The Coasean framework of the New York City watershed agreement.

AuthorBlack, Geoffrey
PositionReport

Over 50 years ago, in "The Problem of Social Cost," Ronald Coase (1960) attempted to reorient the economics profession's treatment of externalities. He wanted to draw economists' attention away from the world of pure competition as a policy standard and investigate the consequences of transaction costs and property rights for the operation of markets. In 1991, he was awarded the Nobel prize in economics "for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy" (Royal Swedish Academy of Sciences 1991). The Academy cited both his 1960 article and his 1937 article "The Nature of the Firm."

Still, critics question both the relevance and applicability of the Coasean framework for analyzing, explaining, and ameliorating harmful effects associated with economic activities, reflecting the degree to which the profession's treatment has remained unchanged. Nalebuff (1997: 35-37), for example, has argued that for environmental problems "as the scope of the externality affects more and more people, it becomes increasingly difficult to assign property rights." Moreover, "even when property rights have been assigned, exclusion is difficult if not impossible." In this article, we argue that the New York City Watershed Memorandum of Agreement (MOA) proves the usefulness of the Coasean framework--even when there are a large number of affected parties from nonpoint source pollution.

In 1997, nearly a decade after the Environmental Protection Agency ordered New York City to filter its water to remove contaminants originating in upper New York State watersheds, NYC entered into a MOA involving the State of New York, a number of local governments and environmental groups in the Catskills, and the EPA. In Coasean terms, the MOA is the consequence of the State of New York's assignment of property rights to the Catskill/Delaware Watershed communities to continue with regional development and current practices, although some of those activities degrade NYC's drinking water. This rights assignment positioned NYC as the responsible party for initiating negotiations and programs protecting the Watershed system. Once responsibility was established, NYC opted to buy lands contributing to water quality degradation (for example, farmlands on riparian corridors), instead of building a multibillion-dollar filtration system. Residents and landowners upstream were compensated for development restrictions incurred from the MOA. New York State's role as mediator eliminated bargaining barriers and effectively reduced the transaction costs of arranging negotiations, demonstrating potential economic benefits to all parties, and providing alternative options to unilateral regulatory decisionmaking.

Externalities and the Pigouvian Tradition

Externalities exist when the effects of a transaction between two parties spill over to nonparticipants. Effects can be either beneficial (positive externalities) or harmful (negative externalities) to non-participants. When externalities are unaccounted for in the decision-making of the participants, transactions will result in either "too much" or "too line" consumption or production. This very language, which economists use, derives from modern welfare economics founded on Pigou's extension of marginal analysis to the utilitarian market-failure analysis of J. S. Mill and Henry Sidgwick (Medema 2009).

In the history of welfare economics, the classical approach to solving negative externality problems, such as pollution, was through the use of regulation, or what Mill (1871) termed "authoritative" solutions, "in which certain types of conduct are prescribed or proscribed" (Medema 2009: 37). Sometimes referred to as "command and control" policies, authoritative solutions prohibit firms from producing a negative externality, require a certain standard of emissions of a negative externality be reached, or require firms to employ specific externality-reducing technologies, all backed by legal penalties. The costliness and difficulty of obtaining information tailored to specific firm production methods, in conjunction with the nondiscriminatory or universality requirement of legal standards, generally yield uniform standards across all firms in an industry. Yet, this type of policy response often imposes solutions that are more costly than alternatives, inhibit innovations in pollution-reduction technologies, and deter economic growth (Marlow 1995, Davis 1992).

Modern welfare economics, based on the work of Pigou in The Economics of Welfare (1932), offers "corrective" taxation as another solution. Pigou raised the solution specifically in relation to spillovers, where he assumed there was a divergence between private and social net products. Pigou (1932: 174) also addressed spillovers due to "the separation between tenancy and ownership of certain durable instruments of production." This divergence, he believed, could be removed by renegotiating the landlord-tenant contract. However, Pigou (1932: 192) argued that spillovers could not "be mitigated by a modification of the contractual relation between any two contracting parties, because the divergence arises out of a service or disservice rendered to persons other than the contracting parties." He did not address the reasons why a contract could not be concluded by the contracting parties with those "persons other than the contracting parties."

The Pigouvian tax solution to a pollution externality places responsibility on the firm producing the pollution. The government then imposes a tax on emissions of a magnitude equal to the divergence between social and private marginal costs, so that the external costs are internalized into the decisions of the polluting firm. Pigouvian taxation differs from authoritative regulation because firms that pollute above a set amount are forced to pay an emissions tax. (1) Although Pigouvian taxation reduces pollution at a very low cost, there are problems that may arise. First, Pigouvian taxation will achieve pollution reduction only as long as the tax level is set equal to or above the marginal cost of abatement (MCA). In the event the tax rate is set below the MCA, pollution reduction will not take place. Second, because some firms may have "modern, well-maintained pollution control equipment," while other (typically, older) firms possess outdated pollution control equipment, it is inefficient "for all firms to carry identical burdens" (Marlow 1995: 96). Third, even if those harmed by the pollution are compensated from corrective taxes, further complications may arise. Compensation is bound to be difficult when not all affected parties suffer from the problem equally. Fourth, it is costly to discover the appropriate level of the corrective tax, and the information costs may exceed the benefits from implementing the Pigouvian tax. Fifth, "compensation policies may also create a perverse incentive for individuals or firms to move into areas for the sole purpose of receiving compensation payments" (Marlow 1995: 96).

In sum, Pigou's analysis in both The Economics of Welfare and his earlier Wealth and Welfare (1912) provided a list of examples where self-regarding behavior creates divergences of private and social net product (benefits, costs) providing "a strong sense that market failure is a pervasive problem" (Mederna 9,009: 64). 2 The Pigouvian framework, as further developed by Bergson (1938), Lange (1942), Meade (1952), Graaf (1957), and Bator (1958) in mathematical form, gave to modern welfare economics a seemingly powerful tool and standard for welfare improvement:

The rhetorical, persuasive force of this analysis should not be underestimated. What this theory demonstrated, in a nutshell, was that perfect markets work perfectly, imperfect markets work imperfectly, and perfect government can cause imperfect markets to also function perfectly. This became the textbook model [Medema 2009: 76].

The Coasean Argument and Framework

For Coase, the Pigouvian framework fails on several grounds, but most fundamentally, he notes:

Analysis in terms of divergencies between private and social products concentrates attention on particular deficiencies in the system and tends to nourish the belief that any measure which will remove the deficiency is necessarily desirable. It diverts attention from those other changes in the system which are inevitably associated with the corrective measure, changes which may well produce more harm than the original deficiency [Coase 1960: 42-43].

What is necessary, according to Coase (1960: 34), is an approach comparing the total social product of alternative measures that gives attention to alternative specification of property rights and the transaction costs associated with different property rights regimes. He rejects the Pigouvian framing of the problem in terms of "restraining the producer" of the negative externality:

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 [Coase 1960: 2].

Indeed, making "restraining the producer" the problem to be solved dictates the solution--whether making the producer liable for damages, imposing a tax, offering a subsidy, or restricting the producer's location. Such "solutions" take for granted that restricting the producer causes less harm than restricting the recipient. Coase (1960: 3) contends that the Pigouvian "courses of action are inappropriate, in that they lead to results which are not necessarily, or even usually, desirable." According to Coase (1960: 3), "If we assume that the harmful effect of the pollution is that it kills the fish, the question to be decided is: is the value of the fish lost greater or less than the value of the product...

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