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Market Failure 2: Externalities (Coase and Effect)

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?

Ronald Coase, The Problem of Social Cost

An externality is a cost (or benefit) of a market activity that does not accrue to the parties to the transaction. They are external to the transaction, hence the name. These can be negative like pollution, or positive like the herd immunity of vaccinations.

Externalities are a problem for markets because they introduce a bias into the price signal. Prices are supposed to account for all the costs and benefits generated by the production and consumption of a good, but in the case of externalities, some of those costs are left out. This leads markets to under-produce goods with positive externalities and over-produce goods with negative externalities.

The first economist to identify externalities and suggest how to deal with them was Arthur Cecil Pigou, in 1920. His proposed solution was to use taxes on products with negative externalities, and subsidies for ones with positive externalities. If the government can estimate the magnitudes of the external costs and benefits, it can improve the market’s function by bringing the market’s price closer to where it should be. In honour of his contributions, we refer to this kind of intervention a Pigouvian Tax (or subsidy).

A couple of quick notes on doing Pigou right:

  1. Magnitudes matter. The purpose of the exercise is to fix a bias in the pricing system, so the goal is to set the tax / subsidy at a specific price. Estimating that price can be a tricky exercise, but you should at least try to be confident the price you settle on is closer to the real value than $0 would be, since that’s the price you could impose by doing nothing.
  2. The market may not react exactly the way you expect; assuming you’ve paid attention to point 1, this is a feature, not a bug. The advantage of Pigouvian interventions over more direct regulation (like bans, mandates and similar) is that the market’s discovery process is working for you. Some producers will respond to a tax by changing their production methods, some will end up contracting due to reduced consumer demand, and others will decide that eating the extra cost is cheaper than doing anything different. The market figures all this stuff out so you don’t have to.
  3. It doesn’t really matter where in the production chain the tax or subsidy is placed. As I’ve discussed before, taxes and subsidies are passed through the system. Just tax or subsidise whichever part of the process is administratively easiest.
  4. For reasons of distributional equity, many people advocate using revenue from Pigouvian taxes to compensate those hurt by the externality (or tax those who benefit from an externality to pay for a Pigouvian subsidy), but this isn’t actually necessary from an efficiency standpoint. All that matters is that the market price is corrected; beyond that the market will work fine, no matter what happens to the money.

So this may all seem pretty simple so far, right? Well let me disabuse you of that by introducing the other big name in externalities – Ronald Coase.

Coase is one of the genuine legends of economics and he wrote one of the most important, and misunderstood, articles in economics: The Problem of Social Cost. For those who have heard of Coase at all, they may have heard of the “Coase Theorem,” which is sometimes rendered as “private bargaining can deal with externalities,” occasionally with a caveat about transaction costs. But this misses the complexity and importance of Coase’s contributions to externalities.

What Coase offered was a different approach to thinking about externalities, though one that is not necessarily opposed to Pigou’s. Coase used a simple example to show how complex externalities can be:

Consider a rancher and a farmer who are neighbours. The farmer grows crops, and the rancher raises cattle. Left to their own devices the cattle will trample and/or eat the crops, to the detriment of the farmer. The Pigouvian solution would be to tax the cattle, and while that works, there are several other options that would work just as well:

  1. Make the rancher liable for damages. The rancher would have to compensate the farmer for any damage, leaving them to either simply pay out when they need to or come up with some cheaper solution like fencing their cattle in or moving them somewhere else.
  2. Don’t make the rancher liable for damages (bear with me here). If the farmer bears the losses from cattle damage they can fence their crops in to prevent damage, or if that’s too expensive pay the rancher to go elsewhere or reduce their herd.

The important point is that from an efficiency standpoint it actually doesn’t matter who pays for the damage, as long as the government makes it clear who has to pay. The rancher and farmer can figure out between themselves what happens from there. Clearly each side benefits more from one assignment of rights than the other, but from a social efficiency standpoint it doesn’t matter – the lowest cost outcome will prevail regardless. This leads to the standard economists’ formulation of the “Coase Theorem.”

In the absence of transaction costs, private bargaining will be efficient no matter how responsibility for an externality is assigned.

Doubtless many of you are already formulating objections, but let me cut you off before you go there. Coase was well aware of how important transaction costs are in the real world; the complexity of the real world was one of the recurrent themes in Coase’s work throughout his life. His point was that how rights should be allocated will depend on those real-life complications (and distributional concerns), not the demands of allocative efficiency. Coase showed us that an externality problem can be thought of as a market that has failed to emerge and that sometimes the government’s best option is to facilitate the creation of a market to solve the problem (you may be familiar with this option under the name Cap and Trade). And sometimes private bargaining will do the job and all the government needs to do is mediate the dispute. And sometimes you need a Pigouvian solution after all.

The primary factor that determines whether private bargaining will be sufficient is how local the externality is. If all the affected parties are near each other, or better yet are already doing business with each other, then private bargaining may well be sufficient. For more diffuse externalities, more direct intervention may be necessary.

The other side of Coase’s insight is that classifying something as an externality is equivalent to saying that someone’s rights are being violated in some way. This means that you can define externalities based on who has the right to do what. This helps answer some uncomfortable edge cases that can render Pigou problematic.  For example: should forms of expression that the majority finds offensive (like flag burning or blasphemy against the majority religion) be taxed? It takes a bit of hand-waving to dodge this question with a Pigouvian framework, but Coase makes it much easier – offence is only a negative externality if people have a legally-defensible right to not be offended.

As an aside, this is why I am uncomfortable when people use the argument that unhealthy things should be taxed because unhealthy people cost the government more money. By saying that a person’s lifestyle imposes a negative externality on the government, you are implying that the government has a property right in our bodies, and is entitled to compensation if you misuse its property. I much prefer the reverse model, where the government subsidises healthy actions (if doing so would save the government money) as that assigns rights of bodily autonomy to people rather than to the government.

Tune in next week where we’ll be discussing imperfect competition.

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James is a government policy analyst, and lives in Wellington, New Zealand. His interests including wargaming, computer gaming (especially RPGs and strategy games), Dungeons & Dragons and scepticism. No part of any of his posts or comments should be construed as the position of any part of the New Zealand government, or indeed any agency he may be associated with.

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166 thoughts on “Market Failure 2: Externalities (Coase and Effect)

      • The subject is a fun/interesting one. Noone likes being on the receiving end of a negative externality; believe me I know. Externalities are the yawning fissure that keeps me firmly out of the libertarian camp.


        • There’s plenty of room in the libertarian camp for people who support correction of externalities. See, for example, the Pigou Club, whose membership includes a number of prominent libertarians.

          I would argue that the left is worse when it comes to externalities, as much left-wing economic policy creates and aggravates negative externalities.


          • That’d be why I’m happily parked in the center left which, while being lamentably vulnerable to corporatism, I feel strikes closer to the right balance between markets and government. I like libertarianism but I think it’s enormously more useful as a razor/critique.


          • I remain distinctly unimpressed towards Libertarian solutions to externalities, particularly in the areas of the environment and workplace safety. My reading of history tells me that the incentives are for industrialists to pollute and create unsafe workplaces in the name of short and medium term profit.


            • The Pigou Club, which I linked above and whose purpose is to advocate taxation of fossil fuels, was founded by Greg Mankiw, a libertarianish Republican, and also contains a number of other prominent libertarians. Most serious libertarian thinkers have no problem with environmental regulations as such, and part company with the left primarily on the issue of cost-benefit analysis.

              Externalities have nothing to do with workplace safety, as both the worker and the employer are party to the employment relationship.


              • I don’t disagree with the Pigou Club on a carbon tax on fossil fuels; I disagree with them on the things that follow. At this point in time, anything done about fossil fuel consumption is going to be a Pigovian tax in practice because the only option is to use less [1].

                Where I disagree with them is that a tax on carbon-rich fuels and the resulting price increases in consumer energy are part of an enormously complicated system. The poor spend 16% of their household income on energy; the rich less than 6%; a straight increase in price falls much more heavily on the poor in terms of its effect on their household budget. Some of the Club want to cut other taxes to offset the carbon tax (which also offsets some but not all of the benefit), but are all over the place, and often with ideology on clear display in their proposals. Eg, cut payroll taxes, which does nothing for the unemployed.

                [1] Eg, “we’ll switch wholesale from coal to natural gas” has to be delayed while more wells are drilled, pipelines laid, power plants converted, etc. Years. When the sulfur dioxide cap-and-trade program went in the 1990s, there were multiple more immediate options: fuel switching, coal washing pre-combustion, multiple scrubber tech that acted on combustion gases, etc. The big winner, though, came out of left field: Wyoming increased low-sulfur coal production much faster than anyone thought possible, and the big railroads added shipping capacity much faster than anyone thought possible. So we have, for example, the Scherer plant in Georgia meeting its SO2 target by burning three trainloads per day of Wyoming coal.


  1. Before I jump into the post, I want to comment on the quote as it deeply resonates with me.

    I often thing about that very topic. To perhaps use some terms in non-technical manners, I am more often harmed by restrain than force. I want to do something with some other person but they don’t want to for any reason and I cannot force them to. And, technically, they can’t force me not to but they can choose not to… which in a way sort of forces me not to do what I want to do because part of what I want to do entails that other person being a part of it. But because forcing someone TO DO something is different than forcing someone NOT TO DO something and because the default position tends to be NOT DOING something, the assumption tends to be that harm is only able to flow in one direction: if I force that person to do the thing. But this doesn’t seem to fully account for other forms of harm.

    This isn’t necessarily about externalities but it does have to do with how we assess the harm done during different interaction and the bias I think we generally have (and perhaps rightfully so) to one side of the relationship.


    • I’m not sure I’m reading your comments correctly, but I don’t see the issue with “not to do” something. I can’t force Audi to sell me a R8 for 20K. There is no harm there. And perhaps, in your example, “I want to do something with some other person but they don’t want to for any reason and I cannot force them to.” is true, but it’s more likely true if you add “at the price I want to pay.” This is completely different than, say the ACA, which forces you to purchase something you don’t want.


      • I think the ACA is exactly what he’s talking about, in the sense of “I can’t buy health insurance unless everyone else does too, and so if the government does not force everyone else to buy health insurance, it causes me harm”.


        • The issue with health insurance is trying to balance several concerns like covering offering universal coverage and not allowing insurance companies to deny HI to people who are expensive to treat. If you don’t care about those issues that simplifies things mightily. But if you are going to eliminate those problems then getting everybody to pay in when they are currently healthy becomes much more important. Especially since for almost everybody people are temporarily healthy and will need some expensive care at some point. If people can wait until they get sick to get insurance that sporks up the business model for insurance companies.


        • Then Kazzy’s clearly wrong because people had private non employer based health insurance prior to the ACA. Perhaps not at the price they preferred and/or with lots of limitations, but it DID exist. Witness the bitching from all the people who’s plan got cancelled when they didn’t comply with the ACA minimums.

          Regardless, he wasn’t harmed, but making people, through force of federal law, buy insurance they don’t want, sure as hell harms a lot of folks.


          • Well, during the sausage grinding which resulted in the ACA, insurance company reps specifically said that in order to remain profitable certain folks simply couldn’t be insured: folks with pre-existing. So basically they copted to the fact that the current model (for profit!, no guarantee issue!) entailed that the folks who most needed insurance couldn’t, and wouldn’t, get it. Now, that isn’t a harm based on your definition of that term, but it is pretty fucked up, right? That the unregulated market, via recission and rejecting folks with PECs, deprived people who actually needed insurance of getting it?

            The only protection they had from that market-based decision-calculus was getting or maintaining their already gotten employer-based health insurance.


            • That the unregulated market, via recission and rejecting folks with PECs, deprived people who actually needed insurance of getting it?

              I talk about insurance in Part 5, I’ll be able to explain some of what is going on there to you at that point, but there’s an important government action that is causing insurance companies to behave that way.


      • I meant on a more personal level. I want to go to the circus with Damon. Damon doesn’t want to go to the circus (either at all or with Kazzy). Result: Damon gets his way, Kazzy doesn’t. Which is (probably) how it ought to be. But we can’t ignore that Kazzy experiences harm. Even if we don’t find Damon cuplable.


        • No. You were not “harmed” Kazzy. Social rejection isn’t an economic harm. Of course, you should find better friends that this loser Damon who won’t go to the circus with you!


          • Which touches on the point that economic analysis is one tool, but only one tool that can be brought to bear when considering public policy.

            Socially excluding people IS a tremendous harm, just not an economic one.


        • I’ll take a different tack than Damon: Yes, you were harmed, but the balancing factor is your right to not be harmed against Damon’s right to not be forced to take undesired actions. Incorporated into that balance is the extent of your harm, versus the extent to which Damon would suffer harm accommodating your wishes.


          • Oh, I agree. But sometimes we say that Kazzy suffered NO harm. Which I think is wrong.

            My ex and I battled over this. I physically needed to hugged firmlt in a similar, if not stronger, way than she needed to not be hugged firmly. Firm hugs hurt her and we all get that. But a lack of firm hugs hurt me… Actual physical discomfort. But that sounds crazy to people who don’t experience physical discomfort at the lack of input. That doesn’t give me a right to hugs — from her or anyone — but the harm remains and at least deserves acknowledgement.

            It’s like our tendency to insist on quietness for people who need it while ignoring that some people *need* noise in the same way others need quiet. Because being overwhelmed by quiet (like I am!) sounds crazy!


    • This isn’t necessarily about externalities but it does have to do with how we assess the harm done during different interaction and the bias I think we generally have (and perhaps rightfully so) to one side of the relationship.

      I don’t think it does have anything to do with externalities, actually. The hypothetical James introduces is two people engaging in private activities to further their own rational self-interest in which one person’s activities harm the other person’s interests. Force only comes into play when talking about possible solutions to the putative harm.


    • I want to do something with some other person but they don’t want to for any reason and I cannot force them to.

      Of course I know you don’t mean the most obvious example of this, but it would be interesting for you to explain how that’s different from what you do mean.


      • Suppose I am a sex addict who gets jittery if I go too long without sex. And the jitters hurt. Does that entitle me to sex? Fuck no. But if I can’t find anyone to have sex with and get the jitters and spend a day hurting… Well, I’m hurting, no? Maybe the blame lies with my physiology or psychology… I’d *never* lay it at the feet of the people who didn’t have sex with me… Or maybe no one or nothing is to “blame”… But the hurt/harm exists.

        Now that is an extreme example and yet I think you can work backwards from there and still jibe my argument.


        • Not to get all notme about this, but when did emotional pain become a political issue? Has it always been that way and I never noticed, or are people so entranced by postmodern narratives that they can no longer distinguish between the two?


          • The histories and memoirs of those involved in the civil rights movements- both racial and sexual orientation- made it clear that the social exclusion was a major motivating factor.

            Being told you can’t vote is one thing, sort of abstract and remote; being told to sit at the back of the bus stings on a very personal level.

            I know Kazzy and Mike were sort of kidding around, but non-economic harm is very powerful.


            • You don’t have to quantify it.

              You merely have to talk about how important it is when you’re using it as a weapon. Alternately, you have to talk about how subjective it is when you’re defending yourself against someone using it as a weapon against you.

              There’s also a handful of ingroup/outgroup games that you can play but those are the big two.


            • The usual way. How much is it worth to you in cash to always have to sit in the back of the bus?

              And I’m not joking. That’s the way that “value” is quantified. Period. It’s no different from “How much is it worth to you to live in a gated community and not ever have to see any riffraff?”


              • Mike,

                Changing the policy requiring her to sit at the back of the bus didn’t have anything to do with her feelings, tho. If it did, we’da taken into consideration the feelings of white people as well and called it a draw where a tie goes to the status quo.


              • That would have been an interesting solution…

                New rule, you can’t sit at the front of the bus unless you are a fare paying rider. If you want to ride for free, you have to sit in one of the free seats at the back of the buss.


            • Serious question: Is physical harm — e.g., a broken bone, a split lip, a black eye (which have decreasingly economic ramifications) — economic harm inherently?

              I have a crazy idea that we are biased towards certain types of harm over others because of the tangible measurability of certain types (which might be a fancy way of delineating between objective and subjective).

              But the idea that we say, “Well, that guy has a black and blue and I can see it so it’s real and that guy has emotional distress and I can’t see it so it’s not real,” feels really cave-man-esque. Very “Sticks and stones…”-esque.

              But damned if I have a solution!


              • This is why I keep referring to this sort of analysis as one tool, not the entirety of the toolbox which we use to evaluate policy choices.

                Family law, estate tax law, agricultural policy, environmental law, are just things that I can name immediately that are crafted out of non-economic, non-rights centered analysis.


              • I think you are right about the bias. Physical harm is measurable, thus it is easy to develop models of compensation. And yes, physical harm is economic, since it can cost you money to fix, and it can prevent you from engaging in productive (or valuable leisure) activity.

                This is not to say that psychological/emotional harm can not prevent you from engaging in valuable activity, or that it has no cost to treat, only that the question of how to compensate is much more difficult because the effect is so subjective & difficult to measure (& thus much easier to be used to perpetrate fraud).

                As our knowledge of mental health issues grows, this may change.


                • On this we are in agreement. I think people are assuming when I say, “There are ways that mental/emotional harm mirror physical harm,” and assume that the next step in my argument is to say, “And we should treat them identically!”

                  I’m not there. Not yet. Not until we can better understand them.


                  • Show me solid evidence that cortisol levels correlate tightly with emotional distress such that it can serve as an objective measure, and we’ll talk.

                    But IIRC, cortisol levels comparisons need a baseline value, and that baseline is not fixed in stone. So people would have to get baseline values taken when they feel normal, and as they age, those baseline values would have to be updated with some regularity. Then we’d have to take another measure during the height of emotional stress in order to get a good read on how bad it is.


              • You’ve hit upon the problem right? A broken bone or a black eye is intersubjective in a way that hurt feelings are not. Any public system of adjudication* must have a public basis of accounting for harms (or else it lacks legitimacy). Since any public basis must be intersubjective, non-intersubjective harms like emotional harms cannot properly figure into a public system of adjudication

                *That is, any public basis which people with conflicting claims can have their disputes resolved. Its a bit stylised but nevertheless largely accurate way of characterising the function of governments and anything that would replace governments in any possible anarchist society.


              • Who says we can’t measure emotional distress?
                I’m pretty damn sure heart attacks are measurable…
                As is people urinating in public because they’re scared… (granted, I’m sure that leads to more emotional distress…)


                • Again, not objective. Is the heart attack due to stress/emotional harm, or 3 chili dogs a day. Is urination due to fear, or other underlying issue?

                  And what about the people who have completely different physical reactions to fear/emotional distress?


                  • Trolls can create a situation where 33% of the participants pee their pants. 33% of the Voluntary participants, I might add.

                    Pissing yourself, particularly for women, is a deepseated psychological reaction to extreme fear.


                • Have you heard of the tuba player/piano player thought experiment? Goes like this: TP and PP want to practice their instruments in the same space but when the Tuba player is practicing the piano player can’t. Cuz he can’t hear his ownself play over the tuba racket. Tuba player does just fine either with or without the piano player playing.

                  What to do? Is this a situation in which the piano player has a legitimate reason to compel the tuba player to not do something?


                  • Honestly, I don’t know. I’m not arguing that point. My point is simply that, in your scenario, the piano player suffers (maybe that is a better phrase than “is harmed”). Maybe there is nothing we can do about that suffering. But that doesn’t mean it doesn’t exist.


                  • That came up in a previous discussion about cell phone use on planes. I thought that forbidding it (or, alternatively, considering it it grounds for justifiable homicide) was the sensible approach; Kazzy disagreed, for the same reasons he’s stating here,


                    • I don’t remember what I argued at the time, but my position today would necessarily be pro or anti-cell phone, but that either policy risks causing suffering. Which, as I believe James K is pointing out, is inevitable when rights come into conflict. And as our dear Tod so often reminds us, the conflict is rarely tyranny versus freedom but rather one very legitimate right (e.g., to use one’s cell phone) versus another very legitimate right (e.g., a quiet plane ride). (And perhaps ‘right’ isn’t the correct word here — maybe ‘desire’ is more appropriate — but I think you catch my drift.)


    • I like how I was first assumed to be talking about the ACA and now assumed to be talking about sex. In reality, I’m mostly thinking about more mundane things. I love eating diverse foods and get bored eating the mundane. My friend only eats grilled cheese. So we eat at the diner cuz dragging her to the pho place — where she “can’t” eat — is mean. But dragging me to the diner? No problemo.


                  • If we wanted to argue that the person who had arthritis was entitled to some pain relief (subsidized by the society), would that be crazy? Isn’t the ACA, for example, something that we put together in order to address such things as “people with arthritis”?


                    • Sure. And if the person who feels emotional pain at loneliness wants to see a therapist, perhaps we facilitate that. But we don’t mandate playdates for the person. That is not what I’m talking about.

                      Honestly, I’m really struggling to understand your position. My position is, “Hey, sometimes people suffer in ways most people don’t understand.” Nothing more, nothing less.


                        • That is to say, we have definite examples where we can look at it, say “man, that sucks” but I don’t know how to distinguish those from the ones where we say “man, that sucks AND WE ARE OBLIGED TO CHANGE IT.”

                          Is it little more than a sorites problem?


                            • What we’re trying to establish here is why you even brought it up in the first place.

                              “Emotional harm exists!” Duly noted, but nobody was actually arguing otherwise, and so we’re trying to unpack what you actually intended by bringing that into the discussion.


                              • If you read my initial comment, you’ll see I was not responding to the broader conversation of externalities but the opening quote of the OP because I think it is an argument that is too often ignored. And I think the conversation here confirms that.


                                • It’s not “ignored” as much as seen as not particularly interesting.

                                  People feel things.

                                  Does this mean that we should change a policy? “NOBODY IS ARGUING THAT!”
                                  Does this mean that we have obligations?”
                                  “SHOW ME WHERE I ARGUED THAT!”
                                  Does this mean that we should do anything at all?
                                  “STOP PUTTING WORDS IN MY MOUTH!”
                                  So what’s the point?
                                  “People feel things.”

                                  I agree that people feel things.

                                  Is there anything that follows from people feeling things?

                                  If the answer is “no”, then it’s not something that is being “ignored” as much as acknowledged as being, apparently, trivial.


            • Not really. Everyone here acknowledges at least one instance of cases where the mere fact that people feel very strongly about it is sufficient to generate a moral obligation: namely freedom of religion.

              Just about everyone is an atheist here. In fact, among the non-atheists (myself included), the number of people here who think that they will be sent to hell for having false religious beliefs is close to if not 0. Thus, when we think of how people are harmed when they are prevented from practicing their religion, the only plausible candidate here is that they feel very strongly about their religious practices and preventing them from practicing their religion would cause them intense psychological pain. Yet everyone here believes in freedom of religion. People might quibble about certain aspects pertaining to the extent religious freedom ought to be protected when it conflicts with other important rights, but no one here disputes that religion is an area of activity and the central cases of its exercise are perhaps the most important and most stringently protected sphere.


              • “Everyone here acknowledges at least one instance of cases where the mere fact that people feel very strongly about it is sufficient to generate a moral obligation”

                And what happens in that case is a balancing test between the government’s responsibilities and the individual right.

                Which, um, everyone seems to be ignoring for some reason.

                People are all “ooh, Hobby Lobby means that we can do whatever we want and say it’s religion”, and that is not even a little bit true, and it never was.


    • I can relate to this dynamic.

      It’s like the girl who asks if I want half of her donut.
      Without even knowing what type of donut it is, sight unseen, on any given day, hell no I don’t want half that donut! I want the whole darned thing, and I want to know if she has any more donuts lying about!

      Yet to simply grab her by the wrist and say, “Give me that donut, b*tch!” then force the donut, still in her hand, to my mouth and take a big bite of it . . . , well cafeteria personnel sort of frowns on that, to my understanding.

      Granted, I haven’t tried it yet, and I may be held in check only by an out-dated regulation.


    • I don’t think he came up with it (and, as far as I recall, he does directly cite the source in the text whenever he quotes it).

      It is a very good formulation of the concept, though.


  2. “2. Don’t make the rancher liable for damages…[i]f the farmer bears the losses from cattle damage they can fence their crops in to prevent damage, or if that’s too expensive pay the rancher to go elsewhere or reduce their herd.”

    Inherent in this is the assumption that the farmer can take whatever action they wish, and that any solution they and the rancher come up with will is both permitted and enforced by the government. Maybe the ranchers have convinced the government to set up a system whereby they pay extra taxes and in return get “ranching rights” on any land within the state, and farmers are therefore prohibited from fencing parts of it in.


  3. The other side of Coase’s insight is that classifying something as an externality is equivalent to saying that someone’s rights are being violated in some way. This means that you can define externalities based on who has the right to do what.

    I’m confused about this. Upthread an externality was defined in terms of a cost or benefit accruing to someone external to a transaction, so I’m not sure how rights enter into it at this level. Is it that one way to remedy disputes resulting from externalities and internalize them to the transaction itself is for gummint to assign rights to certain types of transactions? Eg., the farmer has a right to his property boundaries which the cattle rancher cannot abridge, so the burden is on the rancher to build a fence?

    Also, I wonder about another example you’ve mentioned: cap and trade as a solution to carbon emissions problems. Does this proposal assign rights to those negatively effected by pollution, or does it merely try to mitigate those costs on some other grounds (pragmatic, say, or efficiency, or perhaps even moral considerations)?

    Adding: And nice post, btw! I remember reading up on Coase during some of our other discussions and, probably with some helpful direction on your or someone else’s part, was struck by the same (counterintuitive, to me) insight you mention in the thread.


    • I think that James offers the best response right there in the OP. If you think of externalities as a rights violation, then you can identify whether a claimed harm actually exists, what the remedy should be, and how best to implement that remedy; which usually involves a balancing between two competing rights.

      So in the “farmer and rancher” example, it becomes “the rancher’s exercise of his right to let his cattle graze is infringing on the farmer’s right to control access to his property”. And the test would involve factors like “which is considered more fundamental, the right to extract natural resources or the right to control access to property”, and “if we restricted the rancher’s business rights in this way, how much harm would he suffer, compared to restricting the farmer’s property rights?”


      • Doesn’t this work better for negative externalities than positive ones? If you put up a billboard right next to someone’s property, I could see them complaining that their right to an unimpeded view has been impaired. But if you install a beautiful fountain that the person enjoys, how has a right of theirs been modified? Is it a rights enhancement?


      • If you think of externalities as a rights violation, then you can identify whether a claimed harm actually exists, what the remedy should be, and how best to implement that remedy; which usually involves a balancing between two competing rights.

        My worry with doing that is that it introduces political concepts into economic analysis. Nothing wrong with that on the solution side of things, of course, but it isn’t entailed by the economic concepts themselves, it seems to me.

        More specifically, tho, I wonder about the merits of such a proposal in any event, on two levels. The first is that if we’ve already determined a set of rights, then the judgment that transaction T creates externalities will be justified only if a third-party’s rights have been violated, which makes the concept of an externality (which is an economic concept) entirely dependent on a previously determined conception of rights (which are a political one). The second is that it seems to me some types of practices, like carbon emitting ones, aren’t viewed as externalities because they violate anyone’s rights, but because continuing to permit them is inefficient (in some meaning of that term) insofar as they incur huge financial and pragmatic costs born by third parties.


        • “introduces political concepts into economic analysis.”

          Introduces? Weren’t political concepts already embedded into the framework?

          Property exists, and can be owned like thus and so;
          Rights exist, and are described like this;
          The relationship of people is organized like such and such;

          The entire field of economics assumes human behavior most familiar to Americans and Europeans of recent centuries, containing the ethical and political traditions developed here.
          Not to say it is totally alien to other cultures, but it is grounded in a reality which is shaped by political theories which are not universal.


            • Imagine this essay being read by a Native American, pre-Columbus. Or an Australian Aborigine, or African tribesman.

              Their concepts of property, rights, and societal relationships were so different as to make the essay meaningless.

              In many pre-modern societies, land is not a passive feature- it is an active living thing. The keeping of livestock, the cultivation of crops was not just unfamiliar, but was simply not considered a desirable thing to do.

              This isn’t a pedantic point. I know we try to keep explicitly political concepts separate from economic ones, but we shouldn’t forget that even our most basic foundational concepts of what the world is and how it works, are fundamentally political and ethical choices we make.

              Turning things like [our current understanding of] rights into a naturally occurring phenomenon loads the dice by making the assumptions unquestionable.


              • This is important, and it’s what makes the rights-balancing test implicit in Coase’s formulation of externalities possible. If it’s all just made up, then no one thing is inherently superior to another; it’s a matter of to what extent each party’s rights are being infringed on, and what harm results.


                • If it’s all just made up, then no one thing is inherently superior to another;

                  I don’t understand what this means.
                  What one thing is inherently superior to another?
                  What isn’t made up?


                  • What I mean is that there’s no trump card of Rights, no end boss, no perfect defense. I can’t say “oh, Free Speech, therefore anything you say to criticize my behavior is prima facie invalid”.

                    We can say “infringing on your right to not be emotionally assaulted is less costly, to you and to society overall, than infringing on everyone else’s right to speak freely”. But we cannot say “your right to not be emotionally assaulted is insignificant next to the right to speak freely”.


                    • I believe all property rights are created by positive law.
                      Otherwise, systems of communal property would be invalid.

                      There are no natural rights as the basis of economics.
                      I don’t believe that diminishes Coase’s work in any way.


              • I get your point Chip, I do. Our economic models are largely dependant upon our rights framework that has been built up over centuries. Perhaps James could make the argument that many would still function independent of that framework, but I suspect a lot of them would need modifying.

                Still, pragmatically, that framework is not just a couple of decisions, it’s an incredibly heavy bulwark of law. It is a major supporting pillar of the social contract, as it were. It might be fun to engage in an intellectual exercise as to how things would look if out rights framework was different, but changing the framework would be an undertaking, or it would require a reset.


                      • Personally, I don’t like the term “Social Contract”, because it implies that A) there is something written down with terms I can read & review; & B) something I signed or otherwise agreed to explicitly.

                        I just call it modern civilization.


                      • It is odd that the social contract is only used to challenge certain things, while others are ignored.
                        For example, the current regime of property and wealth distribution is coercive and monopolistic and considered sacred and unquestioned.

                        I certainly was never asked for input or agreement on how the land was to be divided up, or who was going to be given
                        a slice.

                        In the great land rush of the 19th century, the government stole the land and gave it away to certain persons, and not others.
                        Are those land holdings valid? Should they be recognized and defended?

                        Or should they be questioned, challenged, and redistributed?


                        • Again, the question of time & the building of the… societal inertia with regard to a past sin is the issue.

                          The longer a question is assumed irrelevant or otherwise ignored, the longer the original stake holders are allowed to die & the rights in question are allowed to exist unchallenged in the system, the less able we are to right a wrong.

                          The conundrum we face is that the legitimacy for these sins largely rests with government, and the larger and more entangled government becomes, the more difficult it is to untangle and redo systems that are unjust. So our system of property rights may be coercive & monopolistic to a fault (not saying it is, but for the sake of argument…), but changing it to be better would require a lot of buy-in from people who will be on the short end of the repair.


                          • @oscar-gordon

                            I’m not actually proposing confiscation and redistribution of land and wealth.

                            What I am doing is pointing out how the challenge to the legitimacy of the social contract leads to places most challengers never intend.

                            The social negotiation that produced the dictate “You Must Accept The Status Quo Land Divisions” are the same social negotiations that say “You Must Pay Taxes” or “You Must Contribute To The Social Safety Net”.


                            • I didn’t think you were. I’m just saying that changing those negotiations is no small thing.

                              I’ll also add that, as you rightly question the Status Quo Land Divisions, I should be able to question the structure of Taxes & Safety Nets. They may not be easy to change, but that doesn’t mean we should not question them, or that a person should be dismissed because they are.


                              • Taxes & Safety Nets are questions all the time, and they can and do change,even radically. See Kansas and Louisiana for examples of that. (Or The Reagan tax cuts and Clinton’s welfare reform, for more responsible versions.) But challenging property rights? That’s un-American.


                      • This was in another context (civil disobedience, and whether it should be prosecuted), but FWIW the notion of observance of law due to some “social contract” has been thoroughly debunked.

                        That was stated very directly and bluntly by either Ronald Dworkin or Joel Feinberg. It was in the first few paragraphs of the article, so I should be able to find it fairly easily.
                        “Social contract” is not a serious consideration in the area of rights.


                • I believe this is false.
                  The property rights needed for a workable system are so rudimentary as to be wholly inconsequential.
                  That property exists, and it belongs to someone, and there is also other property is fully sufficient.


          • You are correct, the question of rights assignment is inherently political. That was one of Coase’s main points, externalities are something that can only be determined inside of a political context, and in particular within a specific context of which rights the government defends.


  4. In our society, the rancher first destroys the farmer’s crops, and this makes the farmer too poor to buy what the rancher is producing, which hurts the rancher. Then the government taxes the farmer, so it can give the rancher more livestock to make up for the rancher not being able to sell to the farmer.


  5. Coase makes it much easier – offence is only a negative externality if people have a legally-defensible right to not be offended.

    You’re the economist, but I think you stole a base here.

    The whole point of Coase’s work on externalities, as I understand it, is to provide a guide for how to assign legal rights. Specifically, they should be assigned in as Kaldor-Hicks-efficient a manner as possible, taking into account transaction costs, which typically involves siding against the least-cost avoider. If you’re using Coase as justification, you can’t just assign legal rights according to your ideological preferences and say that means there’s no externality.


    • BB,

      I wrote a bit about this same worry upthread and agree with what you said here, especially that last sentence. It seems odd to me that rights assignments can determine whether or not something is an externality given that the concept of an externality doesn’t include any rights language.

      Maybe the idea is this: government is justified in acting on exernalities only if the cost born by the third party constitutes a political harm, ie., a rights violation. Thinking about it this way keeps the economic concepts distinct from the political such that an action could create negative externalities without that cost constituting a harm which government ought to act on.


        • I guess I’m not clear on what aspects of the issue you believe permit the above analysis. I don’t know exactly what’s happening there, but I believe women have the right to a choice on the matter, and legislation which restricts or eliminates acting on that choice constitutes a first order harm.


          • Except the stated justification for the legislation is one of ensuring safety with health care, etc.

            So government is attempting to restrict a right by claiming it is addressing an externality (that of health care safety). Or something.

            Unpacking the layers of BS with all that is gonna require a diagram.


            • I mean, the government is allowed to lie, or be overzealous. Not in the sense of “we want them to”, but they do it. The problem, of course, is that we’re dealing with intangibles, so it’s hard at best to get firm numbers where you can say “no, that means of addressing that externality is excessively costly for the benefit it provides”. Now if you want to claim there is actually an infinite value in the equation, well, Pascal would like a word with you about Catholicism.


    • Yeah, but by the same token, there are a lot of assumptions that get smuggled in to what’s considered the Kaldor-Hicks state of affairs, and who is the least-cost avoider. You can’t make those determinations without making highly ideological assumptions about what properly counts as a cost. These are the under-the-water parts of the government iceberg that makes capitalism work the way it does, and they can be just as coercive as the above-water parts — if not more so, because their workings are often much harder to articulate.


  6. Chip Daniels: I’m not actually proposing confiscation and redistribution of land and wealth.

    So you’ve changed your tune b/c last time you were telling us how the laws about taxing and private property could be changed at any time to take from the wealthy as much as you deemed necessary.


  7. I think Coase’s model is incomplete, and ultimately fails to show what he’s trying to prove. Differential initial distributions of property rights can still change the relative allocations of resources, even assuming bargaining costs are zero.

    For example, if the government structures property rights in a certain way, and that if that structuring systematically requires that the costs of sussing out these issues are borne by ranchers, then pretty soon ranchers will just start treating those costs as an inseparable part of their doing business. This will affect ranchers’ willingness to continue or expand their businesses, and will affect whether prospective ranchers will choose to enter that market. As a result, you’ll start to see inefficiently-low levels of ranching activities relative to farming activities.

    It can be seen by this example that a principal failing of Coase theorem is that it models only a single interaction, and fails to account for how repeated iterations of the game can have lasting effect on the distribution of harms in the long- or even the medium-run.


  8. Merely as a sidebar – since I don’t really expect the author to address the larger topic directly (I think he will have to declare it to be incurably “external” to what he’s interested in talking about) – I have a question about this statement:

    The first economist to identify externalities and suggest how to deal with them was Arthur Cecil Pigou, in 1920.

    Is it true that Pigou is the one who coined the term “externality”?

    If so, then I think it’s more likely that, to use the Marxist terminology, the term “externality” was proposed by the bourgeois economist Arthur Cecil Pigou, later to be re-considered by Ronald Coase, in a typical if not the typical example of a theoretical attempt to re-integrate within capitalism what capitalism begins by and always depends on excluding. Prior to Pigou, the most systematic attempt to assess what Pigou and Coase refer to as externalities within “economics” would be the one performed by Marx, though there have been many parallel critiques, all of which sooner or later must, replicating the same pattern, address what is “external” to bourgeois economics as such, or what is “external” to what Georg Lukacs, writing around the same time as Pigou, called “bourgeois science.” For those allergic to Marxism, there are many other traditions or schools, ancient and modern and post-modern, to choose from for getting to the same problem.


      • Short, conventional answer would be no, not really – at best indirectly or inadequately – with baleful effects for the environment in Marxist-Leninist states in the 20th Century. Long answer, having to do with ecologism and dialectical materialism as alternative “holisms” that needed a century to approach each other, possibly too late, is probably too much for me to attempt in a comment thread.

        …but you didn’t answer my question about crediting Pigou with coining the term “externality” in relation to economics.


        • I’m not aware of anyone else using the term before Pigou, but its possible someone who doesn’t form part of the tradition of mainstream economics was using it for something before Pigou. In any case the concept was originated by Pigou.


          • Sidgwick and J.S. Mill dealt with externalities long before Pigou. Pigou is best thought of as the systematizer of the idea of externalities, not as the first person who was concerned with those kinds of problems.

            It’s important to remember that the classical economists who are typically considered the forefathers of capitalist thought were much more sophisticated than most modern proponents of capitalism; even if they didn’t think about externalities using the welfare analysis framework that’s common today, they still grappled with the idea in a more abstract form, and accordingly felt compelled to cabin “laissez-faire” to a degree that would make lots of modern libertarians squirm.


            Also, Marx was actually pretty prescient when it comes to questions of the environment. He followed the physiocrats pretty closely when it came to their view on the dependence of human well-being to the natural world, and a few of his most important ideas seemed to flow from this stance. His concept of alienation, for example, was at times explicitly rooted in environmental concerns, and at any rate was always concordant with and served as a useful theoretical basis for 20th-century ecology, foreshadowing the likes of Murray Bookchin and other anti-capitalist environmentalists.



            • Likewise RG – tho I aint gone nowhere. U da stranger.

              I’m not sure why Murray Bookchin, a name I haven’t run across in years, is pretending in that article that the research on Marx’s crypto-ecologism is some relatively recent (2000) discovery, since the same passages have been reference points for a much longer time. They were especially important for the Green and Alternative parties/movements of the ’70s-’80s (in which Bookchin & co were players) seeking to make common cause with whatever available Reds. As noted earlier – prior to James K’s question – the Lukacs critique points from the far left in an eventually convergent direction with critiques of technology or technologism or scientism and so on that are often associated with the right or even the far right.

              In support of the more conventional view is the fact that a few comments in the never-finished 3rd volume of Capital , some relatively obscure utterances, and some theoretical formulations that will leave many readers with their eyes crossed will be overwhelmed by a great weight of polemical and theoretical work in which issues we would think of as “environmental” are, where they come up at all, subordinated to a highly human-centric and “progressive” standpoint.

              You may remember the short piece I wrote several years ago on the substitution of the Earth or Nature for the Workers in the position of the Proletariat. Uniting dialectical materialism and ecologism, or explaining or discovering an underlying unity seems easy to do on the surface – the planet and its human occupants need revolution, plus it would be cool! Green jobs! The theoretical problems and the eventual practical-political problems are different matters…


              • I don’t think anyone is saying that Marx’s ecologism was hidden before 2000, only that there was a popular misconception around that time that Marxism was incompatible or sat awkwardly with environmentalism. This misconception undoubtedly resulted at least in part from the horrible environmental record of state Marxism in the 20th century, but it existed as a misconception nevertheless.

                Likewise, I don’t think anyone is identifying Marx with the explicitly anti-humanist strains of environmentalism. (All other forms of environmentalism are largely congruent with highly anthropocentric theoretical viewpoints.) But despite what the reflexively-industrial may say, actual misanthropes are few and far between among environmentalists. Indeed, the environmentalist clues in Marx’s writings are mostly congruent even with Deep Ecology:

                Man lives on nature–means that nature is his body, with which he must remain in continuous interchange if he is not to die. That man’s physical and spiritual life is linked to nature means simply that nature is linked to itself, for man is a part of nature.

                I think a lot of the confusion here arises from Marx (famously) being mainly a descriptive theorist of the workings of capitalism, instead of a prescriptive exponent of his favored state of affairs. Marx wrote mostly about how capitalism worked, and so ended up writing a lot about the effects of industrialism, but it would be a mistake to say that he therefore ignored environmental issues.

                The real problem I see for Marx with regards to environmentalism is that Marx was too wedded to his catastrophic teleology of economic history to examine how to meliorate environmental concerns in the short-term — for Marx, the environment would keep getting worse until it got so bad as to sow the seeds of radical renewal. But even this seems merely descriptive and relatively cabined: Instead of being compelled by his historical materialism to stall environmental advocacy, Marx could be read as saying that there can be no unambiguous environmental improvement until the end of extractivist and alienating capitalist relations. In the grand scheme of things, that doesn’t even sound so implausible.


                • Testifying as someone whose early intensive political experiences were about trying to form and to theorize Red-Green alliances or fusions – including by translating the latest pronouncements from Germany for my comrades – I think the popular “misconception” that “Marxism was incompatible or sat awkwardly with environmentalism” would have been a largely accurate perception.

                  To give one example of the problem, the passage you highlight regarding “nature… linked to itself” can be read in the opposite direction, and I think generally and practically tended to be: Since “man” relating to “nature” is always already nature relating to itself, to perfect our relationship to ourselves implies perfection of our relationship to nature. They would be one in the same process, but human beings or “human being” as a species-being, as the only (to this point, anyway) known and knowable “political,” and “rational” being(s)* define the field of political action: All political action is action by human beings in relation to human beings on behalf of human beings – even, or specifically and essentially, as “nature linking to itself.” So, the position you call not necessarily implausible at the end wins out, and the Marxist revolutionary can return once again to the initial position of placing the class struggle and its necessary resolution in favor the proletariat ahead of any solution on secondary matters like civil rights, environmental degradation, governmental reform, or anything else.

                  On this note, I think It’s also important, at least for the discussion’s sake, to maintain the distinction between “environmentalism” and “ecologism.” Revolutionary Marxism would tend to disdain while seeking to exploit the former, in much the same way that it would treat those other other secondary tendencies and concerns. Ecologism would be the name, as I suggested above, for an alternative philosophical standpoint that might conceivably be synthesized with dialectical materialism, possibly requiring fundamental alteration of principles and assumptions on both sides, but might also be seen as fundamentally erroneous and highly problematic. Some thinkers seem to have persuaded themselves that they have succeeded with the former project, but in my observation the mutual alteration of principles has tended toward the invalidation of political praxis as previously conceived: In other words has produced retreats into quietism, nihilism, fantasism, localism, in short de-politicization.

                  *I think Marx and his philosophical father Hegel are finally Aristotelians in this sense. Any (but only) politically and rationally self-conscious being would therefore be “human being.”


                  • CK, thanks for the well-considered reply, as always.

                    Your in-the-trenches experience here is useful, but I don’t think it obviates the possibility of other readings of Marx. Assuming you were talking about East Germany, it seems like your anecdote is fully consistent with what I originally wrote, which is that the experience of state Marxism colored perceptions of the compatibility of Marxism and environmentalism. Even if you were talking about Marxist advocacy in the post-Soviet era, that would have been highly influenced by the intellectual edifice constructed in large part by party Communists, and not necessarily indicative of Marx’s original ideas.

                    Given that Marx and his main collaborator wrote about issues that would seem conventionally environmental by activists today (soil degradation, resource extraction), I think Marx-as-proto-ecologist still seems a totally sensible reading.

                    Also, I’d argue that Marxists who delve into de-politicization aren’t necessarily inconsistent. After all, even as vague as Marx was about the end of history, he still made it a point to say that it would be free of political systems. So while those anti-political activists would probably be working contrary to the catastrophism Marx saw as necessary to bring about the end of alienation, their diagnoses and desired results would be the same. Given the wide diversity of Marxist thought, I don’t see good enough reason to kick them out of the tent just yet.


                    • I guess I should have been more specific. The pronouncements to which I referred were coming from West Germany. Two of the leading Red-Green activist/theorists were Rainer Trampert and Thomas Ebermann, at the time party comrades of Joschka Fischer, later Green Foreign Minister (best known in the US for not being convinced by Donald Rumsfeld before the Iraq War). A crucial earlier figure in the development of Green theory was Rudolf Bahro, whose book The Alternative was written in East Germany, published in West Germany, and became a cause celebre after he was put on trial and imprisoned for betrayal of state secrets, leading eventually to his amnesty and subsequent deportation in 1979.

                      I’m not trying to kick anyone out of any tent. I just think that in this instance the popular “misconception” and a mature critique somewhat coincide. Writers like Jean Baudrillard (see esp. THE MIRROR OF PRODUCTION) and Isaac Balbus (MARXISM AND DOMINATION from the “left” or the “post-left” critiqued Marxist theory on what I recall to be a high level (long time since I cracked open either book), and the general drift of post-structuralism and of certain precursors tended, like the critiques of Marxism from (generally) conservative or writers like Strauss, Voegelin, and Heidegger, to place Marxism within an Enlightenment tradition that whichever new or renovated thinking was meant to surpass or escape.


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