Every American and every citizen of Montgomery County should care about the Coase Theorem

University of Chicago Professor and Nobel Laureate (Economics) Ronald Coase (1910-2013).

The Woodlands, July 1 – Every American and every citizen of Montgomery County should care about the Coase Theorem. Ronald Coase won the Nobel Prize in Economics in 1991 for his Theorem. He was an economist who taught at the University of Chicago. Coase died in 2013 at the age of 102.

We’re witnessing how awry a community can transgress, if the citizens ignore the Coase Theorem, an important concept.

Here is the Coase Theorem:

“If transaction costs are zero, then resources will move to their best use.”

The perfect world

Here’s an example of what that means. Let’s suppose Fred owns a piece of real estate, Whiteacre, and he’s using it for agriculture. Fred lives in a perfect world where there are no taxes, deed restrictions, lawyers, or other sources of cost. Fred’s piece of real estate, Whiteacre, is in a great location. Ricky understands that Whiteacre is the perfect location for a shopping mall. Ricky has the money to build a shopping mall. Therefore, in the perfect world, Ricky buys Whiteacre from Fred for the true fair market value. Ricky builds a shopping mall. Everyone is happy. (Another way of saying that “everyone is happy” is that “everyone’s utility has reached its maximum and their marginal utility is zero.”)

The imperfect world

Now, let’s pretend that Fred’s world is not so perfect. There are taxes, deed restrictions, and lawyers. (Sigh…) Fred gets a nice partial exemption on real estate taxes on Whiteacre, because he uses it for agricultural purposes. Ricky still wants to buy Whiteacre to build that shopping mall. Nevertheless, here’s what happens. Ricky offers Fred the same price as in the previous example. Ricky and Fred discover some horrible things, however, about their proposed transaction:

  • Ricky won’t get that agricultural exemption. He’ll have to pay property taxes on Whiteacre equal to about 1/10 of its value.
  • Fred will have to pay 28% capital gains tax on Whiteacre on the transaction where he sells it to Ricky.
  • There’s a property owners association that requires payment of a transfer fee of 5% of the sale price, which either Fred or Ricky will have to pay at the closing.
  • In order to draft the appropriate legal papers to make the transfer effective, Fred has to hire Thurgood, a local lawyer who wears very nice shoes and has a fancy office. Since Ricky doesn’t trust Thurgood, Ricky has to hire Marshall, his own lawyer, to watch what Thurgood is doing. The cost of Thurgood and Marshall is about 12% of the sale price.

After factoring in all of the extra transaction costs, Fred and Ricky decide that the transaction just isn’t worth completing. Whitacre remains agricultural. No one gets a shopping mall. A lot of people are far less happy than they would be, if Ricky had been able to build the shopping mall. (Everyone’s utility is far below its maximum and their marginal utility is a large positive number.)

The world in which we live

Sometimes property is more appropriate for agricultural use than it would be for a shopping mall. When government interferes with the free markets, real estate can move to a use that is not its best use. For example, there was a swampy piece of land along the Potomac River, which was so undesirable that only the national government would be stupid enough to spend the massive amount of money to develop it. It’s now called the District of Columbia, and, as we all know, it’s a constant source of national trouble.

So let’s take a look at the example in our backyard. There is a small group of influential real estate developers. They’ve got agricultural land that is garbage in value. They want to make it more valuable. Therefore, they have bought influence with some of the scariest people alive on this planet: the members of the Montgomery County Commissioners Court. Along with a group of engineers and contractors who also bought influence, they used their backroom persuasion (also known as money) to convince the Commissioners Court to help them turn their low-value agricultural land into extremely valuable commercial land. Of course, the amount of increase in their land value will be far less than the amount of money that taxpayers will have to pay along the way. But why should the influential real estate developers care? They’re not paying those taxes. In fact, neither are the County Commissioners Court members. They’re using other people’s money to enrich themselves!

It’s glorious. It’s exciting. It’s called the Tx-249 Extension. They’re imposing massive transaction costs on others in order to move land, the best use of which is likely agricultural, to a use that is far from its best and most economic use.

The cost to Montgomery County citizens and other Texas citizens who will pay their taxes is far above the increase in the value of the real estate that the influential real estate developers own. Nevertheless, since they control government decision makers, and since they’re playing with other people’s money, it’s a great deal for them and one for which they’re highly motivated to complete.

 

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