Friedman, Pigou, Coase

In a rightly famous 1960 meeting⊕ Famous among economists, at least. Ronald Coase persuaded a room full of University of Chicago economists that his view on what we now call externalities and transaction costs (the costs associated with market exchange) was correct. His argument subsequently appeared in the very readable The Problem of Social Cost. In a delightful interview with Richard Epstein, Coase likened his claims to asserting $2+2=4$.

I was once privileged to speak at some length with Deirdre McCloskey, who repeated a statement from The So-Called Coase Theorem that ‘something like a dozen people in the world understand that the “Coase” theorem is not the Coase theorem’. I’m presumably outside of that group. Nevertheless, I will try to provide some intuition from one non-economist to another.

The primary insight in The Problem of Social Cost is typically Coasean: beautiful, simple, and deep. It is that an externality is a joint production between two parties: a polluter and a nearby resident; a noise maker and someone within earshot; a spark-producing train and a grain farmer (Coase’s example).

When my neighbor blasts his music loud and I’m not home, there is no conflict. When I’m home and he is not blasting music, there is no conflict. But when he is blasting and I am home, together we produce a conflict. The conflict is transactional. You cannot speak meaningfully of one side imposing harm on the other, because the conflict is a joint production.

Normal economic reasoning about transactions applies. The terms of the interaction are potentially subject to negotiation. What makes it worthwhile for each party to accommodate the other? Can they agree on terms? Compensation of one kind or another could change hands to satisfy an aggrieved party. Is it feasible to reach such an arrangement?

Transaction costs associated with this negotiation are an obstacle to its resolution. Therefore one should look to reduce transaction costs to improve the chances for the two parties to resolve the conflict.

That’s my understanding of Coase’s meaning in The Problem of Social Cost.

The pre-Coasean view was based on work by Arthur Pigou. In this view, one party imposed costs or conferred benefits on another in the case of externalities. For imposed costs, a tax should apply to the offending activity to cause the offender to internalize the costs of the externality on the offended party. One party produces the conflict, and the other is its mere victim. There is no notion of transactional conflict.

The contrast between the pre- and post-Coasean rhetoric is stark. In the pre-Coasean case one speaks of “imposed costs” and interventions in order to force the imposer to “internalize” them. In the post-Coasean case the question is one of transaction costs limiting options for negotiated settlement.

Transaction costs cannot always be reduced sufficiently to resolve a conflict. A standard example is air pollution. In some cases you have many people on one side of the externality transaction (a factory producing smoke in a neighborhood) or many on each side (drivers emitting smog, and bystanders breathing it). Transactions costs could be so high as to prevent any hope of negotiated resolution. Maybe a Pigouvian tax is the best one can do. But even then, we should not abandon the post-Coasean view. The externalities remain transactional, even if impossible to resolve by negotiation.

Watching Peter Robinson interview Milton Friedman prompted me to write this blog. When they discuss the pollution, Friedman explains the desirability and difficulty of negotiated resolution of the conflict, but several times he mentions one party “imposing a cost” on the other. In his defense, he sometimes qualified with “uncompensated”, but not always.

I have little doubt that Friedman understood Coase well. He was reportedly the leading questioner in that famous meeting. But here he wandered between the pre- and post-Coasean rhetoric, even if not between the views. Every utterance of “imposing a cost” sounded like a small step away from Coase’s fundamental insight about the joint production of externalities.