II. Law and economic analysis
B. Foundations for the economic analysis of the common law
1. Economics and externalities

Example 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 an effluent fee equal to the damage done by the pollution.

    Example: Effluent fee = 20 cents per lb.
        --> higher cost of steel ($4 per ton with 20# of SO2 per ton)

    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.

2. Coase and externalities
Ronald Coase: "The Problem of Social Cost" (1960)
    published the year after Pigou died
    Coase case handout