Introduction to Law and Economics Seminar 2: The Coase Theorem PDF

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Introduction to Law and Economics Seminar 2: The Coase Theorem. Seminar 2 out of 10. Dealing with Coase's views on private bargaining and government intervention....

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LAWW3130: Introduction to Law and Economics 2021

2. The Coase Theorem: Dealing with Externalities through Private Cooperation I. AN INTRODUCTION

TO THE

COASE THEOREM

1. The Problem of Externalities An externality is essentially a cost imposed or a benefit conferred by one person on another (“negative” and “positive” externalities respectively). It is generally thought to maximise economic efficiency to “internalise” externalities i.e. to make the party responsible for an activity bear its costs and receive its benefits. This is one explanation for the preference for private property rights over other ways of regulating resource use. Private ownership encourages the efficient exploitation of assets because owners know that they will get to enjoy the fruits that come from that exploitation and that they will generally bear the costs. However, even with private property rights, problems of externalities arise from our use of resources. Pollution provides the classic example of negative externalities. Coase examines the assumption favoured by the proponents of what is known as “welfare economics”, such as Arthur Pigou, that it will often be desirable to deal with polluters by taxing them according to the amount of pollution they produce by reference to the social costs of that pollution. Coase suggests that such courses of action may often be unnecessary and will, at times, be positively undesirable. According to Coase, the problem with taxing a polluter is that it is difficult to identify an optimal price. Any tax will affects the relative costs of parties’ activities and consequently is liable to result in a level of activity that is less socially optimal than a level that the parties in question would settle on if they bargained on the matter. This represents a distortion of the market and, if possible, is best avoided. In his view, it would often be better to assign property rights and rely on the parties to resolve their problems through private bargaining. More strikingly, he suggested that it did not necessarily matter which of the competing parties was assigned the entitlement in question. Moreover, Coase suggests that regulation through cooperation would be preferable to state regulation because the very notion of a negative externality is problematic. In his view, pollution is not a simple matter of one party harming another but rather reflects the unavoidable problem of incompatible uses. He offers the example of Sturges v Bridgman, where a doctor moved in next door to a factory producing confectionery. They shared a common wall and the doctor complained of noise and vibrations caused by the confectioner’s operation. To favour one party would be to

harm the other. Demanding silence from others can be regarded as an externality of a sort.

2. The Coase Theorem Coase argues that, where bargaining is costless, the setting of entitlements in regard to pollution will not affect the efficient allocation of resources. Although the law establishes rights, it is bargaining that determines outcomes. In other words, cooperative contracting may result in the entitlement being traded. Coase’s theorem can be understood in the light of a simple example. X runs cattle, which cause £200 of damage to Y’s corn fields per annum. X could prevent the damage by fencing the large area upon which the cattle graze, which would cost £100. However, Y could fence the smaller area on which he grows corn for only £50. If we concluded that the damage caused to the cornfield is a negative externality, it would seem to follow that we should make X liable, but this would seem to be an inefficient solution. Coase argues that, in terms of allocative efficiency of resources, the initial allocation of entitlement might not matter. If there are no impediments to bargaining, the parties should agree to Y fencing his property in return for a payment from X of between £50-£100. This is of course, would be the same result as if X were held not liable, Y would fence his corn to keep the cattle out. The difference being that Y would not receive a payment from X to do so but would have to carry the burden of the cost. Through private bargaining, the parties effectively act as a cooperative unit. Absent any impediments to bargaining, whichever rule is chosen, resources will be put to their most valued use and the result can be described as economically efficient (see the account of notions of Pareto efficiency below). One difference, of course, lies in the distribution of income. Whoever is given the relevant entitlement is thereby wealthier, having a bargaining chip to exploit in subsequent negotiations. While the decision as to initial entitlement raises questions of equity or fairness, it does not, according to Coase, ultimately have any effect on the efficiency of the matter. It might be thought that Coase’s theorem would not be helpful in thinking about how we should determine entitlements because it has nothing to say about justice. However, there is an implicit suggestion in his article that questions of justice are not as useful as we might think. If Coase is right that the problems in this context are essentially the result of incompatible uses, notions of causation and wrongfulness upon which our judgements of justice are dependant seem problematic.

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3. Taking account of the costs of market transactions Coase notes that the assumption of costless bargaining with which he commences is an unrealistic one. He notes that one solution to dealing with the problems entailed with the costs of bargaining is the growth of large firms. A firm that manufactures a product and produces all the components necessary in the process rather than purchasing those components from others is responding to the realisation that there are advantages in being able to organise such transactions internally as an administrative process rather than suffering the costs involved in negotiating with others. This is the essential insight of an earlier article “The Nature of the Firm”, which in conjunction with the “Problem of Social Cost” was responsible for Coase’s winning the Nobel prize for economics. Another response to the costs of bargaining, notes Coase, is direct governmental regulation. However, he argues that it cannot be assumed that, just because the market does not operate to achieve an optimal result, the government can do better.

4. Legal Delimitation of Rights Coase emphasises that much judicial discourse on the question of the parties’ rights in nuisance cases is gibberish. This is especially true of judicial analysis of issues of causation. Consistently, with his earlier analysis, he notes that the judicial allocation of rights might not always be crucial, as it provides a starting point that the parties might bargain around. Nonetheless, he notes that that, given that bargaining is not costless, the judicial delimitation of rights is important and he devotes a section to examining how the courts “have often recognised the economic implications of their decisions and are aware … of the reciprocal nature of the problem.”

5. Cost-benefit analysis: Pareto and Kaldor-Hicks Efficiency Coase’s theorem can be understood against the background of welfare economics. Sometimes characterised as “normative” economics, welfare economics is generally contrasted with “positive” economics. The positive/normative distinction essentially reflects a distinction between descriptive and prescriptive, between identifying what is and determining what should be. Needless to say, the normative enterprise of welfare economics is much more controversial than positive economics. The field of positive economics is the stuff of supply and demand curves with which most of us are vaguely familiar. On the basis of certain fundamental assumptions, it indicates relations between supply, demand and price – of market behaviour in the context of scarce goods. It essentially provides a descriptive theory of human behaviour. Normative economics, in contrast, seeks to provide policy prescriptions for the improvement of society. It tends to start from a utilitarian premise of a desire to maximise public welfare. However, it quickly runs into

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methodological problems as a result of the difficulty if not impossibility of making interpersonal comparisons of utility. While economics is good at comparing how much one person values one good versus another good, it has no real basis for measuring one person’s wellbeing or utility in comparison to another’s. Modern economists concluded that such comparisons were impossible, and this made it difficult for economics to make judgements as to whether one state of affairs is better than another. Consider for example, a reform that would make A and B £300 better off each, while leaving C worse off by £500. Would it necessarily be efficient in the broadest sense (i.e. would increase aggregate utility)? We cannot say. It is true that it would increase overall wealth. But if C was someone who loved money much more than the B, who is a man with little taste for material goods, the reform might have actually resulted in a lowering of the aggregate sum of satisfaction. One tool allowing economists to draw cost-benefit conclusions is the notion of Pareto superiority. This states that a state of affairs is efficient if it makes at least one person better off without making anyone else worse off. A state can be characterised as Pareto optimal if there are no more Pareto-superior moves to be made. The notion of Pareto superiority makes it possible to refer to some states as more efficient than others without making interpersonal comparisons of utility. Unfortunately, in practice, it is pretty useless as a policy tool. For it is generally difficult to tell whether one a change would leave anyone worse off. Its application has largely been as a heuristic device in explaining the consequences of contracting. Contracts freely entered into by rationally and fully-informed participants are presumed to be for the benefit of both parties and therefore Pareto superior. A more practical way of explaining cost-benefit decision-making was subsequently developed by Nicholas Kaldor and John Hicks, two English economists. Kaldor-Hicks efficiency theory states that a reallocation of resources is efficient if those who gain from it obtain enough to fully compensate those who lose from it. It is sometimes known as Paretopotential efficiency because it suggests that by compensation we could ensure that no one was worse off. However, actual compensation is not demanded. The problem with this standard is that it is difficult to see how it can really be applied without making interpersonal comparisons of utility. In practice it is liable to be applied measuring gain and loss according to objective assessments and it tends to focus on financial gains and losses rather than less quantifiable issues. As a result, in practice, it is likely to be more a standard of wealth maximisation than of utility maximisation. The Coase-theorem has the virtue that it can be analysed in terms of Pareto efficiency. Given an entitlement, the parties will make Pareto superior moves until they arrive at a Pareto-optimal point. If we are to decide that we wish to regulate through tax or zoning, in contrast, we are going to be required to make a cost-benefit analysis of our intervention which is more likely to be premised on Kaldor-Hicks efficency.

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II. Readings 1. Coase’s article

The Problem of Social Cost RONALD COASE I. THE PROBLEM TO BE EXAMINED This paper is concerned with those actions of business firms which have harmful effects on others. The standard example is that of a factory the smoke from which has harmful effects on those occupying neighbouring properties. The economic analysis of such a situation has usually proceeded in terms of a divergence between the private and social product of the factory, in which economists have largely followed the treatment of Pigou in The Economies of Welfare. The conclusion to which this kind of analysis seems to have led most economists is that it would be desirable to make the owner of the factory liable forhe damage caused to those injured by the smoke, or alternatively, to place a tax on the factory owner varying with the amount of smoke produced and equivalent in money terms to the damage it would cause, or finally, to exclude the factory from residential districts (and presumably from other areas in which the emission of smoke would have harmful effects on others). It is my contention that the suggested courses of action are inappropriate, in that they lead to results which are not necessarily, or even usually, desirable. II. THE RECIPROCAL NATURE OF THE PROBLEM The traditional approach has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. 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. I instanced in my previous article the case of a confectioner the

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noise and vibrations from whose machinery disturbed a doctor in his work. To avoid harming the doctor would inflict harm on the confectioner. The problem posed by this case was essentially whether it was worthwhile, as a result of restricting the methods of production which could be used by the confectioner, to secure more doctoring at the cost of a reduced supply of confectionery products. Another example is afforded by the problem of straying cattle which destroy crops on neighbouring land. If it is inevitable that some cattle will stray, all increase in the supply of meat can only be obtained at the expense of a decrease in the supply of crops. The nature of the choice

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is clear: meat or crops. What answer should be given is, of course, not clear unless we know the value of what is obtained as well as the value of what is sacrificed to obtain it. To give another example, Professor George J. Stigler instances the contamination of a stream. If we assume that the harmful effect of the pollution is that it kills the fish, the question to be decided is: is the value of the fish lost greater or less than the value of the product which the contamination of the stream makes possible. It goes almost without saying that this problem has to be looked at in total and at the margin. III. THE PRICING SYSTEM WITH LIABILITY FOR DAMAGE I propose to start my analysis by examining a case in which most economists would presumably agree that the problem would be solved in a compeletely satisfactory manner: when the damaging business has to pay for all damage caused and the pricing system works smoothly (strictly this means that the operation of a pricing system is without cost). A good example of the problem under discussion is afforded by the case of straying cattle which destroy crops growing on neighbouring land. Let us suppose that a farmer and cattleraiser are operating on neighbouring properties. Let us further suppose that, without any fencing between the properties, an increase in the size of the cattle-raiser’s herd increases the total damage to the farmer’s crops. What happens to the marginal damage as the size of the herd increases is another matter. This depends on whether the cattle tend to follow one another or to roam side by side, on whether they tend to be more or less restless as the size of the herd increases and on other similar factors. For my immediate purpose, it is immaterial what assumption is made about marginal damage as the size of the herd increases. To simplify the argument, I propose to use an arithmetical example. I shall assume that the annual cost of fencing the farmer’s property is $9 and the price of the crop is $1 per ton. Also, I assume that the relation between the number of cattle in the herd and the annual crop loss is as follows: Number in Herd (steers) (Tons)

Annual Crop Loss Crop Loss per Additional Steer (Tons)

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1 2 3 4

1 3 6 10

1 2 3 4

Given that the cattle-raiser is liable for the damage caused, the additional annual cost imposed on the cattle-raiser if he increased his herd from, say, 2 to 3 steers is $3 and in deciding on the size of the herd, he will take this into account along with his other costs. That is, he will not increase the size of the herd unless the value of the additional meat produced (assuming that the cattle-raiser slaughters the cattle) is greater than the additional costs that this will entail, including the value of the additional

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crops destroyed. Of course, if, by the employment of dogs, herdsmen, aeroplanes, mobile radio and other means, the amount of damage can be reduced, these means will be adopted when their cost is less than the value of the crop which they prevent being lost. Given that the annual cost of fencing is $9, the cattleraiser who wished to have a herd with 4 steers or more would pay for fencing to be erected and maintained, assuming that other means of attaining the same end would not do so more cheaply. When the fence is erected, the marginal cost due to the liability for damage becomes zero, except to the extent that an increase in the size of the herd necessitates a stronger and therefore more expensive fence because more steers are liable to lean against it at the same time. But, of course, it may be cheaper for the cattleraiser not to fence and to pay for the damaged crops, as in my arithmetical example, with 3 or fewer steers. It might be thought that the fact that the cattle-raiser would pay for all crops damaged would lead the farmer to increase his planting if a cattle-raiser came to occupy the neighbouring property. But this is not so. If the crop was previously sold in conditions of perfect competition, marginal cost was equal to price for the amount of planting undertaken and any expansion would have reduced the profits of the farmer. In the new situation, the existence of crop damage would mean that the farmer would sell less on the open market but his receipts for a given production would remain the same, since the cattle-raiser would pay the market price for any crop damaged. Of course, if cattle-raising commonly involved the 6destruction of crops, the coming into existence of a cattleraising industry might raise the price of the crops involved and farmers would then extend their planting. But I wish to confine my attention to the individual farmer. I have said that the occupation of a neighbouring property by a cattle-raiser would not cause the amount of production, or perhaps more exactly the amount of planting, by the farmer to increase. In fact, if the cattle-raising has any effect, it will be to decrease the amount of planting. The reason for this is that, for any given tract of land, if the value of the crop damaged is so great that the receipts from the sale of the undamaged crop are less than the total costs of cultivating that tract of land, it will be profitable for the farmer and the cattle-raiser to make a bargain whereby that tract of land is left uncultivated. This can be made clear by means of an arithmetical example. Assume initially that the value of the crop obtained from cultivating a given tract of land is $12 and that the cost incurred in cultivating this tract of land is $10, the net gain from cultivating the land being $2. I assume for purposes of simplicity that the farmer owns the land. Now assume that the cattle-raiser starts operations on the neighbouring property and that the value of the crops damaged is $1. In this case $11 is obtained by the farmer from sale on the

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market and $1 is obtained from the cattle-raiser for damage suffered and the net gain remains $2. Now suppose that the cattle-raiser finds it profitable to increase the size of his herd, even though the amount of damage rises to $3; which means that the value of th...