Maria Cristina Fenoglio The problem of Social Cost Coase, Ronald H.(1960) The Journal of Law and Economics, 3 (October): 1-44 Maria Cristina Fenoglio Ronald Coase, 1991 Nobel Laureate, Economics

The problem of social cost “Actions of business firms which have harmful effects on others” Usual economic analysis follows Pigou, bringing most economists to three alternatives: Liability: The owner of the factory is liable for the damage caused Taxation: The owner of the factory is taxed according to the monetary value of the damage caused Exclusion: The factory is excluded from residential districts

The problem of social cost Coase’s contention: These alternatives are inappropriate, hence they lead to results not necessarily, or even usually, desirable The problem has a “reciprocal” nature

Coase theorem (so labeled later by George Stigler) When trade in externalities is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights

The example of the straying cattle Assuming that “the market works smoothly” = No transaction costs First case: Liability for damages = 1$/ton Second case: No liability for damages Assumption: annual cost of fencing = 9$ Number in Herd (Steers) Annual crop loss (tons) Crop loss per additional steer (tons) 1 2 3 6 4 10

The example of the straying cattle Key concepts Whitout transaction costs it is economically irrelevant who is assigned initial property rights: the cattle-raiser and the farmer will work out an agreement whether to restrict the cattle or not based on the economic efficiency of doing so Initial property rights allocation will matter only in determining income distribution

Transaction costs into account Initially property rights will have a non-trivial effect The property of the rights should be assigned such as that the owner of the rights want to take the economically efficient action The role of the Government as “super-firm” Economists tend to over-estimate the advantages coming from governmental regulation

Coase’s critics on Pigou’s position Pigou: when divergences between social and private net products arise, additional State action may be required and desirable Government can internalize externalities correcting market failures Coase: Pigou’s position is inadequate

The example of the Railway company The “Pigovian” way 1 train 2 trains Value of services 150 250 Costs - 50 - 100 Crops destruction - 60 120 Since it would be better if the second train were not run (fall in value ot total production) Since it would not run if the railway should be made liable for damages Liability for damages seems the right approach

The example of the Railway company Coase’s way: 2 trains Value of services 250 Costs -100 Crop destructions -120 Fall in value of crop production -160 Increase of production elsewhere +150 Overall, operating the railway will increase the value of total production by 20$ A situation in which there is “uncompensated damage” is not necessarily undesirable: whether it is desirable or not depends on the particular circumstances

Conclusions Ronald Coase: what is needed is a change of approach Taking into account “opportunity costs” Starting the analysis with a situation approximating that which actually exists Considering factors of production not as “physical entities” but as “rights”

Conclusions “In devising and choosing bertween social arrangements we should have regard for the total effect”

Comments In the last 40 years in many economies the field where legislation changed probably the most is the one dealing with “social costs” of firms externalities.

Comments In economies where: Transaction costs are very high The “value” attributed to issues such as health and environment is extremely high Taking into account the “total effect” has led to an increase in those very measures criticized by Coase, that is: Liability Taxation Exclusion