Michael Giberson
Last summer, Harold Demsetz spoke at the Property and Environment Research Center on Ronald Coase’s big mistake in “The Problem of Social Cost.” PERC has just posted the video.
The article he is presenting is, “Fallacies in the Economic Doctrine of Externalities,” but I bet in the written article he doesn’t say, “what the hell is a court doing in this model?” (at least not in those words).
Demsetz notes that his title is a nod toward Frank Knight’s 1924 response to Pigou, “Some Fallacies in the Interpretation of Social Cost.”
After thinking about Harold Demsetz’s example, the case of a steel Mill that burns soft coal, and then the smoke from that coal soils the cloths being washed at a neighborhood laundry, I have concluded that the example actually supports the case for external cost, The coal smoke increases the laundry’s cost of dong business, while burning coal lowers the steel mills costs. Hence the use of polluting soft coal represents a cost that is paid by the laundry, not the steel mill. Further Demsetz suggested that the laundry could pay the steel mill to not burn soft coal, here again a cost is being transfered from the steel mill to the laundry. Thus the example points to the existence of external or social costs in a market economy.
I had to listen to the discussion more than once to catch the key point. This is it: In the example Demsetz’s assumes that the steel mill has legal right to emit the smoke. The laundry owner would be willing to offer the steel mill some amount to stop emitting smoke (in the limit, any amount up to the costs imposed by smoke). Given the offer of payment available to the steel mill, the costs of the smoke imposed on the laundry are no longer externalities – the steel mill owner will choose whether or not the laundry’s offer is sufficient to induce it to cut back smoke.
He could have also assumed that the laundry has the right not to have soot damaging its product. The laundry’s assertion of that right would impose a cost on the steel mill, which would either have to shut down, install control systems or switch coal types. Still no externality, because the steel mill owner would be willing to offer the laundry an amount up to the cost of adjustment to not assert its right. The laundry owner considers the offer in its choice of how it uses its property right to smoke-free air, so again no costs are external to the private economic calculations.
What appear to be cases of externalities are just cases in which the rights to property are not clearly specified. But this isn’t a market failure – the specification of property rights is a social/political/legal issue that is logically prior to market exchange.
Michael there are two sorts of practices which arguably can lead to external costs. The first practices are those in which it is impractical to establish a market. For example, everyone burned coal in East Tennessee during my childhood. Most people lacked other heating options. Unregulated coal burning had lots of environmental and social costs. Then gas companies built pipelines, and TVA built power plants. The the burning of coal was regulated, and the coal smoke problem largely disappeared. In this instance the externality of social costs related to burning coal was a matter of practice. As practice changed it became practical and desirable to move the previously unpriced economic burdens associated with burning coal from the farmers, foresters, and the victims of coal smoke triggered illnesses, to the would be burners of coal.
A second sort of external cost is related to the sale of addictive and harmful products. The use of tobacco products leads to a variety of illnesses. The cost of treating those illnesses should be paid by either the buyers and sellers of tobacco products, but much of treatment costs are paid by insurance premiums paid by employers, and others, or by governmental entities. Thus some costs of smoking are externalized from the tobacco market. Further this externalization was a matter of policy on the part of tobacco companies.
A similar external cost has to do with the economic consequences of the use of fossil fuels. For example, the spread of Global Warming denial propaganda by oil and coal companies. The purpose of this propaganda is to prevent the internalization of CO2/Global Warming related costs into the fossil fuel market.
Demsetz’s argument appears to be that if it is theoretically possible to internalize costs, then the concept of external costs in invalid. But in fact it is possible for buyers and sellers to avoid paying some of the costs related to the buying and selling of many products, and they in fact do so. The idea of external or social costs, permits the capturing of this market reality.
A good rejoinder. You are mostly holding to the Coase line and for the moment I’m trying to advance Demsetz’s position. I like both, so this interchange is helping me clarify my thoughts.
First, Demsetz’s primary effort is to clarify the concept of externalities within neoclassical economic theory. Pigou had advanced the idea of externalities as a challenge to the efficiency conclusions of neoclassical economic analysis. Demsetz counters that the examples Pigou and (sometimes) Coase use are problems with the definition of property rights, issues which belong to law and policy, but not in neoclassical economics analysis. Demetz’s further point is that Coase’s invocation of transactions cost does not preserve a role for externalities in neoclassical economics.
I think in this realm Demsetz is right about Pigou and about Coase, but in a sense the point is a narrow one about the logic of neoclassical economic theories.
Perhaps a more interesting question concerns the economy we have, not merely the logic of standard economic theories. Does the fact that Demsetz demolishes externalities within the world of neoclassical economic theory also mean that the concept of externalities isn’t useful for understanding the economy?
In the Tennessee coal burning case, judging from this lecture Demsetz might point to the changing social attitudes and changing laws and policies as changes in the content of property rights: at one time the power plants had the right to dump smoke into the air, but over time those rights were limited and the rights of other users (farmers, foresters, breathers!) increased. This is not an externalities challenge to the efficiency of markets, but rather a story of developments outside of markets.
The tobacco case raises somewhat different questions. I’d say if there are inefficiencies arising from cost-shifting, that waste should be blamed on policy choices. I’m sure that health insurance companies have some sense of the additional cost of insuring smokers, and attempt to price that additional cost in their products.
In the analytical scheme that Demsetz is providing, I think we’d put the lobbying by oil and coal companies in the law and policy realm – they are fighting over the assignment of property rights. This is clearly something which has significant economic consequences, but again for Demsetz this is an effort which is outside of market exchange. Calling it “outside of market exchange” only means that you can’t call what is going on an example or source of market inefficiency.
But right at the end of the lecture, Demsetz invokes the concept of public goods – goods which are nonrival in consumption and non-excludable in production. It is a somewhat different framing of issues, but frequently the concepts are worked together. Demsetz appears to want to keep public goods and reject externalities as tools for economic analysis. (NOTE: Some edits to this last paragraph after first posting it.)
Michael, I suspect that a neo-classical economist would find this statement troubling:
“I think we’d put the lobbying by oil and coal companies in the law and policy realm – they are fighting over the assignment of property rights. This is clearly something which has significant economic consequences, but again for Demsetz this is an effort which is outside of market exchange. Calling it “outside of market exchange” only means that you can’t call what is going on an example or source of market inefficiency.”
In effect you have acknowledged externalities “the lobbying by oil and coal companies in the law and policy realm,” and the fact that “This is clearly something which has significant economic consequences, but again for Demsetz this is an effort which is outside of market exchange.” So in attempts to explane the cases which could be offered in defense of the social cost, Demsetz is forced to acknowledge activities that ocurre outside the market, which have economic consequences. As we have noted these external activities may determine who pays for the secondary consequences of market based exchanges. I would describe the failure of participants in the tobacco market – tobacco companies and smokers – to pay the cost of treating smoking related health problems as something external to that market as producing market inefficiency. The market has failed to internalize a price for a known consequences of product use. While we can see this as part of the social arrangement, we will also see it as a discrepancy between the price which tobacco purchasers pay for the use of tobacco, and the actual cost of tobacco use. That discrepancy is what social costs are about. The market is inefficient in its failure to allocate all of the cost associated with tobacco use, and therefore to shift some costs associated with product use to people who do not participate in the market.