Background
The result that we now know as the Coase theorem (Coase 1960; Stigler 1966) was developed as a critique of Pigovian welfare theory and, in particular, of the Pigovian view that efficiency in the presence of externalities could not be assured apart from the governmental imposition of tax, subsidy, or regulatory remedies.
That is, externalities were perceived as impediments to efficiency, and Pigovian remedies were conceived as means by which efficiency could be assured.[82]One piece of Coase's challenge to the Pigovian position involved a demonstration that the externality-generated inefficiency was the result of an absence of property rights over the relevant resources. Once such rights were established, Coase argued, efficiency would follow if the costs of transacting were zero. Using his now well-known illustration of a farmer and cattle raiser, Coase (1960, pp. 2-8) showed that it would be in the interests of the parties to negotiate a resolution of the externality problem, and that the outcome would be both efficient, in the sense of maximizing the value of output, and independent of whom rights were initially assigned.
Lying at the heart of Coase’s analysis here is his view that externalities are reciprocal in nature (1960, p. 2). If A imposes harm (or costs) on B, the imposition of a rule that reduces the harm on B has the effect of imposing costs on A. For example, while it is true that the chemicals a factory dumps into a river as byproduct of its production process cause harm to the downstream farmer who uses the river water for irrigation, forcing him to substitute a higher-cost source of water supply, it is equally the case that a prohibition on such dumping makes the factory’s production process more costly. The Pigovian approach, Coase argued, focused only on the former path of causation and so ignored the possibility that the least-cost method of dealing with the issue may, in fact, be to allow the dumping to continue.[83] Once one recognizes the reciprocal nature of the problem, Coase said, “The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm” (1960, p.
2). For Coase, then, it was wrongheaded to even speak in terms of causation in these contexts, given the reciprocal nature of harm.[84] And, in failing to recognize this essential reciprocity, the economist was at risk of mis-applying the efficiency criterion.This reciprocity is brought out neatly in Coase’s analysis of the process by which negotiation between affected parties will bring about an efficient and invariant resolution of externality problems in a world of zero transaction costs. Suppose that the aforementioned chemical plant saves 100 dollars by dumping its waste into the river rather than filtering the discharge, and that the alternative water supply costs the farmer 200 dollars. Efficiency then dictates that the plant should abate, as this generates a net savings of 100 dollars. If the owners of the plant are made liable for damage, they will abate the pollution, since the 100-dollar cost of abatement is lower than the 200-dollar damage payment associated with dumping waste into the river. If the plant owners are given the right to pollute, however, the same result obtains. The farmer, faced with the prospect of paying 200 dollars for the alternative water supply, will be willing to offer the owners of the chemical plant up to 200 dollars to filter its discharge. As the plant owners would be willing to undertake this abatement for any price greater than 100 dollars, a deal will be struck. Thus, Coase argued, bargains among affected agents will efficiently resolve externality problems, and the outcome will be identical regardless of which party is assigned the rights over the relevant resources.
The upshot of Coase’s negotiation analysis is that the Pigovian contention that tax or regulatory instruments are necessary to efficiently resolve externality problems in a neoclassical framework was in error. If coordination is costless, private action can generate efficiency just as well as can state action. Moreover, if one wishes to counter that exchange is a costly process, one must allow that state action, too, has its costs.
And, in fact, it is possible that the least-cost way of dealing with the externality is to do nothing at all about the problem, as the costs of remedies may exceed the harm done by the external effect itself. The appropriate means for dealing with divergences between private and social costs, then, comes down to an evaluation of which among these imperfect remedies will maximize the value of output.It is fair to say that Coase’s analysis in “The Problem of Social Cost,” as elsewhere in his policy-related writings, was conducted on typical welfarist principles - wealth maximization or the Kaldor-Hicks criterion - the very principles that were standard fare in the discussion of externalities over the nearly five decades prior to the publication of Coase’s article.[85] It is usually not noticed, however, that, when winding up his discussion in “The Problem of Social Cost,” Coase emphasized that his approach in the article was “confined, as is usual in this part of economics, to comparisons of the value of production, as measured by the market.” “But,” he continued,
it is, of course, desirable that the choice between different social arrangements for the solution of economic problems should be carried out in broader terms than this and that the total effect of these arrangements in all spheres of life should be taken into account. As Frank H. Knight has so often emphasized, problems of welfare economics must ultimately dissolve into a study of aesthetics and morals. (1960, p. 43)
Coase’s own view of the role that these factors should play is unclear, as he did not elaborate on this line of argument in “The Problem of Social Cost” or elsewhere in his writings. Little did he know, however, that considerations of “aesthetics and morals” would become a major point of emphasis in the reactions to his analysis over the next few decades.
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