Thoughts on economics and liberty

Transcription of externality-related content from a Demsetz interview

With reference to this [see details here]

The relevant transcript

Demsetz (at around 22 minutes):

If the market can’t easily handle a problem like air pollution…

Why can’t it easily handle the problem?

Well, it’s difficult to have somebody own the quality of the air. There’s a big free-rider problem. If I drive a car and I say I’m going to put a small controlling device (for pollution) on my car at my cost and everybody benefits freely from that because they get to breathe the cleaner air. Well, hardly anybody’s going to want to put a device on their car. They want to wait for other people to do it. So it’s a difficult problem for the market to wrestle to the ground.

But you can have the authorities, presumably with high quality research behind them – which is not necessarily true – say what the total amount of air pollutants are we want to allow into the air, and then you could specify the number of tonnes of air pollutants. And you could issue coupons or certificates that give permission to put a ton of pollutant in the air. And you could distribute these to the industry with the total number of coupons equaling and sum the total amount of pollution you want to put into the air. And then you let these guys buy and sell these coupons back and forth.

The nice thing about that is that a firm that finds it very costly to get rid of pollution – and that means costly for customers of its product also – would buy the coupons from a firm that finds it very easy to get rid of pollution. And you’d get the total desired amount the pollution obtained at the lowest possible cost, whereas if you go around with detailed regulation of “you could put this out, you could put that out” you get a mess.

So that’s a good was a good idea and it shows what private property rights can do. The coupons are a form of property rights.

Interviewer Mark Grady: It’s a successful idea, they use that idea. The EPA uses that idea. That would be an example of how your ideas on property rights have led to a major policy change. The environmentalists support it. Before you wrote this piece I don’t think people understood clearly how property rights solve social problems, and what that article led to was really a more aggressive use of property rights in order to solve some very thorny problems that couldn’t be solved [otherwise]

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Interviewer at around 35 minutes: Who was AC Pigou?

Demsetz: A.C. Pigou who was a famous British economist who inherited the chair of the more famous economist at that time, Alfred Marshall, at Cambridge, I believe. He pointed out something that economics was ignoring. He wasn’t the first one, by the way. Alfred Marshall pointed it out in his textbook, but he did it in an entirely different context in a very different way and it didn’t make many waves.

Pigou picked up the idea and he wrote a book called the Economics of Welfare in which this was the centerpiece. This idea came to be known as externalities in the profession. What it was about was the following:

Well, in the marketplace if you want something you pay for it, and if you want to supply it you pay the cost of supplying it, and if you can’t find somebody who wants to buy it, well you go out of business. You get what you pay for. And whoever buys what they purchase from me gets what they purchase from me. Whoever doesn’t buy it from me, doesn’t get it.

Pigou said, “Just a minute!” You run this steel plant, a steel mill. You use coal and you produce steel. You sell the steel to people. They get the steel, just like the market says – they pay for it. They don’t get it unless they’re willing to pay enough to cover the cost of producing it. So that’s the way resources get allocated nice and efficiently. They only go where people are willing to pay to have them.

But, when you burn that coal soot comes out of the smokestack. And that soot descends on, let’s say, a neighboring laundry. It makes it more expensive to launder the clothes. Well, this launderer didn’t buy that soot. He doesn’t want it. That’s an externality. It’s something that’s an external cost. There could be external benefits. External benefit is if I put to put a nice garden in my front yard and all the neighbors enjoy it as they walk by they don’t pay for it. So it breaks the nexus between getting what you pay for and what you ain’t getting. Sometimes you get a bad externality, sometimes you get a good externality. So he pointed this out and said: “Ah, because of this you’re not really getting the efficient allocation of resources that the exponents of neoclassical economics claimed, came from the market, because there was no market transaction here”.

Interviewer Mark Grady: So you’re getting too many bad externalities like soot, and too few …

Demsetz: It’s not just the soot, but what you said is true. What it really is, you raise the cost of laundering, so you so the price of laundering goes up. You get less clean clothes than you otherwise would get. And since the steel mill owner doesn’t pay the launderer for the damages, he produces more steel than he would if he had to pay the damages, so you get too much steel and too little cleansing of clothes, as a result of these externalities, as compared to what you would get if everybody paid for everything they got and didn’t get anything they didn’t pay for.

Interviewer Mark Grady: Now, what was his solution to that problem, because he had some solutions, I think.

Demsetz: Well, his solution was – I call it a Nirvana solution. Somehow the government knows exactly how much the steel mill ought to pay for putting out that soot, so it would levy a tax on the steel mill in proportion to the amount of soot that’s put out, or the amount of soft coal that it uses. And that tax raises the cost to the steel mill of using the soft coal, so it’ll use less soft coal, and you’ll get a lesser steel, and if the government sets the tax at exactly the right place, you’ll get the efficient amount of steel out of there and the efficient amount of cleansed clothes.

Interviewer Mark Grady: And why would that be a Nirvana for the government?

Demsetz: Well, the government doesn’t know what tax to levy and how to calculate these things at all.

Interviewer Mark Grady: Taxation was his solution, and he had to get the taxes exactly right in order to get efficiency.

Demsetz: Yes, he could overshoot and have too little coal and too little steel, and make the problem worse.

That’s Pigou’s claim to fame. He created this [externality] problem. And over the years he convinced almost the entire economics profession of the validity of his criticism.

Interviewer Mark Grady: Now that’s where your friend and colleague at Chicago ..

Demsetz: I’m coming to that.

He didn’t convince at least one person and that was Ronald Coase. Ronald Coase thought that Pigou was ignoring an important consideration, and that is he was ignoring the fact that it costs something to use the price system, it costs something to transact in the marketplace. And therefore, his reasoning went askance.

Well, yes and no.

Coase conjured up two cases. One, in which there’s no cost of transacting. You can carry out any transaction as you like without having to pay somebody to be your agent or whatever the case may be. In that case there is no externality. Why, because let’s suppose the law says that the steel mill has the right to burn soft coal without paying a tax. In that case the soot comes out and descends on the laundry.

Now look at this whole thing prospectively. This hasn’t happened yet. The steel mill is about to open up business, so the launder says, “Oh wait a minute. you’re going to make my business worse because they’re imposing a cost on me”. Steel mill says, “Well, I’m sorry but I have the right to do this”. So in that case the guy who owns the laundry goes over and knocks at the CEO’s door of the steel mill and says: “I’ll pay you to use less soft coal or produce less steel”. And how much will he pay? He’ll pay an amount that’s up to the additional cost that’s imposed upon him by the soot (if he didn’t eliminate that soot).

Interviewer Mark Grady: The damage to his laundry.

Demsetz: The damage to his laundry, right. Well, in this way the owner of the steel mill does take into account the damage done to the laundry because if he continues to produce the same amount of steel, he forgoes receiving this payment from the launderer. So, this cost is not external.

Interviewer Mark Grady: There’s no externalities.

Demsetz: The cost is no longer external to the steel mill owners calculations.

Interviewer Mark Grady: Now, that depends upon the laundry owner being able actually to go over and to make this.

Demsetz:  That’s the zero transaction cost case. So let’s suppose that it costs a hundred dollars to install the smoke precipitator which takes the soot out of the smokestack. So the launderer comes over. If he’s willing to pay a hundred dollars or more the soot gets taken out of the air. If he’s not willing to pay that much, the precipitator does not get installed and the soot still comes out of the smokestack. So he had these alternatives depending on what the arithmetic is in the case.

Let’s suppose now that he doesn’t want to pay $100, so the soot comes out in the air. Now a law student or a law professor jumps up and says: “Oh well, the law should have said that this the owner of the laundry has a right to soot-free air”. So now the steel mill can’t put that soot out without breaking the law. These are all law-abiding citizens. And if he does put the soot out, he’ll have to pay damages. So now to CEO who owns the steel mill goes over to the laundry and says: “Gee my costs are higher as a result of this law. I’ll pay you for your permission to put soot up in the air”. And the laundry says: “Well, how much are you’re willing to pay?” And the steel mill says: “I’ll pay you more than $100 dollars, or a hundred dollars anyway”. And the launderer stops and says, “Well, the cost that’s imposing on me (as we reckoned in the last example) is less than a hundred dollars” so he says “OK it’s a deal”. So, you get soot in the air no matter which way the law assigns the right.

Interviewer Mark Grady: And that’s Coase theorem, I think.

Demsetz: That’s right, that’s the Coase theorem. George Stigler called it the Coase theorem, Coase never did. That no matter which way you define the law, you get the efficient amount of soot and the efficient amount of laundering.

Interviewer Mark Grady:  That’s why your work was so important in the Chicago tradition because you could have the Coase theorem but unless you have property rights as you demonstrated.

Demsetz: You’re right about that, and I don’t think I’ve ever really emphasized that. So I think that’s a good point – I’ll have to write an article. Well, I [have] this new book of essays about property rights being a prerequisite to transactions, so that’s true.

Interviewer Mark Grady: How about here in the Los Angeles basin where they’ve created these property rights to emit pollution.

Demsetz: They’re really property rights to these certificates which give you the right to put pollution in the air. If you don’t have any certificates you can’t put this soot in there.

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Sanjeev Sabhlok

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