The Problem of Social Cost

Ronald H. Coase

The Journal of Law and Economics, vol. 3, (October, 1960), pp.1-44

 

Summarized by xiaoyang

                                                           2007-12-23

 

I.  Abstract

  

This paper deals with the harmful effects problem in a way different from traditional Pigovian approach. The author finds that in the zero transaction cost world, initial legal arrangement of rights cannot affect the total production through the transaction of the delimitated rights. If the cost of using price mechanism, the initial arrangement of legal rights affects the allocation of resources. When divesting and choosing among social arrangements.

  

II. Structure of this paper

 

This paper is divided into 10 Sections. The first two sections claim that to the issue of negative externality, it’s wrong to put liability on the part of the damage causer, we should realized “the reciprocal nature of the problem”.  Section III and Section IV give two cases (cattle-raiser and farmer) which treat the damage causer is and not liable for damage each and their outcomes. Section V, “the problem illustrated anew” gives 4 actual cases for further explanation. Both parties are involved in the harmful effect which would be a cost for both parties. The economic problem in all cases of harmful effects is how to maximize the value of production. In Section VI, the author deals with the initial delimitation of rights and the costs of carrying out market transactions as given. Some negotiations cannot be reached for the transaction costs. Section VII discusses about the legal system which establishes legal rights. The last 3 Sections mainly on the deficiencies of Pigou’s tradition of the problem of externality and advocates a new approach is needed.

 

III. What Gap the Paper has Filled?

 

  Rather than saying what gap this paper has filled, it’s much more suitable to say what a new field this paper has ploughed. Just as Coase himself indicates in this paper, Pigou’s tradition needs to be changed. Three major contributions can be drawn from this paper. First, the Coase Theorem which overturns the Pigou’s orthodoxy and a new paradigm of Transaction Cost Economics, Second, Coase constructs a bridge between law and economics in this paper. Third, not only the marginalism is the tool for the economic analysis, but also, sometimes, total analysis is helpful. The first two are theoretical and the last is analytical.

 

IV. Main points of the paper

 

Four points Pigou ignored. Firstly, the issue of the harmful effects caused by business firms on others is reciprocal in nature, this is the first point Pigou ignored. Suppose A stresses negative effects on the neighboring B in his production process, if solely A is liable to the damage, it would add A’s cost; if A is not liable for the damage, B would be harmed with compensation. The real question is to be decided is who should pay for the harmful effects in order to get better outcomes. It’s wrong to put liability on the part of the damage causer. Secondly, Pigou’s prescription on the externality is bringing in government interventions. So the second flaw of Pigou’s analysis is the absence of the role of market in externality problem. Thirdly, Pigovian economists ignore that a right to damage others without liability is also a factor of resources, similar to physical entity. Rights and efficiency are intertwined.

Based on the revision and criticism on Pigovian, Coase argues at first that social arrangements can affect economic efficiencies. Economists seldom pay attention to the legal rights is an economic problem since compensation is a cost of those who are liable to the harmful effects, hence, legal arrangements has a strong linkage to the value of total production.

The following question is how can this problem be an economic one? In other words, why social arrangement matters? To answer this problem, there is a condition—rights to affects others without any liability is a factor of production and can be exchanged through transaction. Coase uses Section III and Section IV to illustrate this problem. In a world without transaction (namely people can use price mechanism to accomplish transactions without paying the cost) the final result would be the same and desirable no matter who is liable to the harmful effect. Besides the zero transaction cost assumption, there is another conditional: the legal delimitation of rights. Two kinds of transactions are in response to the legal arrangement: paying if liable and bribing if not liable. Given the value and costs of production and the damage:

Case 1: A is liable for the damage of B who is negatively affected by A, A has to pay for the damage by compulsory. If A’s payment is no smaller than the damage, B will give up his right of being unaffected. If A’s payment can be recovered through keeping on producing, A will choose to keep on operating and bear the payment as a cost.

 Case 2: A is not liable for the damage of B who is negatively affected by A, B might bribe A. If B’s bribe is no smaller than his lose caused by A, B will choose to pay A for giving up producing. If B’s bribe is no less than A’s value of production, A will receive the bribe. 

In both two cases, the ultimate result would be indifferent in terms of the value of production. The divergence between these two legal arrangements is the distribution of income which depends on the shrewdness of the A and B.

In the real world, however, the zero transaction cost is “a very unrealistic assumption”. Some transaction costs would too high to make the rearrangement of legal rights economically. Not all the harmful effects can be settled through market mechanism when transaction costs are in presence. So, the initial delimitation of legal rights does have an effect on the efficiency. Economic organizations are means of reducing transaction costs. Government is not one type of organization and government policies (by using subsidy, tax and regulation to compensate damage receiver) are not the only tool to teat the externality, under some condition are unnecessary.

Because social arrangements affect economic efficiency, it’s necessary to analyze those social systems rather than remedy those weaknesses in a certain one as Pigovists do. This paper advocates attentions should be paid on the total effect (total production and the costs involved in operating various social arrangement) when devising and choosing among social arrangements.  

    In sum, this paper can be summarized as following: (1) harmful effects are reciprocal in nature and can not be solely imposed on one party; (2) the real aim is to maximize the total value of production when dealing with the problem of harmful effects; (3) in a world without transaction costs and the rights are clearly delimitated, the initial arrangement of liability cannot affect the result of maximizing the value of production through transaction; (4) in the real world, sometimes the cost of using market mechanism is too high to reaching efficient transaction, we need to make comparative institutional approach to analyze the total effects of various systems and choose the optimal one.

 

V. Comments on this paper

 Although this paper is often neglected for its distribution analysis (a normal on) and arguable policy implication, it reflects Coase’s creative and particular ideas successfully. If Coase’s economics were, so many economic theories would be needed to be refreshed.

Firstly, on how to reduce transaction costs, we can draw a line between Coase (1937) and Coase (1960). In Coase (1937), he explains the emergency of a firm is to save the cost of using price system (transaction costs) with entrepreneur’s coordination within a firm. In the light of Coase (1937) if it stands, when dealing with harmful effects, it’s also possible to build a firm in which two parties of issue of harmful effects are included, and transaction cost is replaced by coordination cost. In fact, when a negotiation is reached just like one person operates all the business, the payment is something like transferring some money from his left pocket to the right, the production would not be changed.

Secondly, it would be interesting to revisit Coase’s analysis under the framework of Inframarginal analysis. As Coase has criticized the insufficiency of Pigou’s marginal analysis on the private cost and social cost for marginalism is limited under a given social arrangement. Transaction of legal rights is qualitative and discontinuous in nature. Inframarginal procedure matches Coase’s strong suggestion well. Well-built mathematical model can retell Coase’s story explicitly.

Thirdly, Coase is cursed by himself. Coase makes following comments on Pigovian tradition, “It is strange that a doctrine as faulty as that developed by Pigou should have been so influential, although part of its success has probably due to the lack of clarity in the exposition. Not being clear, it was never clearly wrong.” Coase himself “did not originate the phrase, the “Coase Theorem,” nor its precise formulation, both of which we owe to Stigler” (Coase, 1988). What is the Coase Theorem? Too many answers are witnessed (Medema, 1994). Furthermore, what’s the cost of using price mechanism or transaction? Obscurity works. Anyway, Coase’s seminal contribution is highly honored.

 

 

 

Some interesting background I find in Stigler’s memories (Ch. 5, Memories of an Unregulated Economist, Chinese edition) help to understand why Coase is so confident about this paper. After Coase submitted this paper to Journal of Political Economy, the editor was certain about Coase’s creative analysis and asked Coase to revise, of course, Coase refused. Coase was invited Coase to A. Dixit’s home with other 20 economists, including Stigler, from Uni. Chicago. Before Coase’s defense, all the 20 economists were against Coase, after that, the 20 economists all convinced and turned to support Coase. After that discussion, Coase had a paper published in Journal of Law and Economics with the name of “The Problem of Social Cost”.