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The great Ronald Coase is 100 years old today.
One year ago today, he celebrated with a 100th birthday party, though he was only 99. I’m not sure what festivities are planned for today but I hope it’s a very good day for him. Also one year ago today, I published a 99th birthday tribute here on this blog. I’m re-running it today. |
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.
[Two other related posts are here and here.]
Very nice. Thank you. I especially like this phrase:
… obsessed with the faulty notion of “fault” …
An important and overlooked observation.
I just want to say “Happy Birthday, Ron Coase” on the off chance that he reads your blog today. His ideas are as fresh and important today as they were decades ago when he first thought of them. You cannot say that about a lot of ideas in economics.
Your books have done a good job explaining the concept of symmetry. Perhaps the fact that lawyers can be forced to argue different points of view made it easier for a lawyer to come up with this.
I believe this is tied to fairness. A classic example of this has happened close to where I live. Cities have formed in what used to be farmland.
The consequence of this is that the new citizens have forced restriction on burning crops, water usage, what roads heavy equipment can be used on, etc. Which of course has reduced the farmers’ productivity.
Is this fair? As Lemony Snicket said in his seminal book “The End”, it depends on how you look at it. However, people should force themselves to look at conflicts from both sides.
Lastly, this is a blog about philosophical questions. I’m willing to bet you $ 5. That if you ask Philosophy Professors from top universities, they would say that this topic is just as interesting as the last 3 posts and therefore deserves as many responses.
Will A: Your example re farmland is great. I’ll probably steal it. Thanks.
This has nothing to do with this post, but I wanted to make sure you saw it in case you have anything to contribute: the authors of Spousonomics are looking for general marital advice from economists.
“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.”
The search should be for efficiency not fault.
The other thing is that finding common ground gets harder as relationship changes from a one-to-one (single rabbit farmer; single lettuce farmer) to a many-to-one (single rabbit farmer; many lettuce farmers) relationship.
@ Babinich:
However, efficiency seems to be easier in a many-to-one situation. The many vote to incorporate all farms into a city. The vote of course is many to 1 thereby qualifying even as a super majority.
The many then pass an ordinance banning rabbit farming.
Very efficient.
For all of you lettuce farmers, here is a link on how to incorporate:
http://www.slate.com/id/2130597/
Once incorporated you can use eminent domain to force the rabbit owner to sell to Walmart:
http://en.wikipedia.org/wiki/Kelo_v._City_of_New_London
Good luck.
Perhaps the reason Coase celebrated his 100th birthday on what we would traditionally call his 99th is that he was concluding his 99th year and entering his 100th. My 91 year old grandmother uses the same logic, she entered her 92nd year last month.
Great post. Excellent retreat from a slow work day.
‘it’s because they were obsessed with the faulty notion of “fault”’
I agree.
I think part of what makes that faulty is our tendency to a) assume a an arbitrary state of things as the “right” reference and b) we have a hard time thinking through more than 2 factors of a scenario when we do not absorb the costs for not doing so, even though we often make actual decisions based on more than 2 factors because we do absorb those costs.
Is necessary to completely abandon the idea of fault? We could find the most efficient solution, which in the example may be for the lettuce farmert to move his crop. We could then decide who has to pay for it, which could be the rabbit farmer. Putting this another way, we make one party responsible for the remedy, but allow them to choose how to implement it.
I think you’ve left off the problems with Coase’s approach: specifically, how far do you extend this principle? Do you grant everyone complete legal immunity from everything? Then what’s the point of the law?
After all, if Bob murders Alice, well then, sure, it’s Bob’s “fault” for terminating her vital functions, but isn’t Alice equally at fault for living in the first place? At some point, this Coasean bargaining becomes what we — correctly, usefully — identify as extortion.
I elaborate here in a reply to Robin Hanson.
Silas: Coase very much stressed the importance of a well-defined and well-maintained system of property rights, so that one knows in advance who will be held responsible for the consequences of various actions. His main point, as I read it, was that it’s important to allocate property rights in such a way that the incentives work out well. In particular, things tend to work out better if we give Alice, rather than Bob, the property right to Alice’s vital functions. Coase would have said (I think) that this is a good idea *because* it tends to make things work out well, and that we don’t need to think about notions like fault to reach that conclusion.
But property rights stop being property rights when they vaporize the moment the lawgivers deem a new arrangement more efficient, which is your only way to salvage Alice’s rights to her vital functions under Coasean reasoning. And that’s still back validation of extortion.
(Note that “talking” is actually a bad idea with kidnappers and terrorists, for example.)
Silas: Have you read Coase’s paper? He argues in some depth that often long-run efficiency requires laying down rules and sticking to them, even if there are temporary efficiency gains from deviating. He also stresses that for this very reason — because it’s a good idea to have established rules from which you’re not going to deviate — it’s really important to get the rules right in the first place.
Interesting, I hadn’t known that was part of the paper. In my defense, Coase’s exponents
a) completely ignore that part (hence my parody), and
b) use his argument to justify not sticking to those rules — like, say, ignoring the farmer’s “property rights” and granting immunity to train companies that torch his crops.
Silas,
You brought up a crime as an extreme example, but even with crimes there are times when immunity might be a good solution.
When apartheid ended in South Africa, South Africa gave amnesty to crimes on the condition that perpetrators of crimes testified about the crimes they committed. South Africa decided that discovering truth was a better solution to forming a new country than trying to find fault.
Maybe South Africa should not have done this. However, some would argue that it was a good thing and it is an example of trying to find a solution and not fault.
It is also a case where defined a rule set (testify to avoid jail) was implemented to be consistent with the solution.
Of course it would be open to argument whether it is fair to come up with a proposed solution and then come up with a set of rules to match the solution.
from a law and economics viewpoint, the insight (the Coase Theorem) was that the initial allocation of property rights isn’t determinative of those rights ending up with the highest value user (given low transaction costs etc). this of course doesn’t squarely address the distributive issues, but the efficiency insight was indeed a new window to analysis long standing concerns issues.
of course, coasian bargaining has its limits. see, e.g., Of Coase and Cattle: Dispute Resolution Among Neighbors in Shasta County by Ellickson (reaching equilibrium outcomes not through coasian bargaining but rather through social norms…)