In the theory of externalities—that is, costs imposed involuntarily on others—there have been exactly two great ideas. The first, forever associated with the name of Arthur Cecil Pigou (writing about 1920) is that things tend to go badly when people can escape the costs of their own behavior. Factories pollute too much because someone other than the factory owner has to breathe the polluted air. Nineteenth century trains threw off sparks that tended to ignite the crops on neighboring farms, and the railroads ran too many of those trains because the crops belonged to someone else. Farmers keep too many unfenced rabbits when they don’t care about the lettuce farmer next door.
Pigou’s solution—and it’s often a good one—is to make sure that people do feel the costs of their actions, via taxes, fines, or liability rules that allow the victims to sue for damages. Do a dollar’s worth of damage, and you’re charged a dollar.
Pigou endorsed this policy not because it seems fair, though it does seem fair to many, but because it yields, under what he believed to be very general conditions, the optimal amounts of damage. We don’t want too much pollution, but we don’t want too little, either, given that pollution is a necessary by-product of a lot of stuff we enjoy. Pigou offered a proof—now standard fare in all the textbooks—that his policies lead to the perfect compromises, in a sense that can be made precise.
The second great idea about externalities sprang full-blown from the mind of a law professor and subsequent Nobel prize winner named Ronald Coase, who stunned the profession in 1960 by pointing out that Pigou’s argument runs both ways. If you breathe the pollution from my factory, I’m imposing a cost on you—but at the same time, you’re imposing a cost on me. After all, if you lived somewhere else, you wouldn’t be complaining about the smoke and I wouldn’t be getting punished for it.
This insight—so simple once stated, but thoroughly astonishing to the economists of 1960 (I’ve heard tales of this astonishment from several of the participants in Coase’s historic seminar)—means that in a case of externalities, pure theory can never tell you who should bear the costs; you’ve got to look at the specifics of the case. Take those spark-throwing railroad trains. Pigou says: There are too many fires because the railroads don’t care; let’s make them reimburse the farmers for all the crop destruction, and then they’ll care. Coase says: Wait a minute. Often, farmers can prevent fires at very low cost by not planting quite so close to the tracks. True, the railroads don’t currently care about the crop damage. But if you reimburse the farmers, then the farmers won’t care, and you’ll get too many crops planted too close to the tracks. The best way to prevent fires might (or might not) be to grant the railroads complete legal immunity.
And as for that rabbit farmer—the one who lives next to the lettuce farmer and lets his rabbits run wild—Pigou would have insisted that the rabbit farmer cover the damages. Coase is more evenhanded. There are a lot of ways for the rabbit farmer to solve this problem: Put the rabbits in cages, or file their teeth down, or raise a different breed of rabbit, or move away, or switch to keeping geckos. There are also a lot of ways for the lettuce farmer to solve this problem: Fence the lettuce, or spray it with rabbit repellent, or move away, or switch to growing barley. If the rabbit farmer is immune from lawsuits, he’ll have no incentive to implement his solutions. But if the lettuce farmer is routinely reimbursed for lost lettuce, then he’ll have no incentive to implement his solutions. Which outcome is worse? That depends on whose solutions are better. Pure theory can’t answer that question.
How did Pigou—and every other economist in the world—manage to miss this point until Coase came along? According to Coase, it’s because they were obsessed with the faulty notion of “fault”—the idea that if there’s a problem, it must be someone’s fault, and we should begin by identifying that someone. But in the rabbit/lettuce example, who’s really at fault? It’s true that if there were no rabbits, the lettuce wouldn’t get eaten. But it’s equally true that if there were no lettuce the lettuce wouldn’t get eaten. The problem is that rabbit farmers should not be next to lettuce farmers, and when you put it that way, you’re forced to recognize the fundamental symmetry of the situtation.
What, then, should courts and legislators do? Coase had a lot to say about this also, beginning with the observation that it’s sometimes a really really good idea to encourage antagonists to talk to each other. From this beginning sprang the entire intellectual framework usually called Law and Economics.
Coase’s Nobel Prize winning paper is surely one of the landmark papers of 20th century economics. It’s also entirely non-technical (which is fine), and (in my opinion) ridiculously verbose (which is annoying). It’s littered with numerical examples intended to illustrate several different but related points, but the points and the examples are so jumbled together that it’s often difficult to tell what point is being illustrated. I frequently assign my students the task of distilling all of the main ideas into two or three pages, and they frequently succeed.
But pioneering work is rarely presented cleanly, and Coase is a true pioneer. Today is his 99th birthday, and a day to celebrate.
Friedman, Hayek, Samuelson, Coase…what is it about Nobel economists that make them so long-lived? Is this evidence of understanding the optimizing of trade-offs in action? (Those of us who think Mises deserved a Nobel have yet another data point…)
That’s interesting: I tend to assume that someone who has a theorem named after him must be very mathematical, but I see no equations in his paper. I guess that somebody else formalized his insight.
Perhaps the reason Coase’s best-known paper is so long is that its basic idea had already been presented in his paper “The Theory of the Firm” and had been ignored. I wonder whether he decided that people needed to be told something repeatedly for it to sink in.
Although you refer to Coase as a “law professor,” he is not a lawyer and wasn’t associated with a law school when he did the work for which he is best known.
Alan Gunn: Thanks for the correction re Coase’s background. I’d thought he taught law at Virginia, but now know better.
Was he teaching econ in an econ department in 1960?
thediffererentphil: Yes, he was teaching econ at Virginia. I hadn’t realized this before Alan Gunn forced me to look it up.
Embarrassingly I had never heard of Coase’s later work. I only knew him because of his work on transaction costs, which is much better known in the field I work in. (Though, if I may rant for a bit, the whole field of software development would be MUCH MUCH BETTER if people would just read and understand more about transaction costs, whether from Coase or “Mythical Man-Month” or “Peopleware” or SOMEthing.)
Happy birthday!
But McCloskey might say, “Theorem? Coase?”
Her article is here, countercurrent as usual:
http://deirdremccloskey.org/docs/pdf/Article_306.pdf
Isn’t Coase’s point that two of those Pigovian examples (the railroad & farmer one and the rabbit & lettuce one) aren’t externalities at all, or if they are it’s simply because there aren’t property rights?
Snorri, I think Xan points to the answer on who formalized the insight (and points to why formalization was problematic … in the sense of saying almost the opposite of what he had meant to say).
Ryan: No, I think that Coase’s point is deeper than that—it’s not enough to assign a property right; you have to figure out who to assign it to. (In the absence of transactions costs, it doesnt matter who has the right, but in the presence of transactions costs it can matter very much.)
*revs Harley motorcycle too loudly for Steven_Landsburg to think while technically not violating any law or property right*
*waits for Steven_Landsburg to pay me to go away or otherwise recognize the superficiality of his Coasean analysis*
*provides link elaborating this point*
I once again am amazed by what passes as a “Nobel” worthy insight in economics. It’s certainly no surprise to see that society makes choices of on whom the costs of externalities should be imposed – typically on the politically and economically weak. I wonder if it’s significant that the Coasean alternatives are so manifestly impractical.
CIP: I’m not sure what you mean by the “Coasean alternatives”; the whole point of Coase’s paper, after all, is to insist that practical considerations trump theory. Do you care to elaborate?
After reading McCloskey, I have a higher opinion of Coase’s point. About Steve’s exposition of that point, not so much.
What would be the economic result (in Coase’s view) of property rights allocated as Henry George suggested?
Letting sparks fly freely from the train would increase the value of the railroad by decreasing costs, but decrease the value of the farmland (the farmer might choose to leave the area by the track clear, or plant less flammable crops, change the use to something else entirely, like mining, or vacate the property altogether). Restricting the sparks from the railroad would raise costs and decrease the value of the right of way, but increase the value of the farmland, since it could be put to its most efficient use.
Under a system of land value taxation, rather than requiring the owner of the railroad to negotiate with every farmer on his route, or requiring the state to figure out who should be given what property right to start with, the state would attempt to maximize the net tax revenue (total tax revenue minus transaction costs), which would tend to maximize the overall land value. If the farmer paid a land value tax for his farm, and the railroad paid an LVT for the right of way, it would be in the interest of the state to maximize the value of both, because that would maximize the tax collected.
(Full disclosure: my economic interests tend to be a bit eclectic. :) )
I did see an interesting discussion from a while back that dealt with some of this:
http://www.cooperativeindividualism.org/coase_landtheory.html
but I was wondering what other insights might be brought to bear.