Coase Theorem & Domains

November 27, 2007 · Print This Article

Yesterday, Dominik provided a basic economic analysis of the supply and demand of domain names. Then today Steve Levitt of Freakonomics made a post about the Coase Theorem and Domain Names. I’m very interested in economics, so I’m going to offer some economic analysis of domain names. If economics bores you, well, consider reading some of my other posts, which are a lot more practical.

The Coase Theorem basically states that it does not matter how property rights are initially allocated, under certain assumptions, property will end up in the hands of the most efficient users. In the context of domain names, this means that it doesn’t matter, in terms of economic efficiency, how the registry initially allocates domain names. The registry can use first come first serve, an auction model, lottery, and so on. Domain names will end up in the hands of the end user that can make the most profitable use of the domain name.

Why is this so? Basically, if A wants a domain that B owns, and A values this domain more than B, the two of them will negotiate and A will buy the domain from B. It will be a good deal for both of them – B will get more for the domain than he could have earned holding on to it. And A will earn more from the domain than he has paid to B. Everyone is happy.

Levitt looks at the notorious case of In this case, a Mr Nissan owned a business using his last name even before Nissan Motor existed. Mr Nissan registered the domain name for his business and used it. Five years later, Nissan Motor started an expensive and lengthy legal battle against Mr Nissan to try (unsuccessfully) to wrest control of the domain from him.

Levitt calls this a case of the Coase Theorem breaking down. With respect, I don’t think he’s entirely right. Let me explain why.

First of all, it is not even clear to me that the Coase Theorem applies to the domain space, simply because of the different nature of domains. This is because a company will only be willing to pay the profits it loses by using the next best alternative + the value of the next best alternative (which may well be a reg fee domain), rather than the entire value of the domain. So, as a hypothetical example, while the domain may be worth tens of millions of dollars to Nissan Motors, they may only be losing $100,000 per year from not owning the domain. Mr Nissan may be earning more than this from running his business on the domain. In this case, even though Nissan Motors would be a more efficient user of the domain, Mr Nissan would never sell the domain to them. In short, the ability to get a “second best” domain name may mean that the Coase Theorem does not apply.

That being said, it’s not clear to me that the Coase Theorem has been broken in the case. In Mr. Nissan’s case, the value of the domain name is not really possible to put into monetary terms. The value he puts on the domain name is so high that he is willing to devote large amounts of time and money and deal with a difficult legal situation for years. Perhaps he does value the domain more than Nissan motors, in which case the Coase Theorem has held and Mr Nissan is the highest valued user. People are extraordinarily attached to domain names with their surname in it. I own my last name and would not sell that for any price. People can go to extraordinary efforts to acquire domains with their last name, as for instance, Shoemoney did.

A couple more thoughts. For the Coase Theorem to work, property rights must be well defined. I’m not sure that’s always the case in the domain space. I don’t think that WIPO panelists always understand what a generic term is (or for that matter, the intrinsic value of a 2 or 3 character domain) and several holders of generic domain names have lost their domains as a result. Similarly, there is uncertainty about the results of any particular UDRP, which encourages large corporations to try to grab property rights without negotiation. The risk of losing your domain in a dispute means that your property rights to the domain aren’t all that certain. In the circumstances, arbitrators should be very cautious about ordering the transfer of a domain name from one party to another.

The Coase Theorem also requires that people understand the value of their property. However, the fact is that domains are difficult to appraise. Even domainers, experts in the field, have difficult ascertaining the value of a domain. Witness the many appraisal threads on the domain forums as proof of this. I have seen two different appraisal companies give completely different values for a particular domain. Add to this the fact that the general public and most of the corporate world is ignorant to the value of domains. The difficulty in valuing a domain makes it less likely for the Coase Theorem to work. I think that is a good example of this. The Dallas Cowboys could probably make this domain worth a lot more than the current owners, but they simply don’t seem to understand its value.

In short, the Coase Theorem is a great economic tool, but there are a number of limitations on it that make its applicability in the current domain market limited. It would probably be in domainers’ best interests to deal with these limitations to increase the probability of negotiating a successful deal with a higher value end user. Steps would include clearer UDRP policies and better education of domain values.

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