9th March 2011
“The Problem of Social Cost: What Problem?” by Harold Demsetz
This article, by Harold Demsetz, published in the February 2011 issue of The Review of Economics and Law, is perhaps one of the most profound articles published since Hayek's pathbreaking 1945 paper "The Use of Knowledge in Society". Demsetz's article can be downloaded free of cost from the link provided above after you provide your your details. It has been an absolute pleasure to read this paper.
Some delectable quotes:
1. [T]here exists an efficient amount of ignorance in an economic system… Ignorance not only may be bliss, it also may be efficient.
2. If it remains positive because the cost of transacting between laundry and mill owners is too great to make a transaction worth undertaking or because the launderer and steel mill owner believe that the cost of substituting hard coal for soft is too great to make a transaction worth undertaking, then this positive amount of soot is efficient.
3. There exists an efficient degree of ownership that generally is smaller than ‘100 percent.’
4. [P]erfect would be inefficient…
5. Our reliance on a transaction cost rationale has caused us to exaggerate the scope of externality problems in a reasonably described decentralized economic system that puts control of resources into private hands.
6. Our reliance on a transaction cost rationale has caused us to exaggerate the scope of externality problems in a reasonably described decentralized economic system that puts control of resources into private hands.
7. [T]he category of problems that we call externality problems now includes a great many that are not strategic in nature.
It is an exquisite exposition on the assumptions underpinning the market (and the role of the state in provision of public goods) that I've read in a long time. Crystal clear. If a negotiation does not occur, that is because it is inefficient to negotiate. This is a basic but crucial insight and extends the Coase Theorem to almost every common situation where the government tends to butt in.
Another point that Demsetz makes supports what I have written in Breaking Free of Nehru (BFN) – arguing against the concept of "perfect competition" on the grounds that it is misleading. It was pleasing to have Demsetz rename this term as "perfect decentralisation" – which makes it so much more compatible with Hayek's paper cited above. The whole story of the free market now emerges so much more clearly than ever before.
The main point of this article is that commonly touted idea of externalities needs to be considered with a pinch of salt.
And indeed, I agree with Demsetz on most of what he says. He is very right to suggest that "transaction cost rationale has caused us to exaggerate the scope of externality problems". I take, however, a justice-oriented view of the world (based on the concept of freedom). I have not fully assimilated Demsetz's points (it will need a couple of further readings, and associated reading of Frank Knight to get to his points perfectly), but I will suggest that at least some externalities have little to do with strategic behaviour (of the sort that leads to the requirement for a coercive state).
In particular, as I note in BFN, "negative externalities are ethical failures, not ‘market failures’. We therefore need to build systems and mechanisms to ensure that everyone is held to account". Thus, I have no doubt that for some of the simple examples offered by Demsetz, his views are fully justified. I would suggest, however, that things can become messy in some cases even where property rights are properly allocated.
Take the example of second hand smoke that causes lung cancer. The venue in this case is private, and the guest pays the appropriate market price for entry, but the potential harm caused to the bar-man (lung cancer) is simply too large and disproportionate. It is not a simple "soot on laundry" type situation.
I believe Demsetz needs to consider the case where one can identify all buyers and sellers over a long period, and everyone involved knows the precise likelihood of harm, but no one knows which individual causes a particular secondary harm. Allocating property rights perfectly doesn't solve this problem (or at least the markets never figured out a solution by themselves).
Such a situation needs to be brought under some umbrella of justice, and that is where a government can enter, by imposing a ban on such risky behaviour even where property rights are fully allocated. I've elaborated on this in The Discovery of Freedom.
Overall, a brilliant article. Well worth a close read.
Note: Demsetz is a classical liberal, having been a Director of Mont Pelerin society.
ADDENDUM: Now please read Demsetz's reply here.