The Problem of Social Cost

From “The Problem of Social Cost” by R. Coase, Journal of Law and Economics, 1960

Pages 39-44 (the most relevant parts are in red):

IX. THE PIGOVIAN TRADITION

It is strange that a doctrine as faulty as that developed by Pigou should
have been so influential, although part of its success has probably been due
to the lack of clarity in the exposition. Not being clear, it was never clearly
wrong. Curiously enough, this obscurity in the source has not prevented the
emergence of a fairly well-defined oral tradition. What economists think
they learn from Pigou, and what they tell their students, which I term the
Pigovian tradition, is reasonably clear. I propose to show the inadequacy of
this Pigovian tradition by demonstrating that both the analysis and the
policy conclusions which it supports are incorrect.

I do not propose to justify my view as to the prevailing opinion by copious

references to the literature. I do this partly because the treatment in the
literature is usually so fragmentary, often involving little more than a reference
to Pigou plus some explanatory comment, that detailed examination
would be inappropriate. But the main reason for this lack of reference is
that the doctrine, although based on Pigou, must have been largely the
product of an oral tradition. Certainly economists with whom I have discussed
these problems have shown a unanimity of opinion which is quite
remarkable considering the meager treatment accorded this subject in the
literature. No doubt there are some economists who do not share the usual
view but they must represent a small minority of the profession.

The approach to the problems under discussion is through an examination
of the value of physical production. The private product is the value of the
additional product resulting from a particular activity of a business. The
social product equals the private product minus the fall in the value of production
elsewhere for which no compensation is paid by the business. Thus,
if 10 units of a factor (and no other factors) are used by a business to make
a certain product with a value of $105; and the owner of this factor is not
compensated for their use, which he is unable to prevent; and these 10 units
of the factor would yield products in their best alternative use worth $100;
then, the social product is $105 minus $100 or $5. If the business now pays
for one unit of the factor and its price equals the value of its marginal
product, then the social product rises to $15. If two units are paid for, the
social product rises to $25 and so on until it reaches $105 when all units of
the factor are paid for. It is not difficult to see why economists have so
readily accepted this rather odd procedure. The analysis focuses on the
individual business decision and since the use of certain resources is not
allowed for in costs, receipts are reduced by the same amount. But, of course,
this means that the value of the social product has no social significance
whatsoever. It seems to me preferable to use the opportunity cost concept
and to approach these problems by comparing the value of the product
yielded by factors in alternative uses or by alternative arrangements. The
main advantage of a pricing system is that it leads to the employment of
factors in places where the value of the product yielded is greatest and does
so at less cost than alternative systems (I leave aside that a pricing system
also eases the problem of the redistribution of income). But if through
some God-given natural harmony factors flowed to the places where the
value of the product yielded was greatest without any use of the pricing
system and consequently there was no compensation, I would find it a
source of surprise rather than a cause for dismay.

The definition of the social product is queer but this does not mean that
the conclusions for policy drawn from the analysis are necessarily wrong.
However, there are bound to be dangers in an approach which diverts attention
from the basic issues and there can be little doubt that it has been
responsible for some of the errors in current doctrine. The belief that it is
desirable that the business which causes harmful effects should be forced
to compensate those who suffer damage (which was exhaustively discussed
in section VIII in connection with Pigou's railway sparks example) is undoubtedly
the result of not comparing the total product obtainable with
alternative social arrangements.

The same fault is to be found in proposals for solving the problem of
harmful effects by the use of taxes or bounties. Pigou lays considerable stress
on this solution although he is, as usual, lacking in detail and qualified in
his support. Modern economists tend to think exclusively in terms of
taxes and in a very precise way. The tax should be equal to the damage
done and should therefore vary with the amount of the harmful effect. As
it is not proposed that the proceeds of the tax should be paid to those suffering
the damage, this solution is not the same as that which would force a
business to pay compensation to those damaged by its actions, although
economists generally do not seem to have noticed this and tend to treat the
two solutions as being identical.

Assume that a factory which emits smoke is set up in a district previously
free from smoke pollution, causing damage valued at $100 per annum.
Assume that the taxation solution is adopted and that the factory owner
is taxed $100 per annum as long as the factory emits the smoke. Assume
further that a smoke-preventing device costing $90 per annum to run is
available. In these circumstances, the smoke-preventing device would be
installed. Damage of $100 would have been avoided at an expenditure of
$90 and the factory-owner would be better off by $10 per annum. Yet the
position achieved may not be optimal. Suppose that those who suffer the
damage could avoid it by moving to other locations or by taking various
precautions which would cost them, or be equivalent to a loss in income of,
$40 per annum. Then there would be a gain in the value of production of
$50 if the factory continued to emit its smoke and those now in the district
moved elsewhere or made other adjustments to avoid the damage. If the
factory owner is to be made to pay a tax equal to the damage caused, it
would clearly be desirable to institute a double tax system and to make
residents of the district pay an amount equal to the additional cost incurred
by the factory owner (or the consumers of his products) in order to avoid
the damage. In these conditions, people would not stay in the district or
would take other measures to prevent the damage from occurring, when the
costs of doing so were less than the costs that would be incurred by the producer
to reduce the damage (the producer's object, of course, being not so
much to reduce the damage as to reduce the tax payments). A tax system
which was confined to a tax on the producer for damage caused would tend to
lead to unduly high costs being incurred for the prevention of damage. Of
course this could be avoided if it were possible to base the tax, not on the
damage caused, but on the fall in the value of production (in its widest
sense) resulting from the emission of smoke. But to do so would require a
detailed knowledge of individual preferences and I am unable to imagine
how the data needed for such a taxation system could be assembled. Indeed,
the proposal to solve the smoke-pollution and similar problems by the use
of taxes bristles with difficulties: the problem of calculation, the difference
between average and marginal damage, the interrelations between the damage
suffered on different properties, etc. But it is unnecessary to examine these
problems here. It is enough for my purpose to show that, even if the tax
is exactly adjusted to equal the damage that would be done to neighboring
properties as a result of the emission of each additional puff of smoke, the
tax would not necessarily bring about optimal conditions. An increase in the
number of people living or of business operating in the vicinity of the
smoke-emitting factory will increase the amount of harm produced by a
given emission of smoke. The tax that would be imposed would therefore
increase with an increase in the number of those in the vicinity. This will
tend to lead to a decrease in 'the value of production of the factors employed
by the factory, either because a reduction in production due to the tax will
result in factors being used elsewhere in ways which are less valuable, or
because factors will be diverted to produce means for reducing the amount
of smoke emitted. But people deciding to establish themselves in the vicinity
of the factory will not take into account this fall in the value of production
which results from their presence. This failure to take into account costs
imposed on others is comparable to the action of a factory-owner in not
taking into account the harm resulting from his emission of smoke. Without
the tax, there may be too much smoke and too few people in the vicinity
of the factory; but with the tax there may be too little smoke and too many
people in the vicinity of the factory. There is no reason to suppose that one
of these results is necessarily preferable.



X. A CHANGE O F APPROACH

It is my belief that the failure of economists to reach correct conclusions
about the treatment of harmful effects cannot be ascribed simply to a few
slips in analysis. It stems from basic defects in the current approach to
problems of welfare economics. What is needed is a change of approach.
Analysis in terms of divergences between private and social products
concentrates attention on particular deficiencies in the system and tends to
nourish the belief that any measure which will remove the deficiency is
necessarily desirable. It diverts attention from those other changes in the
system which are inevitably associated with the corrective measure, changes
which may well produce more harm than the original deficiency. In the
preceding sections of this article, we have seen many examples of this. But
it is not necessary to approach the problem in this way. Economists who
study problems of the firm habitually use an opportunity cost approach
and compare the receipts obtained from a given combination of factors with
alternative business arrangements. It would seem desirable to use a similar
approach when dealing with questions of economic policy and to compare
the total product yielded by alternative social arrangements. In this article,
the analysis has been confined, as is usual in this part of economics, to comparisons
of the value of production, as measured by the market. But it is,
of course, desirable that the choice between different social arrangements
for the solution of economic problems should be carried out in broader terms
than this and that the total effect of these arrangements in all spheres of
life should be taken into account. As Frank H. Knight has so often emphasized,
problems of welfare economics must ultimately dissolve into a study
of aesthetics and morals.

A second feature of the usual treatment of the problems discussed in this
article is that the analysis proceeds in terms of a comparison between a
state of laissez faire and some kind of ideal world. This approach inevitably
leads to a looseness of thought since the nature of the alternatives being
compared is never clear. In a state of laissez faire, is there a monetary, a
legal or a political system and if so, what are they? In an ideal world, would
there be a monetary, a legal or a political system and if so, what would they
be? The answers to all these questions are shrouded in mystery and every
man is free to draw whatever conclusions he likes. Actually very little analysis
is required to show that an ideal world is better than a state of laissez
faire, unless the definitions of a state of laissez faire and an ideal world
happen to be the same. But the whole discussion is largely irrelevant for
questions of economic policy since whatever we may have in mind as our
ideal world, it is clear that we have not yet discovered how to get to it from
where we are. A better approach would seem to be to start our analysis with
a situation approximating that which actually exists, to examine the effects
of a proposed policy change and to attempt to decide whether the new situation
would be, in total, better or worse than the original one. In this way,
conclusions for policy would have some relevance to the actual situation.

A final reason for the failure to develop a theory adequate to handle the
problem of harmful effects stems from a faulty concept of a factor of production.
This is usually thought of as a physical entity which the businessman
acquires and uses (an acre of land, a ton of fertilizer) instead of as a
right to perform certain (physical) actions. We may speak of a person owning
land and using it as a factor of production but what the land-owner in fact
possesses is the right to carry out a circumscribed list of actions. The rights
of a land-owner are not unlimited. It is not even always possible for him to
remove the land to another place, for instance, by quarrying it. And although
it may be possible for him to exclude some people from using "his" land, this
may not be true of others. For example, some people may have the right to
cross the land. Furthermore, it may or may not be possible to erect certain
types of buildings or to grow certain crops or to use particular drainage
systems on the land. This does not come about simply because of Government
regulation. It would be equally true under the common law. In fact
it would be true under any system of law. A system in which the rights of
individuals were unlimited would be one in which there were no rights to
acquire.

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.
Just as we may use a piece of land in such a way as to prevent someone
else from crossing it, or parking his car, or building his house upon it, so
we may use it in such a way as to deny him a view or quiet or unpolluted
air. The cost of exercising a right (of using a factor of production) is always
the loss which is suffered elsewhere in consequence of the exercise of that
right-the inability to cross land, to park a car, to build a house, to enjoy
a view, to have peace and quiet or to breathe clean air.

It would clearly be desirable if the only actions performed were those in
which what was gained was worth more than what was lost. But in choosing
between social arrangements within the context of which individual decisions
are made, we have to bear in mind that a change in the existing system
which will lead to an improvement in some decisions may well lead to a
worsening of others. Furthermore we have to take into account the costs
involved in operating the various social arrangements (whether it be the
working of a market or of a government department), as well as the costs
involved in moving to a new system. In devising and choosing between social
arrangements we should have regard for the total effect. This, above all, is
the change in approach which I am advocating