The+Problem+of+Social+Cost

 ** 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