R.H. Coase The Problem of Social Cost Journal of Law and Economics, 1960 Eva Herbolzheimer University of Illinois at Urbana-Champaign

Background and Objective  Some firm’s production process creates negative effects (externalities) for other firms or individuals  Standard economic analysis at the time in terms of divergence between private and social product of a firm Pigou “The Economics of Welfare”  Firms are liable for the damage  Tax equivalent to the damage (Pigovian Tax)  Exclude firms from certain areas (zoning) The Problem of Social Cost

The Reciprocal Nature of the Problem  Traditional assumption obscures the nature of the choice  Avoid the harm on B would inflict harm on A  Ignores OPPORTUNITY COST  Goal has to be to avoid the more serious harm  Example: Cattle-raiser and Farmer Problem: we have to know the value of what is obtained and of what is sacrificed to obtain it  in total and at the margin The Problem of Social Cost

The Pricing System with Liability for Damage  Assumptions: -Damaging Business has to pay for all damage caused -Pricing System works smoothly (=without cost)  Example: Cattle-raiser and Farmer -Cattle-raiser can put up a fence -Cattle-raiser can reduce his herd (= production) -Cattle-raiser can make a contract with farmer so the farmer does not cultivate the strip of land  Room for a mutually satisfactory bargain  Agreement does not affect allocation of resources (only wealth) The Problem of Social Cost

The Pricing System with NO Liability for Damage  Assumptions: -Damaging Business does not have to pay damage caused -Pricing System works smoothly (=without cost)  Example: Cattle-raiser and Farmer -Farmer can put up a fence -Farmer can abandon production (or move to other place) -Farmer can pay the Cattle-raiser to reduce his herd (contract)  Size of the herd will be the same  Also room for a mutually satisfactory bargain The Problem of Social Cost

Result  The ultimate result (which maximizes production) is the same for situations with or without liability, but only if the pricing system is assumed to work without cost.  There is always room for bargaining unless the marginal gain of one firm is equal to the marginal loss of the other firm / individual The Problem of Social Cost

The system WITH transaction costs  TC may make the perfect / optimal allocation impossible  Possible ways to minimize TC -Single ownership of property rights (Theory of the Firm) -Contract (often long-term)  Government Intervention (Super-Firm) -Laws (Courts) / Regulation -Institutions BUT: Government Intervention might be more costly  Economists and Policy-Makers overestimated advantages The Problem of Social Cost

Critique of Pigou’s Analysis  Pigou does not consider the cost imposed on the firm that causes the damage  Tax equal to the damage caused is not efficient -High probability that there will be a better way to allocate resources -Impossible to measure effects of damage exactly -Tax will not be distributed to those affected by the damage -Tax will create wrong incetives  Pigou had not thought his position through The Problem of Social Cost

Coase’s Proposed Approach  Taking into account Opportunity Cost  Taking into account the difference between private and social cost  Instead of thinking of universal cases, starting analysis with a model similar to the existing situation  Thinking of factors of production as a “right” instead of a physical product  Easier to understand why sometimes it is desirable to give a firm the right to do something that has a harmful effect (socially justified) The Problem of Social Cost

Summary of Coase Theorem If property rights are clearly defined, then agents can reach optimal allocation by bargaining -Final allocation of resources will be independent from allocation of liability for damage -No government intervention is needed -Allocation will be dependent on relative prices The Problem of Social Cost

Interpretations of the Coase Theorem  Efficiency Version: “ Aside from transaction costs, the prevailing outcome will be efficient.”  Invariance Version: “Aside from transaction costs, the same efficient outcome will prevail.” The Problem of Social Cost

Discussion 1) What do we care about more?  The Size of the Pie  The Distribution of the Pie 2) How do opinions regarding this question affect policy and allocation of resources across the globe? The Problem of Social Cost