Learning and Forgetting the Wisdom of Coase

I was an Assistant Professor at the University of Michigan in 1985 when our downsizing department library put a stack of old journals in the hallway for disposal.  Walking by the pile, I spotted the 1960 Journal of Law and Economics in which Ronald Coase had the lead article, “The Problem of Social Cost.”  I grabbed the issue and it has remained on my shelf ever since, even as I’ve expunged nearly all other hardcopy from my office.

JLE1960

When I first read this paper as a graduate student it was so beautiful and compelling that it restored my faith in the importance of applied economic thinking, faith that had faltered at times under the onslaught of math that is the first year of graduate economics training.  In the MBA course I now teach on Energy and Environmental Markets, I spend a full day explaining the significance of this article.

I returned to that issue of JLE last week after reading some of the obituaries for Coase, who died on September 2 at the age of 102.  I decided to reread the original paper to check if my memory was wrong or if many of the right-wing commentators were repositioning Coase to sidestep the obvious application of his work to climate change.  It turned out my memory was fine.

220px-Coase

Ronald Coase (1910-2013)

Coase’s article came 40 years after Pigou had published The Economics of Welfare, in which he had argued that polluters should be required to pay a tax equal to the negative impact they have on others.  Coase had the deep and still surprisingly powerful insight (later termed the “Coase Theorem”) that it wasn’t necessary that the source of a negative externality pay, but rather that the parties (eg, the polluter and the pollutee) are able to bargain over whether and how much of the externality is produced.

For this to happen, Coase showed, two factors are critical:  ownership of the property right must be clear – how much, if any, of the negative externality does the emitter have the right to create? — and the parties must be able and willing to bargain over those rights.

Coase recognized that these are not trivial assumptions.  He spent a chunk of the paper explaining how transaction costs – finding all affected parties, negotiating a contract acceptable to all, monitoring and enforcing that contract, etc. – may be prohibitively costly.  In such cases, it might make sense for the government to act as representative of a large set of affected parties and negotiate or impose a contract.  Coase notes this approach is vulnerable to abuse by an unchecked government.  Alternatively, it may be that the cost of correcting the externality is greater than the problem itself and the best course is to take no action.  That seems very unlikely to apply to climate change.

Still, to the extent these criteria are met, Coase demonstrated, the parties can trade the right so that whichever entity values it most ends up owning it.  Efficient trading of the right to pollute moves society towards the optimal amount and allocation of the pollution.  The idea is central to the cap and trade approach to reducing greenhouse gases and other pollutants.

In its editorial remembering Coase, the cap-and-trade-hating Wall Street Journal stated the principle of the Coase Theorem reasonably well, but then its conclusion echoed much of the right-wing press on Coase’s passing: “The too frequent assumption of modern government is that it can play the role of teacher, even when its taxes or regulation raise costs or otherwise make things worse. The Pigovians have had a political renaissance since the 2008 financial crisis, touting the virtues of regulation. But as we see the results, the Coasians are due for a comeback.”

Whoa!  Coase was clearly skeptical of government regulation, but he recognized – indeed  advocated — that government must establish and enforce property rights for efficient trade to take place.   The costs it imposes on the polluters isn’t part of the calculation, just recognition that the total costs to society can be mitigated by facilitating such trade.

It is ironic and disappointing to hear some commentators laud Coase while at the same time saying that cap-and-trade would be too costly to the U.S. economy.  The WSJ editorial page, and many others of similar inclination, have argued instead that “the market” will solve pollution problems without government intervention.  That’s not Prof. Coase; that’s Prof. Ostrich, the one with his head in the sand.

Coase’s argument was that the market can help solve externalities when everyone agrees on who has the property right and when that right can be traded.  Assigning property rights can be difficult, particularly if they are for something that has previously been treated as an inexhaustible free good (think clean water vs. waste disposal, clean air vs. industrial smokestacks, sunlight vs. shading).  But on climate change, the right wing now fights against assigning any property rights on greenhouse gas emissions, even as the science becomes virtually certain that GHGs are the cause of climate change.  Leaving the property rights unassigned is equivalent to giving unlimited rights to emit and making those right untradeable.  Cap and trade recognizes the value of those rights, assigns the property rights, and makes them tradable.

In the conclusion of his article Coase states, “Economists who study problems of the firm habitually use an opportunity cost approach and compare the receipts obtained from a given combination of factors with alternative business arrangements. It would seem desirable to use a similar approach when dealing with questions of economic policy and to compare the total product yielded by alternative social arrangements.”  Indeed.

The “total product” of the economy to which Coase refers includes the losses due to negative externalities.  He recognized that if property rights were assigned and tradable, the market would account for both the costs and benefits of reducing an externality, because anyone creating the externality would face an opportunity cost of doing so, that is, the opportunity to sell the right.

Coase didn’t argue that externalities should be ignored.  He showed us that market incentives can be harnessed to help reduce externalities by the optimum amount at the least cost possible.  At the time of his paper, many on the left wing saw such market approaches as unreliable or immoral, but most have since been convinced of their power.  Sadly, just as the left has learned the lessons of Coase, the right seems to have forgotten them.

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13 Responses to Learning and Forgetting the Wisdom of Coase

  1. Tim Brennan says:

    Severin — Nice job, thanks.

  2. Kenneth Gillingham says:

    Well said!

  3. CG Dong says:

    It is hard to think CAT as a social arrangement (since it is too similar to carbon tax), but rather a government policy arrangement. The missing party is the impacted communities, which is hard to define. So are the property rights.

  4. Joshua Sharf says:

    For the market to work, don’t you also need to be able to price the damage being done? I think that’s a very tough call to make, given what we know and don’t know about CO2 effects on individual welfare.

  5. David E. Bruderly PE says:

    The WSJ Editorial staff also forgets a fundamental teaching and wisdom of Adam Smith (1776); in order for markets to function fairly and efficiently for the benefit of the CONSUMER the government has the DUTY to ensure TRANSPARENCY and to REGULATE market behavior to protect the COMMONS from exploitation by the MERCANTILISTS. By opposing government regulation of virtually all forms or air and water pollution over the past 40-years, the WSJ Editorial staff has consistently served, in effect, as an advocate for government protection of the right of MERCANTILISTS to pollute the COMMONS regardless of the consequences to CONSUMERS. Webster tells us that those who advocate business control of government are advocates of FASCISM, not democratic capitalism. The WSJ Editorial staff is paid well to rationalize economic behavior that exploits the COMMONS for the benefit of MERCANTILISTS; this is intellectually dishonest behavior for a publication that claims to be a defender of market economics and capitalism.

  6. Azmat Malik says:

    As long as there is information available to the ‘customers’ of the ‘entity that creates the externality’ [ie the polluter] the customers can make the decision to or not to buy-consume that product.
    Unfortunately a lot of the pollution is caused [apparently] in other areas so we in the US often do not see it, and even if we see it it ‘doesnt affect us directly’, such as the child labor in the garment industry or the pollution in China.
    The only practical way is to have a product label that shows the amount of energy consumed in creating the product as well as the energy that would be needed to mitigate the effect of disposing of the product back to its ‘original’ state. Not easy.
    Absent something like that, the consumer has little choice for consistently acting upon such polluters actions. A not-so-recent discussion regarding ‘how green is the Tesla’ makes similar points. The Tesla is not really very green as long as the source of the energy is not ‘clean’. If one were to know the cradle-grave-cradle energy budget in making and operating a Tesla [including the metals, and battery, and seats, etc], and were to generate that much energy from a clean source {again fully bundled all-in energy used to produce the system: such as the energy cost of the panels, etc] and feed it to the grid, perhaps one can then base the green-claim on actual data.

  7. Jack Ellis, Tahoe City, CA says:

    Mr. Malik, there is no such thing as clean energy because all sources of energy production have environmental consequences. The best we can do is to pick our poison and be prepared to live with a certain set of consequences.

    The editors of the WSJ seem to have forgotten how cap-and-trade as applied to SO2 emissions was a far better economic choice than mandating scrubbers.

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  10. I think you need to re-read Coase’s introduction to “The Firm, The Market, and the Law” as well, for it seems you’ve adopted the conventional interpretation of Coase that he disavowed. While Coase did not argue that “externalities should be ignored,” he was closer to this position than the reverse. Specifically, Coase expressly argued that the existence of an “externality” (a word he never uses in “The Problem of Social Cost”) does not constitute a prime facie case for government intervention. If anything, he wrote, it suggests the opposite. (I quote the relevant passages here: http://www.volokh.com/2013/09/02/coase-externalities/)

    As he explained time and again, the “Coase Theorem” was not the point of his essay, and we should not assume that defining property rights is costless, nor should we assume that we know ex ante how the property rights should be assigned (at least if we are concerned with welfare maximization). While failing to restrict GHG emissions effectively allocates an untradeable right to emit to emitting facilities, Coase expressly argued against reflexively assuming that the existence of such effects means government intervention in necessary or even desirable to internalize the associated costs. This is one of the Pigouvian assumptions that Coase expressly sought to refute. Put another way, if we take Coase seriously, we have to recognize that the adoption of a cap and trade system –like the imposition of a carbon tax — cannot be assumed to be welfare maximizing. It has to be shown.

    Coase did not condemn cap and trade, but he did not advocate for it either.

  11. jim roumasset says:

    The real Coase Theorem — the one that can actually be proved and which fits Coase’s 1959 oral presentation — refers only to bilateral spillover effects. Coase himself noted that contracting was probably not appropriate for industrial pollution. http://www.uhero.hawaii.edu/news/view/250

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