Coase on Externalities

Tuesday, September 3, 2013
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The existence of “externalities” — effects (costs or benefits) of market transactions that are not experienced by those involved in the transaction, but are instead experienced by others, those “external” to the transaction —  is routinely proffered as a justification for governmental regulation of private economic activity.  Ronald Coase had a different view, however. In his seminal essay, “The Problem of Social Cost,” Coase never used the term — and with good reason. In Coase’s view, the word “externality” did not do much work.  In his introduction to The Firm, The Market, and the Law, Coase wrote:

the existence of “externalities” does not imply that there is a prima facie case for government intervention, if by this statement is meant that, when we find “externalities,” there is a presumption that governmental intervention (taxation or regulation) is called for rather than the other courses of action which could be taken (including inaction, the abandonment of earlier governmental action, or the facilitating of market transactions). . . .

. . . it is easy to show that the mere existence of “externalities” does not, in itself, provide any reason for governmental intervention. Indeed, the fact that there are transaction costs and that they are large implies that many effects of people’s actions will not be covered by market transactions. Consequently, “externalities” will be ubiquitous. The fact that governmental intervention also has its costs makes it very likely that most “externalities” should be allowed to continue if the value of production is to be maximized. This conclusion is strengthened if we assume that the government is not like Pigou’s ideal but is more like his normal public authority–ignorant, subject to pressure, and corrupt. Whether there is a presumption, when we observe an “externality,” that governmental intervention is desirable, depends on the cost conditions in the economy concerned. We can imagine cost conditions in which this presumption would be correct and also those in which it would not. It is wrong to claim that economic theory establishes such a presumption. What we are dealing with is a factual question. The ubiquitous nature of “externalities” suggests to me that there is a prima facie case against intervention, and the studies on the effects of regulation which have been made in recent years in the United States, ranging from agriculture to zoning, which indicate that regulation has commonly made matters worse, lend support to this view.

The concept of “externality” has come to play a central role in welfare economics, with results which have been wholly unfortunate. There are, without question, effects of their actions on others (and even on themselves) which people making decisions do not take into account. But, as employed today, the term carries with it the connotation that when “externalities” are found, steps should be taken by the government to eliminate them. As already indicated, the only reason individuals and private organizations do not eliminate them is that the gain from doing so would be offset by what would be lost (including the costs of making the arrangements necessary to bring about this result). If with governmental intervention the losses also exceed the gains from eliminating the “externality,” it is obviously desirable that it should remain.

(pp. 24-26)

As Coase notes, this was one of the points he sought to make in “The Problem of Social Cost,” and yet it is a point many seem to have missed. Coase’s essay is routinely cited for the proposition that the existence of “externalities” justifies governmental intervention, when Coase suggested nothing of the sort. Rather, the case for governmental intervention is made by showing that such intervention is likely to make things better — something that must be shown, and not merely assumed.

UPDATE: Coase made a similar point (and corrected some misperceptions) in his Nobel acceptance speech.

I now turn to that other article cited by the Swedish Academy, The Problem of Social Cost, published some 30 years ago. I will not say much here about its influence on legal scholarship which has been immense but will mainly consider its influence on economics, which has not been immense, although I believe that in time it will be. It is my view that the approach used in that article will ultimately transform the structure of microeconomics – and I will explain why. I should add that in writing this article I had no such general aim in mind. I thought that I was exposing the weaknesses of Pigou’s analysis of the divergence between private and social products, an analysis generally accepted by economists, and that was all. It was only later, and in part as a result of conversations with Steven Cheung in the 1960s that I came to see the general significance for economic theory of what I had written in that article and also to see more clearly what questions needed to be further investigated.

Pigou’s conclusion and that of most economists using standard economic theory was, and perhaps still is, that some kind of government action (usually the imposition of taxes) was required to restrain those whose actions had harmful effects on others, often termed negative externalities. What I showed in that article, as I thought, was that in a regime of zero transaction costs, an assumption of standard economic theory, negotiations between the parties would lead to those arrangements being made which would maximise wealth and this irrespective of the initial assignment of rights. This is the infamous Coase Theorem, named and formulated by Stigler, although it is based on work of mine. Stigler argues that the Coase Theorem follows from the standard assumptions of economic theory. Its logic cannot be questioned, only its domain. I do not disagree with Stigler. However, I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transaction costs. The significance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion; let us study the world of positive transaction costs.

If we move from a regime of zero transaction costs to one of positive transaction costs, what becomes immediately clear is the crucial importance of the legal system in this new world. I explained inThe Problem of Social Cost that what are traded on the market are not, as is often supposed by economists, physical entities but the rights to perform certain actions and the rights which individuals possess are established by the legal system. While we can imagine in the hypothetical world of zero transaction costs that the parties to an exchange would negotiate to change any provision of the law which prevents them from taking whatever steps are required to increase the value of production, in the real world of positive transaction costs such a procedure would be extremely costly, and would make unprofitable, even where it was allowed, a great deal of such contracting around the law. Because of this, the rights which individuals possess, with their duties and privileges, will be, to a large extent what the law determines. As a result the legal system will have a profound effect on the working of the economic system and may in certain respects be said to control it. It is obviously desirable that these rights should be assigned to those who can use them most productively and with incentives that lead them to do so and that, to discover and maintain such a distribution of rights, the costs of their transference should be low, through clarity in the law and by making the legal requirements for such transfers less onerous. Since this can come about only if there is an appropriate system of property rights, and they are enforced, it is easy to understand why so many academic lawyers (at least in the United States) have found so attractive the task of uncovering the character of such a property rights system and why the subject of “law and economics” has flourished in American law schools. Indeed, work is going forward at such a pace that I do not consider it over-optimistic to believe that the main outlines of the subject will be drawn within five or ten years.

Originally posted at the Volokh Conspiracy.

PERC Senior Fellow Jonathan Adler
PERC Senior Fellow Jonathan Adler is the inaugural Johan Verheij Memorial Professor of Law at the Case Western Reserve University School of Law in Cleveland, Ohio. He is a prolific scholar, publishing on such topics as regulatory takings, water marketing, fisheries management, and the judicial limits of federal environmental regulation.He is the...
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