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The theory of environmental economics can easily be traced back about 100 years to the work of A.C. Pigou who basically developed the principle of “Polluter Pays.” In other words, he identified the externalities problem in economics as one where actors do not bear the full costs of their actions. This is correct. But Pigou’s “solution” turns out to have only limited relevance.

His canonical solution remains the favorable textbook solution today, mostly because it is amenable to drawing nice graphs and also because it comports with our intuition. His solution? Make the committer of the externality pay. For example, tax the chicken farmer who dumps runoff into the local drinking stream. Seems like a decent idea.

What’s so problematic about that? That’s where the work of Economist Ronald Coase comes in. One of the most important articles ever written in economics is Ronald Coase’s The Problem of Social Cost. Here is the reference:

Coase, Ronald. “The Problem of Social Cost,” Journal of Law and Economics, Vol. 3, (Oct., 1960), pp. 1-44.

Here are a series of questions about the paper to help you read along.


1) Why does Coase argue that “making the polluter” pay is the wrong way to frame the discussion of the “Problem of Social Costs?” (to earn full credit, it would be a good idea to illustrate just, what, exactly a “social cost” is.

It takes two to tango! While it may be obvious that my loud music “pollutes” your ears … it would also not be possible for my music to hurt your ears if your ears were not there! You might call a social cost an “externality” … it is the use of resources by an actor that he or she is not forced to take into account when they are making decisions. A particular illustration would be nice – such as my neighbor who right now is blowing dust all over me while he blows his leaves to the curb for pickup.


2) What is the minimum evidence required to suggest that some level of pollution is inefficient? What does this say about whether pollution itself is “bad” and whether the existence of pollution is “bad”?

Only if the value of the objects and services damaged by the actions exceeds the value of the product what was the source of the contamination in the first place.

Well, pollution is a cost – it is odd to call it a “bad” as distinct from any other cost. What makes leaving a few extra molecules of carbon dioxide in the atmosphere any “worse” than having to toil for an extra hour in the hot sun to get some desirable outcome? Furthermore, pollution is “bad” insofar as we don’t like it, but that says little about whether the existence of it represents an inefficient or undesirable outcome.

Implicit here is that the existence of pollution may be efficient since doing away with it may be more costly than any other alternative. For example, would you say that it is “bad” to have soot emitted? Well, then, that pretty much means the end of civilization before it ever got started. When we started cooking our food over open fires, it took almost 8,000 years for there to emerge a low-cost technology to make that outcome inefficient.


3) Coase illustrates the case where traditional liability rules (i.e. making the polluter pay for damages (this is a liability rule, not a property rights rule per se, see below for the Frech article)”) do indeed comport with efficient economic outcomes. You will soon see that this is not a really relevant observation. In that section he makes a point about whether people who have had their property damaged by a polluter would change their behavior because of the possibility that they would be compensated. What is his point? After all, it seems obvious given what we know about Say’s Law that folks would respond to being compensated for being damaged that they have an incentive to put more stuff at risk!

Interestingly, this would not be the case. In a reasonably competitive market, the price you can sell your goods for equals the marginal cost of producing the last units of it. Thus, expanding your production (since you are a price taker) means you would have lower profits. The damage to your product would mean you sell less, but of course you would end up being compensated for that amount – leaving you no better off than you were without the compensation and damage.


4) Coase moves on to discuss (in a world where the price system works “smoothly”) whether doing away with the traditional liability rule would alter the economic outcome from that which the liability rule exists. What does he find and why?

Coase finds that it wouldn’t matter. The allocation of resources would be identical. And the reason being that resources always find their way to their highest valued uses if it is easy for those values to be realized.


5) The insight above is perhaps among the three most misunderstood insights in all of economics (right up there with comparative advantage and people lapsing into forgetfulness about the relentlessness of scarcity). But that is not my question here. In addition to being misunderstood, it is perhaps the most widely mischaracterized in popular discussions of all economic insights. One of the mischaracterizations is of the transactions cost assumption Coase is making (more on that below). Another is the conclusion critics draw who claim that Coase believed “liability institutions don’t matter.” Where in the paper does Coase actually make that claim? And if you cannot find such a claim, what does he say about the importance of liability insitutions?

Coase NEVER said that liability institutions (unconditionally) don’t matter. What Coase did say was that it didn’t matter to whom liability was applied. Big difference.

And here is how Coase concluded the section on what happens when there are no traditional liability rules:

“It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. 

But the ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost”



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2 Responses to “The Problem of Social Cost, Part I”

  1. Andy says:

    I’m convinced Coase’s example of the farmer and the rancher comes from this scene in the musical Oklahoma!

  2. Harry says:

    Thanks for the reading, WC.

    My own cows having committed numerous jailbreaks onto other people’s property, including several invasions of an adjacent golf course, where the crop was bent grass, got me thinking about a multitude of angles.

    Not to change the subject, but how do we who have our property devalued by the regulators get compensated? Same subject, actors reversed.

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