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.
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.