My previous post triggered a lot of comments accusing me of misunderstanding Coase’s Theorem. It is certainly possible that I did, but I am going to argue that many of my commenters are misunderstanding that famously misunderstood Theorem.
When I was young I constantly breathed in second-hand smoke, and paid no attention to it. Lots of people smoked. My dad smoked all the time. Even university professors smoked in class. Then smoking began to decline and people started becoming much more sensitive to smoke. I don’t know if it was generation X, Y, or Z, but at some point we became almost absurdly oversensitive to smoke. I’m not a smoker but I find it almost comical that people don’t want to stay in a hotel room not because someone else in the room is smoking, but because someone in the past smoked in the room. But enough reactionary whining from me. As an economist it is my job to maximize utility. If people say they are extremely bothered by even tiny amounts of second-hand smoke, it is my job to do something about it. Even though I know deep down that all attempts to make society more comfortable from this point on are doomed to fail. The more discomfort we remove, the more sensitive we become to the remaining annoyances. It’s all about set points.
Suppose the state office building in Boston has both smokers and non-smokers. Over time the non-smokers become increasing numerous and increasingly assertive. At what point should the owner of the building do something about the problem? Coase understood that there were two ways of thinking about the issue. If it was easy for people to negotiate side deals with office workers next door, the non-smokers would be able to bribe smokers into not smoking whenever the benefits from a smoke-free environment exceeded the disutility incurred by smokers having to go outside to light up. All would be well. But Coase also realized that transactions costs might easily make those side deals too costly to implement. In that case he suggested that regulation might be appropriate. Who should regulate the activity? Whoever owned the space where the economic harm occurred. If the annoying smoke occurred in a government office building, then the government should regulate the activity.
Now consider the same example, but this time with a private office building. Again, it might be best for the owner to simply let the employees work out side deals, and not have any regulation at all. Or the best solution might be to regulate the activity. But here is where it seems to me that some of my commenters went off course. They seemed to assume that if regulation was called for, then it should be done by the government. In fact, for two reasons government regulation would be far inferior to regulation by the owner of the office building:
1. The first problem is that government regulations tend to be one-size-fits-all. So they might ban smoking in all offices. Or they might ban anti-smoking rules in all offices, claiming (accurately) that these rules discriminate against potential office workers coming from low SES backgrounds. Either way, it will be a one-size-fits-all regulation. But that regulation would not be optimal in all offices. It is very likely that the best solution in some office buildings is to allow anyone to smoke, and in other office buildings to ban smoking. It all depends on the relative proportion of non-smokers, whether the non-smokers are tough old guys like me who don’t mind smoke or delicate Gen X’s who can’t tolerate it, and how much smokers enjoy smoking. (I might lose half my readers after this post.)
2. Government regulators may have an incentive to maximize votes, not economic efficiency. Suppose 80% of people are non-smokers, but the utility from smoking (in dollar terms) is ten times the disutility from second-hand smoke. In that case it is socially optimal to allow smoking. But since 80% of voters are non-smokers, the government might ban smoking in the workplace anyway.
In contrast, the owner of the firm has an incentive to set in place the socially optimal smoking policy. The easiest case to consider is where the owner is not even present, but adding an on-site owner doesn’t change anything. If the owner is not present at the work site, he has an incentive to put in place a regulation that maximizes the aggregate utility of his workers (or customers, if we are considering a restaurant.) This is because either choice of regulation can be imposed at zero direct cost, so the only thing that matters to the owner is the indirect cost of the regulation, which is the impact on his wage bill. In generally, it is easier to find good workers willing to work at low wages if you have a pleasant work environment. If you are a non-smoker you might assume that a pleasant work environment is one that is free of smoke. But if you are a smoker then you might think that a pleasant work environment is one where you are free to smoke.
The point many people miss is that all of these costs and benefits of smoking are internal to the firm. A factory-owner might not care if its smoke bothers people downwind, as they generally don’t have to pay compensation. That’s an externality to the firm. But a company will care very much if second hand smoke annoys non-smoking workers, as they would then have to pay higher salaries to get people to work there. Of course it is possible that people would sort into smoking and non-smoking firms, and that may be an efficient solution in some cases. But even where it isn’t feasible the owner has an incentive to institute the smoking policy that makes for the happiest employees on average. This will minimize his productivity-adjusted wage bill.
When deciding on optimal employee amenities one must consider costs and benefit. For example, does beautifying the office with flowers and artwork pay for itself in higher employee morale? A smoking regulation has zero direct cost, so you simply compare the negative consequences to one side with the positive consequences to the other side.
Part 2. Beyond Villains and Victims
One thing I learned from Coase is that it is often misleading to think of social problems in terms of villains and victims. Is the problem of bad smells from pork processing plants caused by the plants themselves? Or by the suburban developments which arrive after the plant was already built? Coase showed that this was a meaningless question. The only relevant question is what set of property rights are most likely to produce an economically efficient outcome.
It seems to me that many people are so appalled by smoking that they assume smokers are the villains. In contrast, I see the over-sensitive GenXers as being the villains. Coase would say we are both wrong. The only villains here are those who advocate inefficient government regulation when a much more efficient solution is to let the private market sort things out. The government should (at most) regulate smoking in government buildings. Note that I cannot be accused of being a reflexive opponent of regulation. I support carbon taxes because the area of damage (the atmosphere) is commonly-owned, and the cost of privately negotiating an optimal emissions framework is prohibitively high.
It’s quite possible that everything I have written is wrong. This is certainly not my area of expertise. Or perhaps my argument is correct but has nothing to do with Coase’s Theorem, and was already widely known by the earlier Pigovians. If a GMU blogger or someone like Steven Landsburg comes over here and sets me straight, I will gladly admit I am wrong. But so far in the comment section I’m not seeing arguments that dissuade me from the views I expressed in the previous post. I still say Richard Thaler is wrong, second-hand smoke does not call for government regulation.
Update. I could have avoided wasting on hour writing this post if I had just read David Henderson first. He links to an article that confirms the externality problem does not occur in privately-owned properties such as restaurants and offices. He also answers my question about whether Thaler and Sunstein spend equal time trying to replace burdensome hard paternalism with softer libertarian paternalism. The answer is yes. That means I’m officially on board. But first Thaler has to stop saying those silly things about second-hand smoke.