neighbour's note, that seems unlikely.