Anatomy of Market Failure III: Coase, Transaction Costs, and Missing Markets

Markets don't fail, they fail to exist

(Source: JSTOR Daily, How Barbed Wire Changed Farming Forever)

A few weeks ago in introducing the concept of market failure I referred to Bruce Yandle’s discussion of his childhood paper mill (Coase, Pigou, and Environmental Rights (in P.J. Hill and Roger Meiners, eds., Who Owns the Environment? Rowman & Littlefield 1998)):

Anatomy of Market Failure I: Pigou and Polluter Pays

Imagine a town with a river, where the town has a paper mill and a water bottling company. The paper mill produces and sells paper to consumers. Their production process generates waste, and as a profit-maximizing firm with fiduciary duties to its owners, the firm’s managers look for ways to reduce waste management costs along with other costs. If they can discharge the waste in the river with no financial cost, they have an incentive to do so, because their market is competitive and they have several rivals, so they have an incentive to minimize their costs. But this discharge imposes a cost on the water bottling company by increasing the amount of filtration they have to do; this cost of the paper transaction is borne by the water company, which is not a party to the paper transaction. This is the problem of social cost: a problem of interdependence and third-party spillovers.

Pigou’s approach to this problem used the then-newly-refined (in 1920) model of perfect competition as a theoretical benchmark, because perfect competition defined the theoretical maximum possible welfare/gains from exchange. He defined these external effects and showed that when they exist they lead to outcomes with lower welfare and with lost potential surplus (i.e., deadweight loss) relative to that benchmark. And he framed these external effects as having a creator who should be held responsible for the consequences of creating those external effects; in the case of external costs like in the paper mill example, the paper mill created pollution and should thus be held financially responsible, “polluter pays”.

As a student at the London School of Economics in the 1930s, Ronald Coase was learning economics at a formative period in the field’s evolution, and learning from such important scholars as Arnold Plant, Lionel Robbins, Sir John Hicks, and F.A. Hayek. Although the LSE faculty and the Cambridge faculty had differences in their approaches at this time, Coase would certainly have read Pigou’s Economics of Welfare as a student. Embarking on his own intellectual career in the late 1930s, Coase began developing core ideas that would transform how we think about the organization of industry (as he called it in his Nobel address, the institutional structure of production), and would ultimately be awarded a Nobel Prize in 1991 due to the widespread influence of these ideas. One of the most influential of these ideas was his application of transaction costs and property rights analysis to critique the Pigouvian externality model and to propose an alternative: reducing transaction costs and clarifying property rights to enable decentralized bargaining.

Coase’s critique of Pigou is contained in his seminal work The Problem of Social Cost (1960), which itself builds on his influential 1959 paper The Federal Communications Commission. In his work on government allocation of rights to use radio spectrum for communications, Coase identified the general problem as being conflicting uses of a scarce common-pool resource, a resource over which defining and enforcing property rights is costly or not feasible, so the resource is used in a shared way as a commons.

Coase developed a theoretical framework for analyzing situations in which a market transaction creates costs (or benefits) for a third party, and how to resolve disputes over who should bear such costs (or enjoy such benefits). Think about how this framework applies to our town with a paper mill and a water bottling company. Recall that the paper mill's waste discharge imposes a cost on the water bottling company by increasing the amount of filtration they have to do; this cost of the paper transaction is borne by the water company, which is not a party to the paper transaction. Coase’s primary question was how to determine who should be liable for this cost, or in other words, for the harm associated with this discharge. In developing this theory Coase drew on substantial case law in the English common law tradition.

Coase thought that Pigou’s framing of third-party effects was oversimplified – all models are wrong but some are useful, but Coase thought that Pigou’s assumptions made his model less useful. One assumption is the epistemic one that I critiqued in Anatomy of Market Failure I (linked above), that we can/do quantify and know the magnitudes of external effects well enough to calculate the “optimal” tax or subsidy. Another assumption is the political economy one, that a neutral government can and will implement this “optimal” policy.

The assumption that Coase attacked head-on was this “polluter pays” simplification:

This paper is concerned with those actions of business firms which have harmful effects on others. The standard example is that of a factory the smoke from which has harmful effects on those occupying neighbouring properties. The economic analysis of such a situation has usually proceeded in terms of a divergence between the private and social product of the factory, in which economists have largely followed the treatment of Pigou in The Economics of Welfare. The conclusions to which this kind of analysis seems to have led most economists is that it would be desirable to make the owner of the factory liable for the damage caused to those injured by the smoke, or alternatively, to place a tax on the factory owner varying with the amount of smoke produced and equivalent in money terms to the damage it would cause, or finally, to exclude the factory from residential districts (and presumably from other areas in which the emission of smoke would have harmful effects on others). It is my contention that the suggested courses of action are inappropriate, in that they lead to results which are not necessarily, or even usually, desirable. (1960, p. 1) 

The problem is that the “polluter pays” simplification ignores the fact that because of the inherent interdependence in the situation, costs are two-sided or reciprocal. Here's where adding in the legal institutions adds clarity to the analysis. Suppose that under existing law the paper mill has the right to discharge waste, and is not legally liable for the cost of the harms associated with that discharge. The paper mill discharging waste into the river creates a cost for the water bottling company (increased filtration). Now suppose instead that under existing law the water bottling company has the right to water of a particular cleanliness. By drawing and bottling water for sale, the water bottling company creates a cost for the paper mill of having to manage its waste. Their conflicting uses of the river create a situation of reciprocal costs. The fundamental problem is the ill-defined property rights in the river, so Pigou was in error when he classified external costs as attributable to one creator. Coase put it more generally:

The traditional approach has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm. ... Another example is afforded by the problem of straying cattle which destroy crops on neighbouring land. If it is inevitable that some cattle will stray, an increase in the supply of meat can only be obtained at the expense of a decrease in the supply of crops. The nature of the choice is clear: meat or crops. What answer should be given is, of course, not clear unless we know the value of what is obtained as well as the value of what is sacrificed to obtain it. (1960, p. 2)

Coase found Pigou’s analysis insufficiently general to reflect the reality of how parties could and do resolve such disputes. He approached the problem differently, asking what the least-cost way of addressing the harm would be. The “polluter pays” approach may be the least-cost way to reduce the harm, but it could also be the case that the other party might be able to redress the harm more cheaply. In the town with the paper mill and water bottling company, if the water bottler can more cheaply install filtration than the paper mill can install pollution abatement, then a Pigouvian tax on the paper mill would be a more costly approach, reducing efficiency and potentially resulting in less harm reduction. Only through a process of negotiation and bargaining, Coase argued, could the parties discover and learn the magnitude of the cost and what approach among many may be the cheapest or best way to ameliorate it. This bargaining process would also lead to the emergence of internalizing the Pareto-relevant external effects that Buchanan and Stubblebine (1962) identified.

Anatomy of Market Failure II: Pareto-Relevant Externality

This discovery process is also conducive to innovation to discover and create different approaches or technologies to internalize an external cost. In the case of the cattle rancher and the vegetable farmer, having to resolve the dispute in a framework of clear property rights is more likely to come up with innovations like barbed-wire fencing, while a Pigouvian tax on ranching would not. Unlike Pigou, Coase’s approach acknowledges that the property rights are unclear in such situations, and that the policy focus should be on clarifying property rights, or clarifying who has the rights to use the shared resource and in what ways.

The real challenge in this more general approach is transaction costs – the costs of the search, communications, tracking, and verification costs that slow or prevent mutually beneficial exchange from occurring. Transaction costs prevent markets from emerging and existing that would otherwise exist. In a simple setting with only two parties and with visible and traceable actions, transaction costs are low; in the paper mill/water company example, they can find each other easily and negotiate to the best possible outcome. In this simple setting the definition of which party is entitled to the rights does not affect their ability to achieve that outcome, but it does affect who pays whom.

If the parties cannot resolve their dispute they have recourse to law, and a legal decision will clarify which party either has the right to discharge into the river (the paper mill) or the right to water of a certain cleanliness (the water company). Coase’s analysis suggests that courts should, and historically generally do, consider which party may be the least-cost avoider of the harm when making such decisions, as well as considering how the assignment of rights affects incentives. Rights that are transferable through markets also reduce the costs of discovering who is the least-cost avoider of the harm.

Most situations are not that simple, though, and with more affected parties over larger spatial areas, transaction costs are high and difficult to reduce. In complex situations like greenhouse gas reduction, transaction costs can fall but are very unlikely to be eliminated. Unlike the simple setting with low/no transaction costs, transaction costs can impede the bargaining process of discovering the least-cost way to address the harm as well as affecting the distribution/who pays whom. That means that the allocation of rights and determination of which party is entitled to the value of rights can affect the efficiency of outcomes.

One insight that I take away from Coase’s work is that a proper role for government policy is to identify the transaction costs that exist in a situation and to take steps to reduce those transaction costs. When advocating a regulatory change, a good practice is to ask if the change reduces transaction costs and enables more decentralized coordination, or if it creates more barriers. If it creates more barriers, are there other ways to achieve the objective of the regulation by reducing or at least not creating transaction costs? Coupling lower transaction costs with more legal certainty about who holds property rights/who bears liability for harms would enable more decentralized methods for internalizing the external effects that should be internalized from an efficiency perspective.