Coase

I wanted to add a few words on the passing of Ronald Coase.  ”The Problem of Social Cost” is the most frequently-cited law review article of all time (another count)–and its not even close.  That pretty much says it all in terms of his well-deserved fame and influence.

But the amazing thing to me is that despite that, many people still do not appreciate how profound and nuanced his points are.  In particular, the central insight of “The Problem of Social Cost” is that costs are reciprocal–this is what, as Jonathan notes below, fundamentally destroys the idea of externalities as a coherent concept for most applications.  This means that so-called “externalities” really boil down to a question of incompatible uses, which really boils down to a question of property rights and transaction costs in defining and transferring property rights.  The notion of externalities (in my view) rests on a crude reductionist logic that something that looks like physical causation also must be causation in law.  But this isn’t necessarily correct and the important insight here is that cost not only is reciprocal, but that the idea of “cost” in economics is opportunity cost.

So take take the classic example used to illustrate the Coase Theorem.  Assume that upstream is a factory that makes vaccines that can save 1 million children a year.  Assume also that the water in the river is a special water and this is the only place in the world where the baby vaccine can be manufactured.  Assume that for 10 minutes each year the baby vaccine factory must emit some waste that is completely harmless but gives of a very faint but unpleasant odor.  Downstream lives Mr. Montgomery Burns.  Burns likes to be able to sit out on his porch whenever he wants to even for the 10 minutes a year when the unpleasant odor might bother him (maybe he has “existence value” and he cares more about the aesthetics of a completely pure stream than one million babies too–in fact, assume that he believes that it is morally wrong to enter into any bargain that will “put a price” on the environment and condone pollution, so he objects in principle to the idea).

Now a crude look at this situation suggests that clearly the vaccine factory is “causing” harm to Burns by not allowing him to use his property by being able to sit on his porch whenever he wants to.  But is it really that obvious?  Isn’t it equally valid to say that if the factory is controlling his “use” of his property by emitting the smell, that if he can stop them then he is telling them how to use “their” property and that there is a real cost to the vaccine company as well as the babies they would save?  What creates the externalities is nothing more than the incompatible uses between the vaccine factory and Mr. Burns’s preferences–it is the interaction of their desires to use the same property that creates the “cost.”  If one or the other wasn’t there then there would be no cost.  The question of causation is defined by law, not by the physical world.

While I resisted this idea for a long time, eventually I came to be persuaded that it was analytically correct (I talk about this in my essay on “Libertarianism, Law and Economics, and the Common Law“).  This is one of those insights though that once you see it, you see it everywhere.

Consider just a few examples.  I like to sit on my deck on nice days and read.  My neighbors have been doing an addition to their house recently, so dudes are hammering more or less all day.  Should I be allowed to enjoin them because the noise disturbs me?  Or should they be allowed to say, “We are working only during the day when most people are at their offices?”  Clearly, again the cost is reciprocal–it only arises because of my idiosyncratic preference to be able to work on my deck during the day and their need to add on to their house.

Cigarette smoking is a similarly good example and actually a wonderful example of the implicit logic of the Coase Theorem.  In the old days when a lot of people smoked, there were many places in which the implicit property right was that people more or less could smoke whenever they wanted.  If everyone smoked, then no one was really bothered.  It is only when some people wanted to smoke and others wanted to be free from smoke that there was a cost.  But if you didn’t smoke, the implicit rule was that you had to avoid the smoke.  As fewer people have come to smoke and the risk and nuisance of second-hand smoke have come to be believed to be higher, property rights have gravitated to the non-smokers.

A final example to illustrate how profound Coase’s point was and the degree to which many people still do not grasp it–payment cards.  Much of the logic for interchange price controls (such as the Durbin Amendment) rests on the idea that when a consumer uses a payment card he is “causing” costs for the merchant.  But that is obviously incorrect from a Coasean perspective–costs of any payment mechanism are “caused” only by the interaction of the merchant and the consumer–the consumer wants to use a payment card and the merchant wants to accept the payment card.  So, for example, I might want to use shiny beads or puppies to buy a candy bar–but the “cost” associated with paying with shiny beads only arises if I want to use it and the merchant accepts it.  Once it is recognized that the cost arises only from our reciprocal desire to use payment cards, then as Coase would recognize (and as Bill Baxter explicitly recognized) there is no “natural” allocation of cost between the two parties, but that it should be defined by some other criteria.  Coase suggests that the best way to define the allocation of cost would be on the basis of efficiency criteria, which is also how I think that costs should be allocated for payment cards.  In short, one of the main ideas that supports interchange fee price controls is the idea that when consumers use payment cards they are imposing an “externality” on the merchant.

That this crude notion of “externality” could persist so many years after Coase wrote “The Problem of Social Cost” and its widespread influence is a testament to how subtle, elusive, and far-reaching his idea really was.  Once you get it, it really upends your whole view of the world (or at least it did for me).