C. Review of how markets work (Friedman: explanation)
2.  Markets and externalities

    Most common law cases arise when markets fail to resolve situations in which people impose costs on each other

    Basic problem: Individual rationality vs group rationality

    Examples:
    (1) Armies running away

    (2) Rational pollution:
    --There are 100 individuals who can each burn cheap coal or expensive gas to heat their house.
    --The coal pollutes, but ...
    --99% of the pollution produced by my coal burning is a cost for other people, so I only count 1% of it, so ...
    --I burn coal even if the total cost, including the pollution, is substantially larger than for gas.
    --On net, we are all worse off. I am externalizing 99% of the cost of my pollution, but paying 1% of the cost of the pollution by each of the other 99 people.
    --But on the margin--the margin of how much I pollute--the pollution cost is almost all external.

    In general, externalities lead to inefficient outcomes.

Case 1: pecuniary externalities
Example: competition

    32: "Competition should not be, and is not, a tort."

    Pecuniary externality => offsetting transfers, not net costs or benefits.
    Reserve policy only for nonpecuniary externalities

Case 2: nonpecuniary externalities
Example: pollution
The Pigouvian approach -- British economist Arthur Pigou (1877-1959)

    "If factors of production are thought of as rights, it becomes easier to understand that the right to do something which has a harmful effect (such as the creation of smoke, noise, smells, etc.) is also a factor of production" (Coase 22).

    Impose a carbon tax equal to the damage done by the pollution at the optimal quantity.

    Example: $6 per ton per year
        --> higher cost of airline tickets

    Pigouvian taxes could even charge for past pollution, providing an incentive to cut earlier than mandated.

    The firm is thus forced to internalize the externality--its costs, including the effluent fee, now equal the total cost imposed by its action.

    Results:
    1. So firm chooses the efficient alternative.
    2. Controls pollution if doing so is worth the cost
    3. Switches to alternative production methods if that is cheaper
    4. Closes down if cost is now greater than what the customers will pay.
    5. Note that the fine might go to the state, as in this example, or to the victim, as in tort law. We will discuss later why it matters which it is.

    The pollution cost is now included in the price for the firm's output, so everyone downstream has the right incentives.

Case 3: Pollution policy revisited

    Example: small private lake
    chemical factory owns 1/2 of shore
    fishing resort owns 1/2 of shore
    no one else uses it
    factory pollution kills most of the fish

    Review first worksheet...

    ...then consider the Worksheet: Externalities and Pigouvian taxes revisited

    ? The best solution? Allow pollution, switch resort -- cell 3

    ? Does that happen with Pigouvian tax? no: cell 2
    Pigouvian solution was inefficient

D. Ronald Coase: "The Problem of Social Cost"

    The situation: We have this extensive body of common law which drives civil lawsuits
    What does economics have to say about it?

    Economic comments about law date back to Adam Smith, but law as a focus is much more recent
    First issue of The Journal of Law and Economics dates to 1958

    Recall that markets deal with voluntary exchange, but courts deal with involuntary exchange instead.

    Posner: "An important question in the economic analysis of law is whether and in what circumstances an involuntary exchange may be said to increase efficiency…. An…approach which is in the spirit of Kaldor-Hicks…is to try to guess whether, if a voluntary transaction had been feasible, it would have occurred." (Posner 15)

    A lawsuit => the market didn't work, so the parties have turned to the courts instead.
    What made the market fail--the key is externalities

Ronald Coase: "The Problem of Social Cost" (1960)
    published the year after Pigou died

    36: According to the work of Coase: "Pigou's analysis was wrong, not in one way but in three. The existence of externalities does not necessarily lead to an inefficient result. Pigouvian taxes do not in general lead to the efficient result. Third, and most important, the problem is not really externalities at all. It is transaction costs."

    (1) The Pigouvian approach can be inefficient (Coaseian critique)

    Finding the lowest cost solution requires consideration of possible adjustments by all affected parties.

    Coase perspective: an externality is not unilaterally due to one party; it is jointly determined by the affected parties

    There can be no universal Pigouvian rule because the legal system does not know which party can adjust at lower cost.

    "This paper is concerned with those actions of business firms which have harmful effects on others. The standard example is that of a factory the smoke from which has harmful effects on those occupying neighboring properties.... 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." (Coase 1)

    ? Why is it 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? The problem is to avoid the more serious harm." (Coase 1)

    14: "What we have are not costs imposed by one person on another but costs jointly produced by decisions made by both parties...."

    (2) Externalities may not cause inefficiency

    ? Why not? Affected parties can bargain
    This possibility is captured in the Coase Theorem

    ? What does the Coase Theorem say?

    The Coase Theorem: Any initial assignment of property rights will lead to an efficient outcome as long as transaction costs are zero.

    Note: TC=0 is sufficient but not necessary efficiency.
    The necessary condition: TC < |(Value to A) - (Value to B)|

    ? How does Coase say it?
    Coase builds up to theorem using cattle vs. crops to illustrate
    "It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximizes the value of production) is independent of the legal position if the pricing system is assumed to work without cost." (Coase 7)

    Coase focus: how we bundle property rights
    (1) Does a buyer of lakeshore property buy the right to pollute or to be free of pollution?
    (2) Does ownership of a hotel pool include ownership of the sunlight falling on it?
    (3) Who owns the right to control the movement of currents of air--the air carrying the smells from the brewery into someone else's courtyard, or carrying (or not carrying) the smoke from my chimney away?

Resort example:
Factory's pollution control cost = $30K
Resort's lowest damages with pollution: $10K of lost profit

    ? What outcome will occur if the resort has the right to a pollution-free lake?

    pollution + resort switches to horseback riding: factory can profitably bribe resort to switch.

    ? What outcome will occur if the factory has the right to pollute?

    pollution + resort switches to horseback riding: resort cannot profitably bribe factory to abate.

    ? Do economists concerned with efficiency care how the property rights are assigned?

    No--we reach efficiency either way

    ? Do the parties involved care how the property rights are assigned?

    Yes--parties care about their wealth, not efficiency, and property rights are valuable to own.

    --In a Coase world, although we achieve an efficient outcome with any assignment of rights, we may not achieve the same outcome.
    --if a change of legal rule changes the distribution of wealth, output levels can change. (Regan, LEA 116-117)

Do worksheet

    Result:
    A = Kelty's amount demanded to give up the right to be free of pollution
    B = Kelty's maximum willingness to pay to be get the right to be free of pollution

    C = control cost

    If A > C > B, then:
        Efficiency => no pollution if pollutee gets the property right
        Efficiency => pollution if polluter gets the property right

    Coase Theorem corollary: The particular efficient outcome we get can depend on how property rights are assigned

    So we can have different uses of resources according to who gets the right to impose costs--but both outcomes are efficient.
    A>B is a common result: all it requires is that environmental quality be a normal good.

    "Surveys and experiments reveal that people sometimes demand much more to give something up that they have than they would be willing to pay to acquire it.... The divergence between the buying and selling price is called an endowment effect because the price varies depending on the initial assignment of ownership." (Cooter and Ulen: 91)

    How your desires get weighted in determining the efficient outcome depends in part on how much money you have, and different initial allocations correspond to different distributions of wealth.

    "[I]n the ideal market setting law can pursue non-economic objectives without any sacrifice of economic efficiency." (Veljanovski, LEA 26)

    (3) The real problem is transaction costs, not externalities

    What are transaction costs?
    Ttransaction costs: "the costs of effecting a transfer of rights" (P 34)
    Transaction costs: (1) search costs, (2) bargaining costs, (3) enforcement costs (CU 92)

    "The argument has proceeded up to this point on the assumption that there were no costs involved in carrying out market transactions. This is, of course, a very unrealistic assumption. In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on. These operations are often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost." (Coase 7)

    Additional transaction complications raised after Coase article:
    (1) strategic behavior
    "For participants in n-person, variable-sum games we do not...have any real satisfactory concept of rational behavior.... Each individual will wish to see not only that the benefits of cooperation are achieved, but that he gets as large a share of the benefits as possible. He will likely be led to threats of non-cooperation as a device to increase his share. Clearly the threats will be ineffective if they are not believed, and it is unlikely that threats will be generally be believed unless they are occasionally carried out." (Regan, LEA 115) Regan, Donald H. "The problem of social revisited." JLE 15 (1972): 427.)
    Friedman emphasizes this in chapter 5.

       (2) bilateral monopoly - 2-party bargaining situation -- monopoly facing a monopsony
    High potential stakes for each make each inclined to devote lots of resources to claim the surplus.

    Note:

    Example: sparks and crops (used by Pigou to illustrate logic of assessing damages)
    Irony to Coase: "The example used by Pigou refers to a real situation. In Britain, a railway does not normally have to compensate those who suffer damage by fire caused by sparks from an engine....
    "In the real world, Pigou's example could only exist as a result of a deliberate choice of the legislature.... The only circumstances in which compensation would not be paid would be those in which there had been government action. It is strange that Pigou, who clearly thought it desirable that compensation should be paid, should have chosen this particular example to demonstrate how it is possible 'for State action to improve upon `natural' tendencies.'" (Coase 13-14)

    Coase case handout
    Coase commentary handout
    (1) Sturges v. Bridgman (1879) - doctor v. confectioner
    What efficiency effect hinges on the court decision?
    "[T]he circumstances in which it would not pay the confectioner to continue to use the machinery and to compensate the doctor for the losses that this would bring (if the doctor had the right to prevent the confectioner's using his machinery) would be those in which it would be in the interest of the doctor to make a payment to the confectioner which would induce him to discontinue the use of the machinery (if the confectioner had the right to operate the machinery).... With costless market transactions, the decision of the courts concerning liability for damage would be without effect on the allocation of resources. It was of course the view of the judges that they were affecting the working of the economic system--and in a desirable direction."

    (2) Cooke v. Forbes (1867-8) - matting mfr v. chemical mfr
    Sturges v. Bridgman ruled for plaintiff; here for the defendant--what difference does it make?
    "[T]he situation is essentially the same as that found in Sturges v. Bridgman, except that the cocoa-nut fiber matting manufacturer could not secure an injunction...."

    (3) Bryant v. Lefever (1878-9) - chimney v. wall
    Who caused the smoke nuisance?
    "Who caused the smoke nuisance? The answer seems fairly clear. The smoke nuisance was caused both by the man who built the wall and by the man who lit the fires. Given the fires, there would have been no smoke nuisance without the wall; given the wall, there would have been no smoke nuisance without the fires. Eliminate the wall or the fires and the smoke nuisance would disappear. On the marginal principle it is clear that both were responsible and both should be forced to include the loss of amenity due to the smoke as a cost in deciding whether to continue the activity which gives rise to the smoke. And given the possibility of market transactions, this is what would in fact happen."

    (4) Bass v. Gregory (1890) - public (beer) house v. private house
   How relevant is the "doctrine of lost grant" to the economic problem presented by the case?
    "The economic problem was to decide which to choose: a lower cost of beer and worsened amenities in adjoining houses or a higher cost of beer and improved amenities. In deciding this question, the "doctrine of lost grant" is about as relevant as the colour of the judge's eyes. But it has to be remembered that the immediate question faced by the courts is not what shall be done by whom but who has the legal right to do what. It is always possible to modify by transactions on the market the initial legal delimitation of rights. And, of course, if such market transactions are costless, such a rearrangement of rights will always take place if it would lead to an increase in the value of production."