Author:Johnsen, D. Bruce

Many federal regulators are required to perform cost-benefit analysis of rules proposed to correct the failure of private markets to efficiently allocate society's resources owing to so-called "externalities." Yet, as Ronald Coase showed decades ago, social inefficiencies cannot persist if the "costs of market transactions" are zero, putting the entire notion of market failure on shaky ground. Transacting is of course costly, but these are real costs that must be factored into the social welfare calculus. What kind of failure is it when the parties affected by an apparent externality could resolve the inefficiency but in practice decline to do so because the costs of transacting outweigh the net benefits? This article proposes a relatively simple Coasean approach to cost-benefit analysis. Where the parties deal face-to-face in competitive markets, a rule is justified only if the regulator can show it is likely to reduce the relevant transaction costs. If so, the parties can be relied on to adjust their private arrangements to maximize the net gains from trade out of self-interest. There is no need for the regulator to quantify costs and benefits. This is information the parties--the men and women "on the spot"--are best able to identify on their own.

INTRODUCTION I. OVERVIEW OF COST-BENEFIT ANALYSIS OF FEDERAL REGULATION A. Brief History B. Executive Agency CBA C. Independent Agency CBA D. The Scholarly Literature II. OVERVIEW OF TRADITIONAL COST-BENEFIT ANALYSIS A. Assessing Welfare in the Basic Neoclassical Model B. Market Failure as a Basis for Corrective Rules III. A CLOSER LOOK AT MARKET FAILURE A. From Pigou to Knight to Coase B. Externalities Everywhere and Nowhere IV. WHAT ARE TRANSACTION COSTS? V. SUMMARY AND CONCLUDING REMARKS "[W]hatever we may have in mind as our ideal world, it is clear that we have not yet discovered how to get to it from where we are." (1)

"What I think will be considered in future to have been the important contribution of [The Nature of the Firm] is the explicit introduction of transaction costs into economic analysis."2 --R.H. Coase


Economists have struggled for decades over how to do reliable cost-benefit analysis (CBA).3 During this time, Reagan-, Clinton-, and Obama-era executive orders and federal case law have increasingly required executive agencies to address "material failures of private markets" by integrating CBA into the rule-making process, with the stated objective being to "maximize net benefits" to society. (4) Federal statutes and case law have recently extended the CBA mandate to include independent agency rulemaking, primarily by financial regulators. Yet substantial controversy continues to swirl over the feasibility of CBA in a variety of settings and for a host of reasons, the most important among them being uncertainty in quantifying costs and benefits. (5)

The neoclassical model of market exchange provides the theoretical foundation for traditional CBA. It illustrates the welfare effects of trade embedded in market demand and supply assuming, among other things, that people behave "as if" they are rational maximizers, (6) that the affected parties face zero transaction costs, and that there are no externalities. In equilibrium, the model hypothesizes that market prices reflect marginal benefits and costs, and that the parties will capture all possible gains from trade in the form of consumer and producer surplus, which together constitute net social benefits or "social welfare."

The neoclassical model's main scientific function is to predict the direction of affected parties' response to parametric shocks, a method known as comparative statics. If the tax on cigarettes increases, for example, will the price, quantity traded, and quality of tobacco increase or decrease? The model makes no predictions about the magnitude of these changes, only their direction. (7) According to the theory, all that is necessary to make predictions in the basic model is that demand curves slope down and supply curves slope up, that some observable parameter has changed, and that the effects of the change can be measured ordinally. (8) The neoclassical model has tremendous predictive power in this regard. It is testable, has been tested, and has gone largely unrefuted. (9) Federal courts have found it sufficiently reliable to be admissible into evidence as the basis for expert opinion testimony under the Daubert standard, which establishes testability, or falsifiability, of the underlying theory as one important factor. (10)

In contrast to comparative statics, CBA attempts to cardinally measure, or to quantify, the magnitude of changes in total consumer and producer surplus from the imposition of a proposed regulatory rule. This requires an estimate of consumers' subjective willingness to pay for a good and producers' subjective willingness to provide the good along the relevant range of demand and supply. These values are exceedingly difficult to measure reliably. Various workarounds can be used, but ultimately in many settings CBA would have difficulty passing muster under the Daubert standard for the admissibility of expert opinion testimony. How, for example, could someone who wants to challenge the accuracy of a CBA test it and refute it other than to criticize its methods and offer a contradictory CBA, which may be more convincing but will be equally untestable?

A critical question largely ignored in the recent CBA debate but embraced here is why regulation is justified to begin with and how the answer to this question affects the policy analysis. At least as far back as the writings of A.C. Pigou almost a century ago, mainstream welfare economists have asserted that regulation by an omniscient social planner is justified when markets fail to efficiently allocate resources owing to so-called "externalities"--situations in which one party takes an action that imposes costs or bestows benefits on another party but fails to account for them in choosing his activity level. (11) As a result, in pursuing his self-interest he does too much or too little of the activity, leading to socially inefficient resource allocation--failure to maximize net benefits to society. The accepted policy implication is that government regulation correcting the market failure is necessary to improve resource allocation and increase net benefits.

In his path-breaking work The Problem of Social Cost, Nobel laureate Coase turned this belief on its head. (12) He showed that any prospect of inefficient resource allocation creates an opportunity for market participants to benefit by internalizing the externality through private transactions. Put more simply, people can profit by resolving inefficiencies. If transaction costs were zero, the parties would negotiate to maximize net benefits out of self-interest. A change in the regulatory rule would have no effect on resource allocation or the parties' joint welfare and government regulation would be unnecessary. (13)

Transaction costs are never zero, and they inevitably increase with the number, size, and complexity of transactions, eventually overwhelming the benefits from negotiating further adjustments. Some inefficiency will persist in the form of hypothetical resource misallocation, by definition a state of affairs in which marginal social benefits fall short of marginal social costs or vice versa. Potential net benefits are lost, but only because the transaction costs the parties must incur to capture them are even greater. Transactions costs are real costs to society and should be factored into the social calculus. In a given regulatory framework, the parties will negotiate what they privately perceive as efficient resource allocation with due consideration for the costs of transacting. The outcome is an equilibrium in the sense that neither party has any incentive to negotiate further adjustments given the transaction costs they face, and the conclusion must be that net-net social benefits are maximized. In a dynamic world, the parties have ongoing incentives to identify and adopt practices that reduce the cost of transacting and move their equilibrium toward first-best resource allocation.

Coase's main point, often misunderstood, is that transaction costs explain why the rule of liability--here, the regulatory rule--affects resource allocation. Rather than asking whether the overall benefits of a proposed rule will exceed the overall costs, in a Coasean framework the proper question is simply whether, at the margin, a proposed regulation will reduce the parties' costs of transacting. If not, the regulation should be scrapped absent convincing evidence that its benefits exceed its costs. (14) If so, regulators should move forward confident that people can be counted on to perform their own CBA "on the spot," or not, and make all efficient adjustments to the new rule based on their "knowledge of the particular circumstances of time and place." (15) This knowledge is fleeting, circumstantial, and inherently unavailable to outside observers because it re quires them to identify a counterfactual, yet another reason quantified CBA of proposed regulation is so difficult. (16)

This analysis is not to say private markets solve all problems or that government regulation is incapable of improving resource allocation. As a policy matter, it simply says that in low-transaction-cost settings, such as where the parties deal face-to-face in competitive markets, regulation is justified if it reduces the parties' costs of transacting. It is insufficient to identify so-called "problems" that need correcting without having credibly made this showing. Only then can it be properly characterized as a market failure calling for a corrective rule. Regulators should bear this fundamental point in mind when performing CBA of corrective rules in keeping with their executive order charge to base new rules on "the best reasonably obtainable...

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