(One
version of this article was published by Reason Magazine, and a slightly
different version by the University of Chicago Law School Record--their alumni
magazine.)
When the Swedish Academy awarded the Nobel
Prize in Economics to Ronald Coase this year, it was a surprise for two
different groups of people. The larger group consisted of people who had either
never heard of Coase, or heard of him only as the author of something called
the "Coase Theorem," generally presented as a theoretical curiousity
of no practical importance. The second and much smaller group consisted of
people who were familiar with the importance of Coase's work--and assumed that
the Swedish Academy was not.
Some people get the Nobel prize for
complicated and technical work that is difficult for an outsider to understand.
Coase is at the other extreme. His contribution to economics has largely
consisted of thinking through certain questions more carefully and correctly
than anyone else, and in the process demonstrating that answers accepted by
virtually the entire profession were false. One side effect of his work was a
new field of economics: economic analysis of law, the attempt to use economic
theory to understand legal systems. While there would probably be something
called economic analysis of law if Coase had not existed, it would be a very
different field.
One of Coase's important contributions to
economics was to rewrite the theory of externalities--the analysis of
situations, such as pollution, where one person's actions impose costs (or
benefits) on another. His ideas are sufficiently simple to be understood by a
layman, as I will try to demonstrate in the next few pages, and sufficiently
deep so that they have not yet been entirely absorbed by the profession; to a
considerable extent what is still taught in the textbooks is the theory as it
existed before Coase.
To understand the significance of Coase's
contribution to the theory of externalities, it is useful to start with the
theory as it existed before Coase published "The Problem of Social
Cost," the essay that first introduced the Coase Theorem to economics. The
basic argument went as follows:
In
an ideal economic system, goods worth more than they cost to produce get
produced, goods worth less than they cost to produce do not; this is part of
what economists mean by economic efficiency. In a perfectly competitive private
property system, producers pay the value of the inputs they use when they buy them
from their owners (wages to workers in exchange for their labor, rent to land
owners for the use of their land, etc.) and receive the value of what they
produce when they sell it. If a good is worth more than it costs to produce,
the producer receives more than he pays and makes a profit; if the good is
worth less than it costs to produce he takes a loss. So goods that should be
produced are and goods that should not be produced are not.
This
only works if producers must pay all of the costs associated with production.
Suppose that is not the case. Suppose, for example, that a steel producer, in
addition to using iron ore, coal, etc., also "uses" clean air. In the
process of producing a ton of steel he puts ten pounds of sulfur dioxide into the
air, imposing (say) $100 worth of bad smells, sore throats, and corrosion on
people down wind. Since he does not pay for that cost, he does not include it
in his profit and loss calculations. As long as the price he sells his steel
for at least covers his costs it is worth making steel. The result is
inefficient: Some goods may be produced even though their cost, including the
resulting pollution, is greater than their value.
It is inefficient in another respect as well. The steel producer may be able to
reduce the amount of pollution by various control devices--air filters, low
sulfur coal, high smokestacks--at a cost. Calculated in terms of the net effect
on everyone concerned, it is worth eliminating pollution as long as the cost is
less than the pollution damage prevented--in our example, as long as it costs
less than $10 to prevent a pound of sulfur dioxide emission. But the steel
producer, in figuring out how to maximize his profit, includes in his
calculations only the costs he must pay. So long as he does not bear the cost
of the pollution, he has no incentive to prevent it. So the fact that air
pollution is an external cost results in both an ineffiently high level of
steel production (it may be produced even when it is not worth producing) and
an inefficiently low level of pollution control.
There
are two obvious solutions. One is direct regulation--the government tells the
steel company how much it is allowed to pollute. The other is emission
fees--referred to by economists as Pigouvian taxes (named after A. C. Pigou,
the economist whose ideas I am describing).
Under
a system of Pigouvian taxes, the government charges the steel company for the
damage done by its pollution--$10 per pound in this example. By doing so it
converts the external cost into an internal cost--internalizes the externality.
In deciding how much steel to produce and what price to sell it at, the company
will now include the cost of its pollution--paid as an emission fee--along with
other costs. In deciding how much pollution control equipment to buy, the
company balances the cost of control against its benefits, and buys the optimal
amount. So a system of emission fees can produce both an efficient amount of
steel and an efficient amount of pollution control.
In
order to achieve that result, the government imposing the fees must be able to
measure the cost imposed by pollution. But, unlike direct regulation, the use
of emission fees does not require the government to measure the cost of
preventing pollution--whether by installing air filters or by producing less
steel. That will be done by the steel company, acting in its own interest.
I have just described the theory of
externalities as it existed before Coase. Its conclusion is that, as long as
externalities exist and are not internalized via Pigouvian taxes, the result is
inefficient. The inefficiency is eliminated by charging the polluter an
emission fee equal to the damage done by his pollution. In some real world
cases it may be difficult to measure the amount of the damage, but, provided
that that problem can be solved, using Pigouvian taxes to internalize
externalities produces the efficient outcome.
That analysis was accepted by virtually
the entire economics profession prior to Coase's work in the field. It is
wrong--not in one way but in three. The existence of externalities does not
necessarily lead to an inefficient result. Pigouvian taxes, even if they can be
correctly calculated, do not in general lead to the efficient result. Third,
and most important, the problem is not really externalities at all--it is
transaction costs.
I like to present Coase's argument in
three steps: Nothing works, Everything works, It all depends.
The first step is to realize that an
external cost is not simply a cost produced by the pollutor and born by the
victim. In almost all cases, the cost is a result of decisions by both parties.
I would not be coughing if your steel mill were not pouring out sulfur dioxide.
But your steel mill would do no damage to me if I did not happen to live down wind
from it. It is the joint decision--yours to pollute and mine to live where you
are polluting--that produces the cost.
Suppose that, in a particular case, the
pollution does $100,000 a year worth of damage and can be eliminated at a cost
of only $80,000 a year (from here on, all costs are per year). Further assume
that the cost of shifting all of the land down wind to a new use unaffected by
the pollution--growing timber instead of renting out summer resorts, say-- is
only $50,000. If we impose an emission fee of a hundred thousand dollars a
year, the steel mill stops polluting and the damage is eliminated--at a cost of
$80,000. If we impose no emission fee the mill keeps polluting, the owners of
the land stop advertising for tenants and plant trees instead, and the problem
is again solved--at a cost of $50,000. In this case the result without
Pigouvian taxes is efficient--the problem is eliminated at the lowest possible
cost--and the result with Pigouvian taxes in inefficient.
Moving the victims may not be a very
plausible solution in the case of air pollution; it seems fairly certain that
even the most draconian limitations on emissions in southern California would
be less expensive than evacuating that end of the state. But the problem of
externalities applies to to a wide range of different situations, in many of
which it is far from obvious which party can avoid the problem at lower cost,
and in some of which it is not even obvious which one we should call the
victim.
Consider the question of airport noise.
One solution is to reduce the noise. Another is to soundproof the houses. A
third is to use the land near airports for noisy factories instead of housing.
There is no particular reason to think that one of those solutions is always
best. Nor is it entirely clear whether the "victim" is the landowner
who finds it difficult to sleep in his new house with jets going by overhead or
the airline forced by a court or a regulatory agency to adopt expensive sound
control measures in order to protect the sleep of people who chose to build
their new houses in what used to be wheat fields--directly under the airport's
flight path.
Consider a simpler case, where the nominal
offender is clearly not the lowest cost avoider. The owner of one of two
adjoining tracts of land has a factory, which he has been running for twenty
years with no complaints from his neighbors. The purchaser of the other tract
builds a recording studio on the side of his property immediately adjacent to
the factory. The factory, while not especially noisy, is too noisy for
something located two feet from the wall of a recording studio. So the owner of
the studio demands that the factory shut down, or else pay damages equal to the
full value of the studio. There are indeed "external costs" associated
with operating a factory next to a recording studio--but the efficient solution
is building the studio at the other end of the lot, not building the studio
next to the factory and then closing down the factory.
So Coase's first point is that
externalities are a joint product of "pollutor" and
"victim," and that a legal rule that arbitrarily assigns blame to one
of the parties only gives the right result if that party happens to be the one
who can avoid the problem at the lower cost. Pigou's solution is correct only
if the agency making the rules already knows which party is the lower cost
avoider. In the more general case, nothing works--whichever party the blame is
assigned to, by government regulators or by the courts, the result may be
inefficient if the other party could prevent the problem at a lower cost.
One of the arguments commonly offered in
favor of using Pigouvian taxes instead of direct regulation is that the
regulator does not have to know the cost of pollution control in order to
produce the efficient outcome--he just sets the tax equal to damage done, and
lets the pollutor decide how much pollution to buy at that price. But one of
the implications of Coase's argument is that the regulator can only guarantee
the efficient outcome if he knows enough about the cost of control to decide
which party should be considered the pollutor (and taxed) and which should be
considered the victim.
The second step in Coase's argument is to
observe that, as long as the parties involved can readily make and enforce
contracts in their mutual interest, neither direct regulation nor Pigouvian
taxes are necessary in order to get the efficient outcome. All you need is a
clear definition of who has a right to do what and the market will take care of
the problem.
To see how that works, let us go back to
the case of the steel mill and the resorts. Suppose first that the mill has a
legal right to pollute. In that case, as I originally set up the problem, the
efficient result occurs immediately. The lowest cost avoiders are the owners of
the land downwind; they shift from operating resorts to growing timber.
What if, instead, the legal rule is that
the people downwind have a right not to have their air polluted? The result
will be exactly the same. The mill could eliminate the pollution at a cost of
$80,000 a year. But it is cheaper to pay the landowners some amount, say
$60,000 a year, for permission to pollute. The landowners will be better off,
since that is more than the cost to them of changing the use of the land, and
the steel mill will be better off, since it is less than the cost of
eliminating the pollution. So it will pay both parties to make some such
agreement.
Now suppose we change the numbers in the
example, to make pollution control the more efficient option--say lower its
cost to $20,000. In that case, whether or not the mill has the right to
pollute, it will find that it is better off not polluting. If it has the right
to pollute, the landowners will pay more than the $20,000 cost of pollution
control in exchange for a guarantee that it will not exercise its right. If it
does not have the right to pollute, the most the steel mill will be willing to
offer the landowners for permission to pollute is $20,000, and the landowners
will turn down that offer.
The generalization of this example is
straightforward:
If transaction costs are zero--if, in
other words, any agreement that is in the mutual benefit of the parties
concerned gets made--then any initial definition of property rights leads to an
efficient outcome.
It is this result that is sometims
referred to as the "Coase Theorem." It leads immediately to the final
stage of the argument.
Why is it, if Coase is correct, that we
still have pollution in Los Angeles? One possible answer is that the pollution
is efficient--that the damage it does is less than the cost of preventing it. A
more plausible answer is that much of the pollution is inefficient, but that
the transactions necessary to eliminate it are prevented by prohibitively high
transaction costs.
Let us return to the steel mill. Suppose
the mill has the right to pollute, but that doing so is inefficient--pollution
control is cheaper than either putting up with the pollution or changing the
use of the land down wind. Further suppose that there are a hundred landowners
down wind.
With only one landowner, there would be no
problem--he would offer to pay the mill for the cost of the pollution control
equipment, plus a little extra to sweeten the deal. But a hundred landowners
face what economists call a public good problem. If ninety of them put up the
money and ten do not, the ten get a free ride--no pollution and no cost for
pollution control. Each landowner has an incentive to refuse to pay, figuring
that his payment is unlikely to make the difference between success and failure
in the attempt to bribe the steel mill to eliminate its pollution. If the
attempt is going to fail even with him, then it makes no difference whether or
not he contributes. If it is going to succeed even without him, then refusing
to contribute gives him a free ride. Only if his contribution makes the
difference does he gain by agreeing to contribute.
There are a variety of ways in which such
problems may sometimes be solved, but none that can always be expected to work.
The problem becomes harder the larger the number of people involved. With many
millions of people living in southern California, it is hard to imagine any
plausible way in which they could voluntarily raise the money to pay all
pollutors to reduce their pollution.
This is one example of the sort of problem
referred to under the general label of "transaction costs." Another
would occur if we reversed the assumptions, making pollution (and timber) the
efficient outcome but giving the landowners the right to be pollution free. If
there were one landowner the steel mill could buy from him the right to
pollute. With a hundred, the mill must buy permission from all of them. Any one
has an incentive to be a holdout--to refuse his permission in the hope of
getting paid off with a large fraction of the money the mill will save from not
having to control its pollution. If too many landowners try that approach the
negotiations will break down, and the parties will never get to the efficient
outcome.
Seen from this perspective, one way of
stating Coase's insight is that the problem is not really due to externalities
at all, but to transaction costs. If there were externalities but no
transaction costs there would be no problem, since the parties would always
bargain to the efficient solution. When we observe externality problems (or
other forms of market failure) in the real world, we should ask not merely
where the problem comes from, but what the transaction costs are that prevent
it from being bargained out of existence.
Ever since Coase published "The
Problem of Social Cost," economists unconvinced by his analysis have
argued that the Coase Theorem is merely a theoretical curiousity, of little or
no practical importance in a world where transaction costs are rarely zero. One
famous example was in an article by James Meade (who later received a Nobel
prize for his work on the economics of international trade).
Meade offered, as an example of the sort
of externality problem for which Coase's approach offered no practical
solution, the externalities associated with honey bees. Bees graze on the
flowers of various crops, so a farmer who grows crops that produce nectar
benefits the beekeepers in the area. The farmer receives none of the benefit
himself, so he has an inefficiently low incentive to grow such crops. Since
bees cannot be convinced to respect property rights or keep contracts, there is,
Meade argued, no practical way to apply Coase's approach. We must either
subsidize farmers who grow nectar rich crops (a negative Pigouvian tax) or
accept inefficiency in the joint production of crops and honey.
It turned out that Meade was wrong. In two
later articles, supporters of Coase demonstrated that contracts between
beekeepers and farmers had been common practice in the industry since early in
this century. When the crops were producing nectar and did not need
pollenization, beekeepers paid farmers for permission to put their hives in the
farmers' fields. When the crops were producing little nectar but needed
pollenization (which increases yields), farmers paid beekeepers. Bees may not
respect property rights but they are, like people, lazy, and prefer to forage
as close to the hive as possible.
The fact that a Coasian approach solves
that particular externality problem does not imply that it will solve all such
problems. But the observation that an economist as distinguished as Meade
assumed Coase's approach was of no practical significance in a context where it
was actually standard practice suggests that the range of problems to which the
Coasian solution is relevant may be much greater than many would at first
guess.
"The Problem of Social Cost"
provides more than merely a revolutionary rethinking of the question of
externalities. It also suggests a new and interesting approach to the problem
of defining property rights.
A court, in settling disputes involving
property, or a legislature in writing a law code to be applied to such
disputes, must decide just which of the rights associated with land are
included in the bundle we call "ownership." Does the owner have the
right to prohibit airplanes from crossing his land a mile up? How about a
hundred feet? How about people extracting oil from a mile under the land? What
rights does he have against neighbors whose use of their land interferes with
his use of his? If he builds his recording studio next to his neighbor's
factory, who is at fault? If he has a right to silence in his recording studio,
does that mean that he can forbid the factory from operating, or only that he
can sue to be reimbursed for his losses? It seems simple to say that we should
have private property in land, but ownership of land is not a simple thing.
The Coasian answer to this set of problems
is that the law should define property in such a way as to minimize the costs
associated with the sorts of incompatible uses we have been discussing--factories
and recording studios, or steel mills and resorts. The first step in doing so
is to try to define rights in such a way that, if right A is of most value to
someone who also holds right B, they come in the same bundle. The right to decide
what happens two feet above a piece of land is of most value to the person who
also holds the right to use the land itself, so it is sensible to include both
of them in the bundle of rights we call "ownership of land." On the
other hand, the right to decide who flies a mile above a piece of land is of no
special value to the owner of the land, hence there is no good reason to
include it in that bundle.
If, when general legal rules were being
established, we somehow knew, for all cases, what rights belonged together, the
argument of the previous paragraph would be sufficient to tell us how property
rights ought to be defined. But that is very unlikely to be the case. In many
situations a right, such as the right not to have noises of more than X decibels
made over a particular piece of property, may be of substantial value to two or
more parties--the owner of the property and the owner of the adjacent factory
in my earlier example, for instance. There is no general legal rule that will
always assign it to the right one.
In this case, the argument underlying the
Coase Theorem comes into play. If we assign the right initially to the wrong
person, the right person, the one to whom it is of most value, can still buy
it. So one of the considerations in the initial definition of property rights
is doing it in such a way as to minimize the transaction costs associated with
fixing, via private contracts, any initially inefficient definition.
An example may make this clearer. Suppose
that, in the pollution case discussed earlier, damages from pollution are easy
to measure and the number of people downwind is large. In that case, the
efficient rule is probably to give downwind landowners a right to collect
damages from the pollutor, but not a right to forbid him from polluting. Giving
the right to the landowners avoids the public good problem that we would face
if the landowners (in the case where pollution is inefficient) had to raise the
money to pay the steel mill not to pollute. Giving them a right to damages rather
than giving each landowner the right to an injunction forbidding the steel mill
from polluting avoids the holdout problem that the mill would face (in the case
where pollution is efficient) in buying permission from all of the landowners.
A full explanation of how Coase's argument
can be applied to figuring out what the law ought to be (more precisely, what
legal rules lead to the best outcome from the standpoint of economic
efficiency) would require a much longer article--perhaps a book. I hope I have
said enough to make clear the basic idea, and enough to show the unique and
extraordinary nature of one of Ronald Coase's principal contributions to
economics. He started with a simple insight, based in part on having read cases
in the common law of nuisance--the branch of law that deals with problems such
as noisy factories next door to recording studios. He ended by demonstrating
that what everyone else in the profession thought was the correct analysis of
the problem of externalities was wrong, and, in the process, opening up a whole
new approach to the use of economics to analyze law.
There is at least one more thing worth
saying about "The Problem of Social Cost." Economists, then and (to
some degree) now, tend to jump from the observation that the market produces an
inefficient result in some situation to the conclusion that the government
ought to intervene to fix the problem. Part of what Coase showed was that, for
some problems, there is no legal rule, no form of regulation, that will
generate a fully efficient solution. He thus anticipated public choice
economists, such as James Buchanan (another Nobel winner), in arguing that the
real choice was not between an inefficient market and an efficient government
solution but rather among a variety of inefficient alternatives, private and
governmental. In Coase's words: "All solutions have costs and there is no
reason to suppose that government regulation is called for simply because the
problem is not well handled by the market or the firm."
Cheung, Steven N. S., "The Fable of
the Bees: An Economic Investigation," Journal of Law and Economics
XVI (1973), 11-33.
Coase, R.H. , The Problem of Social Cost, Journal
of Law and Economics 3, 1-44 (1960).
Friedman, D., The Machinery of Freedom,
2nd Edn., Open Court: La Salle, 1989, Chapters 41-43.
Johnson, David B., "Meade, Bees, and
Externalities," Journal of Law and Economics XVI (1973), 35-52.
Meade, J. E., "External Economies and
Diseconomies in a Competitive Situation," 52 Economic Journal 54
(1952).
Pigou, A.C., Wealth and Welfare
(1912) and The Economics of Welfare (1920).
Posner, R., Economic Analysis of Law, 3rd Edn., Little Brown & Co. Boston, 1986.