Economics in Two Lessons by John Quiggin

Author:John Quiggin
Language: eng
Format: epub
Publisher: Princeton University Press
Published: 2019-02-13T00:00:00+00:00

10.1.1. Externalities and Property Rights

Pigou’s analysis of the externality problem was challenged by Ronald Coase in a classic paper entitled “The Problem of Social Cost.” Coase argued that, given well-defined property rights, market transactions could bring opportunity costs into line with prices, even in the presence of what would otherwise be considered externalities. For example, suppose that a company’s ownership of a factory was associated with an explicit right to dump waste into a river, and that downstream water users were harmed by this pollution.

Then, Coase argued, the downstream users could pay the company not to pollute, effectively purchasing the property right. Conversely, if the downstream users had a right to stop the company dumping waste, but could obtain clean water elsewhere, the company could pay them not to exercise their rights.

Obviously, this doesn’t happen in practice. That’s in part because “rights to pollute” and “rights not to be polluted” are typically not assigned to particular individuals or groups, but are general rights governing access to unowned resources. Coase did not analyze this problem very satisfactorily but observed that unspecified “transaction costs” might prevent the parties from reaching an agreement.

In these cases, Coase suggested that the best outcomes would be realized if the property rights were allocated to the party for whom they were most valuable. Coase thought that the common law judicial system performed this function. However, the court system is just one part of the state machinery that creates and enforces property rights. States can create (and restrict or abolish) property rights through legislation or through executive actions such as regulatory determinations.

As was stressed in chapter 7, the creation of property rights invariably involves an opportunity cost. Although many One Lesson economists, following Coase, have stressed the importance of property rights, they have mostly avoided this point.

Coase’s discussion of transaction costs has also given rise to a large literature. A transaction cost may be regarded as a difference between the (higher) price paid by a buyer and the (lower) price received by a seller. The existence of such differences violates a crucial assumption in the theory of competitive equilibrium, namely that both buyers and sellers face the same market-determined prices; this is part of assumption (A) in section 2.4. If there are two different prices, one for buyers and one for sellers, they cannot both be equal to social opportunity cost. The appearance of social cost in the title of Coase’s paper refers directly to this point.

Where transaction costs are large, market outcomes will not be satisfactory. Whether there is a better alternative, however, depends on the nature of the costs involved. Unfortunately, despite extensive research on the topic, transaction costs generally end up being treated as something of a “black box,” the contents of which remain inaccessible. For this reason, analysis in the “market failure” tradition that began with Pigou continues to be a more useful tool.

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