Implications of Coase for Law

my view

When I first published my interpretation of the implications of Coase’s article “The Problem of Social Cost,” Coase was a colleague of mine at the University of Chicago Law School. His comment on the piece was that one never understands one’s ideas until someone else explains them to you. I suspected at the time that the comment was intended to be gently critical of my interpretation, only worked out more precisely why many years later, rereading the body of his work in the process of writing a review of his final book.¹ Coase thought of the article primarily as a critique of modern economics. Since I was an economist with a position in a law school I read it for its implications for constructing legal systems.

This is an account of his ideas from my point of view, not necessarily his.

Externalities Before Coase

Part of what Coase accomplished was to rewrite the theory of externalities, the analysis of situations, such as air pollution, where one person’s actions impose costs or benefits on another. I start with the theory as it existed after Pigou and before Coase.

The argument went as follows:

In an ideal economic system,² goods worth more than they cost to produce get produced, goods worth less than they cost to produce do not. In a perfectly competitive private property system, producers pay the value of the inputs they use when they buy them from their owners 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 works if producers pay all of the costs of production. Suppose they do not. Suppose, for example, that a steel producer, in addition to using iron ore, coal, etc., also “uses” the air: In the process of producing a ton of steel he puts ten pounds of sulfur dioxide into the air, imposing $100 worth of bad smells, sore throats, and corrosion on people downwind. 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: 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 have ways to reduce the amount of pollution damage he produces: air filters, low sulfur coal, high smokestacks. Calculated in terms of the net effect on everyone concerned, it is worth eliminating pollution as long as the cost is less than the damage prevented, as long, in our example, 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; since 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 inefficiently high level of steel production (more may be produced than is 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 steel to produce and what he must do to keep down the resulting pollution. The other is emission fees, referred to by economists as Pigouvian taxes after A. C. Pigou, the economist whose ideas I am describing.³

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. That internalizes the externality, converts the external cost into an internal cost. In deciding how much steel to produce, how to produce it, and what price to sell it at, the company will now include the cost of pollution in its calculations, so a system of emission fees can produce both an efficient amount of steel and an efficient amount of pollution control.

To achieve that result, the agency setting the fees must measure the cost imposed by pollution. But emission fees, unlike direct regulation, do not require the regulator to measure the cost of preventing pollution, whether by producing less steel or installing air filters. 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, if that problem can be solved, using Pigouvian taxes to internalize externalities solves the problem, 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.

Nothing Works

The first step is to realize that an external cost is not simply a cost produced by the polluter 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 live downwind from it, would do no damage to anyone if the land downwind from it was being used for something not harmed by sulfur dioxide It is the joint decision, yours to pollute and mine to live where you are polluting, that produces the cost.

Suppose that the pollution does $100,000 a year of damage and can be eliminated at a cost of $80,000 a year (from here on, all costs are per year). Further assume that the cost of shifting all of the land downwind of the steel mill to a use unaffected by the pollution, growing timber instead of renting out summer cottages, 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, this time at a cost of $50,000. The result without Pigouvian taxes is efficient since the problem is eliminated at the lowest possible cost. The result with Pigouvian taxes is not.

In some cases moving the victims may not be a plausible solution; even 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 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 obvious which we should consider the victim.

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 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 regulatory agency to adopt expensive sound control measures in order to protect the sleep of people who chose to build their new houses directly under the airport’s flight path in what used to be wheat fields.

Consider a 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. 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 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 shutting down the factory.

Externalities are a joint product of “polluter” and “victim;” a legal rule that 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 is 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 polluter 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 polluter (and taxed) and which should be considered the victim.

Everything Works

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 is necessary 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.

Consider again 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 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; the steel mill will be better off, since it is less than the cost of eliminating the pollution. 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 by lowering 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 the 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 sometimes referred to⁴ as the “Coase Theorem.” It leads immediately to the final stage of the argument.

It All Depends (On Transaction Costs)

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 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 a public good problem. 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 to pay 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, 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 polluters to reduce their pollution.

This is one example 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 break down and the parties 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.

For the implications of these ideas for law, again my view, see Chapter 5 of my Law’s Order.

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1. A Very Coasian Revolution, Journal of Human Capital 11, no. 3 (Fall 2017): 373-396.

2. An explanation of what I mean by “cost,” “value” and “ideal.”

3. A third alternative is tort law, letting the people downwind sue for damages. That can be viewed as a different mechanism for Pigouvian taxes, so I am not distinguishing the two here. One significant difference is that a tax goes to the government, a damage payment to the successful plaintiff.

4. Initially by George Stigler, not Coase.