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Today's Economics Thought

Jan. 23, 2011 6:30 PM ET
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ebickel's Blog
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As I sit around on a lazy day such as this, I typically go back to my econ roots.  This typically involves immersing myself into any number of blogs, books, or newspapers.  It usually ends with a question that I find interesting, and one that I focus on for the better part of the entire day.  Today's interest was a little bit different, because I normally find an interest in some abstract study around behavioral economics or something in regards to urban economic theories.  Nonetheless, I find myself asking this:

"What would happen in a world where a country is able to start a war with another country as it pleases, and countries could pay to not be invaded?"

In college, I remember a lot of glossing over in the classroom when professors would discuss Coase's Law and transaction costs.  This question, however, was a bit more interesting to me because instead of focusing on how our world works with its ridiculous amount of individual contracts, to me it's better at stimulating  thought about how our world would work in the absence of these transaction costs. For Example:

Say that in a world, there exists 2 countries, Country X and Country Y. Country X wishes to invade Country Y, and Country Y (understandably) wishes not to be invaded. Now, lets say that Country X values invading Y at $30 (this is a bit unrealistic, but so is a world with 2 countries...) and Country Y values not being invaded at $40. In the absence of transaction costs, Coase's Law tells us that the two countries will negotiate to a point of equilibrium where Y must compensate X for the amount that it values invading Y so that it will forego its invasion. This leads to Y paying X the $30 that it values for invading Y.  Country X is as left as well off as it would have been had it invaded Country Y, and Country Y has actually saved itself an extra $10 and avoided being invaded.

However, in today's world we know this situation of countries paying eachother off to avoid being invade doesn't exactly exist. However, there is a form of this that does actually exist. In today's world countries make agreements (contracts) with other countries based on trade and alliances. These trades and alliances can change the value which countries may place on invading each other in that they increase the opportunity cost born upon them from their actions. To illustrate:

Now consider a world with 3 countries: A, B and C. A is allied with B (which A and B both value at $10) and has a contract to supply some good to B (which B values at $10). Next, suppose C supplies some good to A (which A values at $20) and A supplies the same good it supplies to B (Which C also values at $10). B wishes to invade C and values the invasion at $20. Since C is a valuable supplier to A, naturally A is opposed to such an action and expresses its distaste with a threat to end its alliance with B and enforce a trade barrier. As stated before, B will lose $20 in value if the alliance is broken and the trade with A stops ($10+$10). Therefore, B will not invade C since it will be compensated from not invading by the exact same amount that it would have gained if it had invaded. In a way, A compensates B for not invading C.

Now...this is overly simplified, and there are undoubtedly doubts in the logic.  However, it provided a solid day's worth of thought.  And that's really all I ask for..

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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