I.
The problem to be examined
This paper is about negative externalities of one business firm
upon others. The traditional economics analysis, developed by Pigou, contends
that the firm is liable for the damage and that the firm should either pay tax
of equivalent amount of the damage or close the factory in that area. But
professor Coase argues in this article that such analysis is inappropriate and
often leads to undesirable outcomes.
II.
The reciprocal nature of the problem
The traditional approach focuses on how to restrain the negative
externalities of the firm, but this analysis is wrong because the external cost
is not simply a cost produced by the firm and born by the victim; instead, the
problem is of reciprocal nature. The real question is to decide whether one
group is allowed to harm the other or vice versa. The proper way of analysis is
to determine in total and at margin whether the value of protection is worth
the cost of restraining the firm.
III.
The pricing system with liability
and damage
When the firm has to pay all damage it caused and the transaction
cost is zero, there will be a desirable solution. If the firm that imposes
negative externalities is liable for the damage, it will take into
consideration the marginal social cost of its production, and based on
cost-benefit analysis, it will either reduce production or pay to victim as
compensation. On the other hand, the victim will reach a bargain with the firm
based on his examination of negative externality cost and benefits. The both
parties have to consider the opportunity cost, and if the cost is greater than
the value they can get, then in a competitive market, they will reallocate the
resources and reach a mutually beneficial outcome. The outcome of the bargain
depends on preferences and negotiation skills of two parties, but the net
social gain is the same.
IV.
The pricing system with no liability
and damage
If the damaging business is not liable for the damage it has
caused, but the transaction cost is zero, then the allocation of the resources
will be the same as it was when the firm was liable for the damage. In this
case, the victim will pay the amount no larger than externality cost to the firm
for less damage, and the firm will accept it if the amount is larger than the
value of its marginal product. If this transaction doesn’t happen, the victim
will move out and no negative externalities would happen. As it is the case in
III, the outcome depends on the value of firm’s marginal production and its
cost on the victim.
It is necessary to know if the damaging business is liable for the
damage since the establishment of the delimitation of right facilitates market
transaction, but as long as the transaction cost is zero, people would bargain
with one another to produce the most efficient distribution of resources,
regardless of the initial legal position.
V.
The problem illustrated anew
Problems of negative externalities can assume various forms in
life. But the bottom line is that the problem is caused by both pollutant and
the victim. The economic problem in all cases of harmful effects is how to
maximize the value of production. The immediate question courts have to cope
with is who has the legal rights to do what, but as long as the transaction
cost is zero, the decisions of the courts concerning liability for the damage
have no effect on the final allocation of resources. A legal rule that
arbitrarily assigns blame to one of the parties gives the right result when
that party happens to be the one that can avoid the problem at the lower cost.
VI.
The cost of market transaction taken
into account
In real life, many welfare-maximizing reallocations are forsaken
because of high transaction costs in the process of bargaining. In this
situation, the initial delimitation of property rights will affect the
efficiency with which the economic system functions.
A firm could reach the efficient outcome, but the administrative
cost for firm to organize a transaction isn’t strictly less than that from the
market. People will use firm to organize a transaction when its costs are less
than the cost incurred through market.
When the transaction cost of the firm is very high, an alternative
option is direct government regulation. The government, to some extent, is a
super-firm because it can influence the use of factors of production by
administrative decision and it can avoid the market competition. The government
can use its power to get things done at a lower cost, but the administrative
machine itself isn’t costless, and the regulation may not be efficient. All
solutions have costs and there is no reason to suppose that government
regulation is called for simply because the problem is not well handled by the
market or the firm. The law should produce an outcome similar to what would
result if the transaction costs were eliminated. Hence courts should be guided
by the most efficient solution.
VII.
The legal delimitation of rights and
the economic problem
The courts should take into consideration the economic consequence
of their decision. A comparison between the utility and harm produced is an
element in deciding whether a harmful effect should be considered a nuisance.
The problem of negative externalities isn’t about restraining those
who are responsible for them; instead, the problem is to decide that, given the
negative externalities, whether the gain from preventing the harm is greater
than the loss resulted from stopping the action that produces the harm. In a
world with transaction costs, courts make decisions on economic problem and
determine how resources are to be allocated. The courts are conscious of this
and they make comparisons between what could be gained and what would be loss
by preventing the actions. The delimitation is also the result of statutory
enactment. Sometimes courts may protect the firm too far.
VIII.
Pigou’s treatment in “economics of
welfare”
The existence of externalities does not necessarily lead to an
inefficient result. Pigouvian taxes, even if they can be correctly calculated,
do not in general lead to the efficient result.
IX.
The Pigovian tradition
For Coase, the idea that firm should be forced to compensate those
suffer from negative externalities is the result of not comparing the total
product attainable within various social arrangements. A tax system which is
confined to a tax on the producer of the damage caused will lead to higher cost
of solving the problem if the alternative solutions incur fewer costs. In
addition, Pigouvan taxation begs the question of detailed information of
personal preferences, which is hard to achieve in real market. What’s more,
even if the problem of information is solved, tax will increase because more
people will live in the vicinity, incurring reciprocal negative externalities
on firms. If regulation is truly inevitable, the goal is to approach the
optimum amount of negative externalities rather than just eliminate harm
regardless of the cost.
X.
A change of approach
Coase believes that analysis in terms of divergence between social
and private cost of products pays close attention to particular deficiencies in
market and tends to nourish the belief that any mechanism eliminating the
deficiencies would be desirable, but such mechanism may induce unintended
consequences.
Pigouvan analysis proceeds in terms of a comparison between a state
of laissez-faire market and an ideal world. Coase suggests that a better
approach should examine the transaction costs and delimitation of property
rights, conduct cost-benefit analysis on various proposals and decide which
institution to set up.
Coase thought that failure to cope with externalities correctly
results from a wrong concept of a factor of production. Factors of productions
are a right for a person to perform certain actions on his property. The cost of exercising a right is the loss
born somewhere else in consequence of exercising the right. In deciding social
arrangements in which individual decisions are made, Coase believe that all
solutions have costs and there is no reason to suppose that government
regulation is called for simply because the problem is not well handled by the
market or the firm. Economists should account for total effect of each proposed
arrangement to make the best decision.
The ultimate thesis is that law and regulation are not as important
or effective at helping people as lawyers and government planners believe. Coase
and others like him wanted a change of approach, to put the burden of proof for
positive effects on a government that was intervening in the market, by
analyzing the costs of action.
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