Coase, Demsetz, and the unending externality debate.

• Author: McChesney, Fred S.
• Position: Ronald Coase, Harold Demsetz

Economists, trained in the study of markets, learn early of various problems grouped under the heading of "market failure"--situations that, at least potentially, could justify government intervention to solve them. Cartels and monopolies, for example, are thought by many to require government antitrust action; optimal production of public goods like national defense or national highways likewise are frequently said to necessitate government intervention in otherwise private markets.

Almost certainly, however, externalities (or "social costs") are perceived as the greatest market failure problems. (1) Harold Demsetz (2003: 283) (2) recently described the fundamental economic issue:

The short-hand description for this [externality problem] is that private costs (or benefits), which do influence a resource owner, are not equivalent to the total of social costs (or benefits) associated with the way an owner uses his resources. An example ... concerns the use of soft coal by a steelmaker. The soft coal produces soot. The soot descends on a neighboring laundry, making it more difficult for the laundry to clean its customers' clothes, but this cost is not faced by the owner of the steel mill when he decides to use soft coal to fuel the steelmaking process. Perceptions that externalities are ubiquitous have helped produce a generation of large-scale governmental interventions in the form of national environmental legislation and related regulation.

The externality issue has also occasioned rethinking of basic economic principles, particularly in the context of Ronald Coase's (1960) celebrated article, "The Problem of Social Cost." As is now well understood, Coase explained that externalities were themselves manifestations of a more fundamental issue in economies, the costs of transacting over rights to undertake actions that affect other people. Low transaction costs allow internalization of social costs, and so reduce the incidence of externalities; as those costs rise, so does the extent of externalities. Coase's analysis of the problem of social cost has been so powerful that economists, almost automatically, now think of social costs as a problem only when transaction costs are perceived to be relatively high. In the limit, if there were no transaction costs, there seemingly would be no social costs.

Yet, Coasean analysis of externalities has been the subject of much confusion, even disagreement. Demsetz (2003) in particular has pointed to aspects of the Coase approach that, as a matter of both economics and of government policy, he finds problematic. As a matter of economics, Demsetz says, Coase's focus on transaction costs is not helpful in resolving questions concerning externalities. Even in a hypothetical world of zero transaction costs, Demsetz writes, externalities would still exist. Moreover, Demsetz fears, focus on transaction costs as the reason for the persistence of externalities furnishes spurious reasons for undesirable government intervention in markets.

The recent Demsetz objections to Coase's approach concerning externalities are considered further in the next section. I then evaluate those objections. To a considerable extent, Demsetz ignores points that Coase has made, not in "The Problem of Social Cost," but elsewhere. At the same time, Demsetz adds new insights to the Coase Theorem, in particular emphasizing the weakness of arguments for government intervention to solve externality problems even in the presence of high transaction costs. At points, the present article may read like a literary explication de texte. But in fact, the Demsetz critique raises fundamental economic issues, some new and others worth revisiting.

Internalizing External Costs: Demsetz on Coase

The Coasean Model

"The Problem of Social Cost" sought principally to dispel what Coase saw as economists' unquestioning acceptance of A.C. Pigou's claim that the imposition of costs on one entity (person, firm) by another was reason for government intervention in the otherwise private ordering of economic affairs. (3) By this "Pigovian tradition," (4) as Coase refers to it, intervention might take various forms, such as the imposition of liability on the party creating the costs, or taxes to align private with social cost, or zoning-like expulsion of the offending party to a place where no costs could be imposed on others. Contrary to Pigou, Coase (1960: 2) argued that these "suggested courses of action are inappropriate in that they lead to results which are not necessarily, or even usually, desirable."

The essence of what is now known as the "Coase Theorem" is familiar; only its essential points need emphasis here. Coase assumes that the rights to use a resource are (or will be) well defined and enforced. Coase typically refers to the definition of rights as the result of a judicial process. (5) But his analysis applies just as well to nonjudicial definitions of rights. (6)

Once rights to use a resource are defined, the ultimate use of the resource need not depend on who owns the rights. Although "the delimitation of rights is an essential prelude to market transactions ... the ultimate result (which maximizes the value of production) is independent of the legal decision" (Coase 1960: 27). Regardless of who owns the rights initially, subsequent negotiations between owners will move resources to the highest-valued use. Let the right to clean air belong to the laundry. If the value of emitting smoke exceeds the costs to the laundry, the steelmaker will pay to pollute. Alternatively, let the steel mill possess the right to pollute the air. Because the value of polluting is worth more to the mill than the costs to the laundry, pollution again will occur. Correspondingly, if the relative cost-benefit magnitudes are reversed--that is, if the cost of pollution to the laundry exceeds the benefits to the mill--there will be no pollution, regardless of which firm owns the right to the air.

However, this proposition assumes that there are zero (or trivial) transaction costs. Whether ownership is irrelevant for the ultimate use of resources is "'dependent on the assumption of zero transaction costs ... That is to say, with zero transaction costs, the value of production would be maximized" (Coase 1988: 158). But with important transaction costs, resource use may not be optimal. High transaction costs mean that the definition of rights may affect the use to which resources are put. Important transaction costs preclude negotiations between the steelmaker and the laundry. Judicial definition of rights to emit or not to emit smoke therefore determines whether the smoke will be emitted, regardless of the relative benefits and costs of pollution. Thus, in the Coasean model with positive transaction costs, judicial determination of rights may result in economic loss.

This Coasean approach to externalities has become economic orthodoxy. However, Harold Demsetz has recently challenged the Coase construct. Demsetz raises two objections. He writes that Coase's arguments concerning transaction costs, while not erroneous, are not sufficient to resolve issues concerning social cost. Moreover, Demsetz claims, inherent in the Coasean approach is the potential for mischief, in the form of unwarranted government intervention when social costs present themselves.

Demsetz on Coase: Transaction Costs

Demsetz rejects the centrality of transaction costs to the existence of externality problems. Regardless of whether transaction costs are high, low, or nonexistent, Demsetz writes (2003: 284), externalities will exist--that is, resource owners will not take into account the full social costs of their activities.

[W]hat I have to say, because I deny the importance attached by Coase to transaction cost, allows us to reject the externality problem in eases in which transaction cost is positive as well as those in which it is zero.... The elements I stress differ from Gosse's, but they also serve to restrict the set of economic activities described as exihibiting policy-relevant externalities. Externalities will persist because phenomena other than transaction costs are relevant to solving the problem of social cost. The two firms could always merge. If a single firm owns both the steel mill and the laundry, there are by definition no external effects from smoke; all costs are internalized.

But a merger would result in a conglomerate firm operating both a steel mill and a laundry, producing what Demsetz terms "management costs," even as transaction costs are eliminated. Greater management costs may arise when a single facility is "devoted to different purposes," that is, there are costs in foregone specialization (Demsetz 2003: 284). Those who specialized in producing steel now must also operate a laundry, and vice versa. With unified ownership, the externality problem facing the mill and the laundry is solved, but only at the cost of lost specialization in producing only steel and only laundry. "It is increased reliance on specialization that is the source of costly interactions that bear the externality label," not transaction costs (Demsetz 2003: 284).

According to Demsetz (2003: 289), "It costs something to engage in transactions, but it also costs something to complicate managerial operations in a unified ownership structure ... [I]f ownership were unified, there also would be greater management cost in controlling the more complicated interface between the steel mill's operations and the operations of many industries." Thus, Demsetz sees the externality problem as merely subsidiary to more fundamental issues involving ownership of rights: "optimal ownership rearrangement not only economizes on transaction cost, [but] it essentially undermines the very existence of the externality problem" (Demsetz 2003: 286). That, says Demsetz, is critical to one's thinking about externalities: "Coase showed that resources are not misallocated in neoclassical...