Chapter 4: What's Wrong with the World, Part 2


"Where two carriages come in collision, if there is no negligence in either it is as much the act of the one driver as of the other that they meet."

Bramwell, B. in Fletcher v. Rylands, 3 H. & C. 774 (Ex. 1865)

The argument of the previous chapter can be stated quite simply:


A takes an action that imposes a cost upon B. In order to make A take the action if and only if it produces net benefits, we must somehow transfer the external cost back to him. The polluting company is charged for its pollution, the careless motorist is sued for the damage done when he runs into someone else's car. The externality is internalized, the actor takes account of all relevant costs in deciding what action to take, and the result is an efficient pattern of decisions.
  • That view of externalities, originally due to Pigou, was almost universally accepted by economists until one evening in 1960, when a British economist named Ronald Coase came to the University of Chicago to deliver a paper. He spent the evening at the house of Aaron Director, the founding editor of the Journal of Law and Economics. Counting Coase, fourteen economists were present, three of them future Nobel Prize winners.

    When the evening started, thirteen of them supported the conventional view of externalities described above. When the evening ended, none of them did. Coase had persuaded them that Pigou's analysis was wrong, not in one way but in three. The existence of externalities does not necessarily lead to an inefficient result. Pigouvian taxes 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 (on transaction costs).


    Nothing Works


    An external cost is not simply a cost produced by one person and borne by another. In almost all cases, the existence and size of external costs depend on 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 downwind from it. It is the joint decision, yours to pollute and mine to live where you are polluting, that produces the cost. If you are not liable to me for the damage done by your pollution, your decision to pollute imposes a cost on me. If you are liable, my decision to live downwind imposes a cost, in liability or pollution control, on you.

    Suppose pollution from a steel mill does $200,000 a year worth of damage and could be eliminated at a cost of $100,000 a year (from here on, all costs are per year). Further assume that the cost of shifting all of the land downwind to a new use unaffected by the pollution, timber instead of summer resorts, is only $50,000. If we impose an emission fee of $200,000 a year, the steel mill stops polluting and the damage is eliminated at a cost of $100,000. If we impose no emission fee, the mill keeps polluting, the owners of the land stop advertising for summer visitors and plant trees instead, and the problem is again solved, this time at a cost of $50,000. The result without Pigouvian taxes is efficient—the problem is eliminated at the lowest possible cost—and the result with Pigouvian taxes is inefficient.

    Even draconian limits on emissions in southern California would be less expensive than evacuating that end of the state; indeed, it is unlikely that moving the victims is often an efficient solution to the problems of air pollution. But consider the same logic applied to the externalities produced by testing high explosives. A thousand-pound bomb produces substantial external effects if it lands fifty feet from your campsite. Keeping campers out of bomb ranges seems a more sensible solution than letting them in and permitting them to sue for the resulting damage.

    For a less exotic example consider 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 wheat fields or 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.

    Finally, consider an example in which the sympathies of most of us would be with the "polluter." The owner of one of two adjoining tracts of land has a factory that 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. 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 since external costs are jointly produced by polluter and victim, a legal rule that assigns blame to one of the parties gives the right result only if that party happens to be the one who can avoid the problem at the lower cost. In general, nothing works. Whichever party the blame is assigned to, by government regulators or by the courts, the result will be inefficient if the other party could prevent the problem at a lower cost or if the optimal solution requires precautions by both parties.

    One advantage of effluent fees over 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 polluter decide how much pollution to buy at that price. But one implication of Coase's argument is that the regulator can guarantee the efficient outcome only if he knows enough about the cost of control to decide which party should be considered responsible for preventing the jointly produced problem, and so required to bear the cost if it is not prevented.



    Everything Works


    The second step in Coase's argument is to observe that, as long as the parties can readily make and enforce contracts in their mutual interest, neither direct regulation nor a Pigouvian tax is 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.

    Our earlier case of the steel mill and the resorts showed one way of getting to the efficient result without legal restrictions on pollution. The lowest-cost avoiders were the owners of the land downwind; since they could not prevent the pollution they shifted from operating resorts to growing timber, which happened to be the efficient outcome.

    What if, instead, the legal rule had been that the people downwind had a right not to have their air polluted? The final result would have been the same. The mill could eliminate the pollution at a cost of $100,000 a year. But it is cheaper to pay the landowners some amount, say $75,000 a year, for permission to pollute. The landowners will be better off, since what they are getting is more than the cost to them of changing the use of the land. The steel mill will be better off, since what it is paying is less than the cost of eliminating the pollution. So it pays both parties to make such an agreement.

    Next suppose we change our assumptions, lowering the cost of pollution control to $20,000. If the mill has the right to pollute, the landowners will pay more than the $20,000 cost of pollution control in exchange for a guarantee of clean air. 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. Either way, the mill ends up controlling its pollution, which is now the efficient solution.

    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.

    This result is sometimes referred to as the Coase Theorem.

    We have just restated the simple argument for laissez-faire in a more sophisticated form. What people own are not things but rights with regard to things. Ownership of a steel mill is a bundle of rights: the right to control who comes onto the property, the right to decide how the machinery is used, ... . It may or may not also include the right to produce pollution. If that right is more valuable to the owner of the bundle of rights we call "ownership of the steel mill" than to anyone else, he will keep it if he owns it and buy it if he does not. If it is more valuable to property owners downwind, they will keep it if they own it and buy it if they do not. All rights move to those to whom they are of greatest value, giving us an efficient outcome.


    It All Depends (On Transaction Costs)


    Why, if Coase is correct, do 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 blocked by prohibitively high transaction costs.

    Let us return again to the steel mill. Suppose it 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 downwind. Further suppose that there are a hundred landowners downwind.

    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 raise enough money to persuade the steel mill to eliminate its pollution. If the attempt is going to fail even with him, 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 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 polluters to reduce their pollution.

    This is one example of the problem of transaction costs. Another occurs if we reverse our assumptions, making pollution (and timber) the efficient outcome but giving landowners the legal 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. Each has an incentive to be a holdout, to refuse his permission in the hope of getting paid off with a large part of the money the mill will save from not having to control its pollution. If too many landowners try that approach, the negotiations break down and the parties never get to the efficient outcome.

    Seen from this perspective, the problem is not externalities but transaction costs. With 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.


    Coase plus Pigou Is Too Much of a Good Thing


    There is one more use for our polluting factory before we move on to more pastoral topics. This time we have only one factory and one landowner, so bargaining between them is simple. Pollution does $60,000 worth of damage, pollution control costs $80,000, switching the land use from resorts to timber costs $100,000. The efficient outcome is pollution, since the damage done is less than the cost of avoiding it.

    The EPA, having been persuaded of the virtues of Pigouvian taxes, informs the factory that if it pollutes, it must pay for the damage it does—a $60,000 fine. What happens?

    Controlling the pollution costs more than the fine, so one might expect the factory to pay the fine and continue to pollute, which is the efficient solution. That is the obvious answer, but it is wrong.

    We have forgotten the landowner. The fine goes to the EPA, not to him, so if the factory pays and pollutes, he suffers $60,000 of uncompensated damage. He can eliminate that damage by offering to pay part of the cost of pollution control, say $30,000. Now, when the factory controls its pollution, it saves a $60,000 fine and receives a $30,000 side payment from the landowner, for a total of $90,000, which is more than the $80,000 cost of pollution control. The result is pollution control that costs more than it is worth.

    We are adding together Pigou's incentive (a fine for polluting) and Coase's incentive (a side payment from the victim for not polluting), giving the factory twice the proper incentive to control its pollution. If the cost of control is less than twice the benefit, the factory buys it even if it shouldn't.

    One solution is to replace administrative law with tort law, converting the fine paid to the EPA into a damage payment to the landowner. Now he is compensated for the damage, so he has no incentive to pay the factory to stop polluting.


    Coase, Meade, and Bees


    Ever since Coase published "The Problem of Social Cost," economists unconvinced by his analysis have argued that the Coase Theorem is merely a theoretical curiosity, of little or no practical importance in a world where transaction costs are rarely zero. One famous counterexample concerns bees.

    Writing before Coase, James Meade (who later received a Nobel Prize for his work on the economics of international trade) offered externalities associated with honeybees as an example of the sort of problem for which the market offered no practical solution. 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 would seem to be no practical way to apply Coase's approach to the problem. 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 turns out that it isn't true. As supporters of Coase have demonstrated, contracts between beekeepers and farmers have been common practice in the industry at least since early in this century. When the crops were producing nectar and did not need pollination, beekeepers paid farmers for permission to put their hives in the farmers' fields. When the crops were producing little nectar but needed pollination (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.

    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 an externality problem was insoluble save by government intervention in a context where Coase's market solution 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. And whether or not externality problems can be bargained away, Coase's analysis points out fundamental mistakes in the traditional way of thinking about externalities: the failure to recognize the symmetry between "polluter" and "victim" and the failure to allow for private approaches to solving such problems.

    A different way of putting the point is to observe that the Pigouvian analysis of the problem is correct, but only under special circumstances, situations in which transaction costs are high, so that transactions between the parties can safely be ignored, and in which the agent deciding which party is to be held liable already knows who the lowest-cost avoider of the problem is. Air pollution in an urban area is an obvious example. Coase provides the more general analysis, covering both that case and all others.

    Considered from the standpoint of a court there are at least two different ways in which these insights might be applied. Courts could follow a policy of deciding, in each case, whether plaintiff or defendant was the lowest-cost avoider, awarding damages for pollution only if it concluded that the polluter could solve the problem more cheaply than the victim. Alternatively, courts could try to establish general rules for assigning liability, rules that usually assigned liability to the party that was usually the lower cost avoider.

    One example of such a general rule is the tort defense of "coming to the nuisance." Under this doctrine, if you build your housing development next to my pig farm, I may be able to avoid liability by arguing that, because I was there first, you were the one responsible for the problem. An economic justification for the doctrine is that it is less expensive to change the location of a development, or a pig farm, before it is built than after, making the second mover usually the lower-cost avoider of the problem. We will return to this example, along with some complications, in later chapters.

    General rules have several advantages over case-by-case decisions. They are usually more predictable, making it possible for parties to take decisions without having to guess who some future court will think was the lowest-cost avoider of future problems. They reduce litigation costs, since using expensive legal resources to convince a court that the other party can solve the problem more cheaply than you can is more likely to work than using similar resources to convince a court that your housing development was built ten years earlier than it really was. The disadvantage of a general rule is that it can be expected to give the wrong answer in some specific cases, which means that a general rule will do a worse job of guaranteeing efficient outcomes than would a perfectly wise court deciding each case on its individual merits.

    General rules that yield easily predictable results are sometimes referred to as bright line rules; rules that require a case-by-case decision by courts are sometimes referred to as standards. Consider, as one example, the requirement in the United States Constitution that a candidate for president must be at least thirty-five years old. Presumably the purpose is to ensure that candidates be sufficiently mature for the job. It is a bright line rule, but not a very good one, since chronological age is only a very rough measure of maturity; all of us can think of examples of people over thirty-five who are less mature than many people under thirty-five. Some of us may even be able to think of ones who have been elected president.

    But consider the alternative—a standard specifying that a candidate for president must be as mature as the average thirty-five-year-old. That is a very fuzzy rule indeed—one that reduces, in practice, to the requirement that any candidate must be acceptable to a majority of the justices on the Supreme Court.

    A still more important example of a bright line rule is the general principle that all human beings, with some narrow exceptions for children and lunatics, have the same legal rights—very different from the legal rights of animals. The features of human beings that give rise to legal rights are not all-or-none matters; most humans are more rational and better able to communicate than most animals, but again many of us can think of exceptions. A perfect legal system with perfectly wise judges would presumably enforce legal rights that varied from person to person (and animal to animal), tracking the variation in the features that gave rise to those rights. The result might well be that a sufficiently retarded human being would have fewer rights than a very smart chimpanzee.

    Our legal system does not work that way and probably shouldn't. The human/not human distinction is not a perfect measure of intelligence, linguistic ability, and the like, but it is a very good one—and it generates a bright line rule that avoids most of the problems of some humans trying to persuade courts that they have different rights than others.


    Coase, Property, and the Economic Analysis of Law


    Coase's work radically altered the economic analysis of externalities. It also suggested a new and interesting approach to the problem of defining property rights, especially property rights in land.

    A court settling disputes involving property, or a legislature writing a law code to be applied to such disputes, must decide 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 is simple to say that we should have private property in land, but ownership of land is not a simple thing.

    The Coasian answer is that the law should define property in a way that minimizes costs associated with the sorts of incompatible uses we have been discussing: airports and residential housing, steel mills and resorts. The first step 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." But 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 always knew 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 rarely the case. Many rights are of substantial value to two or more parties; the right to decide whether loud noises are made over a particular piece of property, for example, is of value both to the owner of the property and to his next-door neighbors. 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 from him. 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 mistakes in the original assignment.

    An example may make this clearer. Suppose 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 polluter 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 more complete explanation of how Coase's argument can be applied to figuring out what the law ought to be appears in the next chapter; a full explanation would require a book—one that has not yet been written. I hope I have said enough to make the basic idea clear. Coase 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.

    Coase's argument first saw print in "The Problem of Social Cost," the most cited article in the economic analysis of law and one of the most cited articles in economics. In addition to showing what was wrong with the conventional analysis of externalities, the article made a number of related points.

    Economists (and others) tend to jump from the observation that the market sometimes produces an inefficient outcome to the conclusion that, when it does, the government ought to intervene to fix the problem. Part of what Coase showed was that there may be no legal rule, no form of regulation, that will generate a fully efficient solution, the solution that would be imposed by an all powerful and all knowing dictator whose only objective was economic efficiency. He thus anticipated public choice economists such as James Buchanan (another Nobel winner) in arguing that the choice was not between an inefficient solution generated by the market and an efficient solution imposed by the government 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." He further argued that the distinction between market solutions and government solutions was itself in part artificial, since any market solution depended on a particular set of legal rules established by the legislature and the courts.

    A second interesting feature of Coase's work was mentioned in chapter 1. Coase got to his conclusions in part by thinking about economic theory and in part by studying law. He based his argument on real cases in the common law of nuisance—a Florida case where one landowner's building shaded an adjacent hotel's swimming pool, a British case where a physician built a new consulting room at the edge of his property adjacent to a neighboring candy factory and then demanded that the candy factory shut down machinery whose vibrations were making it hard to use his consulting room, and many others. He concluded that common law judges had recognized and attempted to deal with the problem of joint causation of externalities, a problem that the economic analysis of externalities had entirely missed.

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