Externalities: Efficiency and Liberalism

The article by Ronald Coase, “The Problem of Social Cost”, was both a contribution to economic thought and a detriment to liberty due to a misguided conception of human decision making.  The result was a justification for government action, in the affairs among men, which reduces the property of some while providing additional property to others.  Coase’s use of common law and a supposedly impartial judicial authority has removed the basic tenant of liberalism which provides the strong presumption of equality among men before the law.  The idea of externalities has been used by activist officials in governments to impose illiberal policy agendas and weaken common and binding property rights.

Coase describes externalities as costs upon non-consenting third parties to a transaction and he offers policy prescriptions which would distribute property rights in what is deemed the most efficient use of resources.  Embedded in Coase’s framework is the disregard for who should have property in something as dependent upon ethical taste.  Instead he argues for reciprocity and shows that, by virtue of physical properties, insatiable desires and less than infinite resources will lead to costs borne by someone regardless of the liberal propriety in which another person acts.  He prescribes that an impartial authority take the case of an externality and determins whether a consensual contract can be made.  The cases in which transaction costs are too high, the authority is to decide upon the most desirable outcome.  Coase’s argument, in cases which transaction costs prevent contract, implies classical utilitarianism.  That is, he promotes a system in which the subjective valuations of an arbiter are used in the place of a voluntary market system of revealed preferences.

Of course, Coase was not intent on diminishing property rights.  He merely sought a more efficient allocation.  However, like all preferred and defined distributions of goods, there does not exist natural mechanisms which reinforce the new and artificial allocation.  Any such system is therefore continuously diverging from the preferred state as resources move toward equilibrium [in accordance with natural law: law of gravity, inertia, demand, thermodynamics, etc].  This requires constant tinkering by an authoritarian in order that the preferred distribution be maintained.  It is constantly necessary that all people are insecure in their property to the extent that the preference of the authoritarian is separate from the laws of nature and economics.  The effect of Coase’s work has been to provoke an army of bureaucratic do-gooders who are continuously employed and looking for opportunities to “correct” the “mal-distribution” of property rights.  They don’t know that Coase presumed, based on historical precedence, that English common law affirms emergent property – it neither discovers nor determines it.

A more complete concept of externalities was provided by Harold Demsetz in “The Exchange and Enforcement of Property Rights” (who obviously had the benefit of Coase’s work).  He pointed out that externalities are not inefficient so long as the uncaptured costs or benefits are internalized by another agent.  In this way, voluntary action would replace artificial and less than omniscient authorities whose job it is to determine property rights.  Of course property regimes would not remain static.  They would change as technology and institutions emerge which would promote the change in order that people could produce and consume more.  Property rights would tend toward efficiency through the confrontation with economic realities rather than require legislative processes.  People would be more free from discretionary authoritarian imposition and enjoy a more stable regime of property.  Market prices, which reflect real underlying scarcities and values, would remain a primary reflection of economic change.  However, at least one less source of volatility, arbitrary government action, would exist.

The alternative to government property determination is that the government refrains from redistributively addressing externalities when all parties have impetus to act as if informed of the externalized costs.  As long as people are aware of relative price changes, then they will adjust their behavior – having internalized the costs of externalities in the prices.  One may attempt to argue over which externalities are just or unjust.  But the economics and natural law frameworks do not require as much.  Once a cost has been internalized and accounted for, it will be monetized and reflected in quantities and prices.  Capital and people will flow appropriately in response to the new feedback scheme of profit and loss.  These price changes always reflect mass interpretations of economics realities, or pending realities, and are more often accurate than any bureaucratic administrator – much less the regulation that actually ends up enacted.

The threat of government imposition upon liberty then becomes a matter of whether prices reflect accurate information.  Luckily, this does not imply that governments levy tariffs and subsidies as Arthur Pigou suggested (The Economics of Welfare).  Rather, it merely suggests that third parties be informed that the costs exist.  Willingness to pay and sell adjust and the knowledge is imparted to the relative prices.  Even then, most costs would not require government intervention in order to be communicated (as by price).   It is entirely possible that some knowledge is unknown to the market participants.  In such a case, it MAY be proper and more efficient if an entrepreneur or the government provided that information.  There MIGHT be a role for public service announcements (PSA) so that people are informed of the additional costs or benefits that they bear or will bear in the future.  In such a way, the cost will be internalized, considered, and weighted to the extent which is consistent with each agent’s unique subjective valuations.  This is not a new intervention and is a holdover from the implications of Coase’s analysis.  This is, however, a far cry from government reallocation of property.

For example:  Let’s use global warming.  It may be that a Kentucky coal-burning electric plant is providing the benefit of electricity to Kentuckians and imposing part of the cost, in the form of climate change, on the poor people of northern Nigeria.  If those Nigerians know that the land in which they enjoy property shall be less fruitful, then the price of that land will adjust to incentivize capital and people to move from it or to allocate their efforts toward more productive purposes.  But maybe this gives too much credit to people.  Maybe people are unable to conceptualize and comprehend the impact of global change.  Even here, there is room AGAINST government action and even against PSAs.

Does it matter that the poor Nigerians don’t accurately anticipate the effects of climate change on their property?  Of course, if prices reflect the expected net present value of future cash flows, then the price of Nigerian land shall be inaccurate for a time.  But the beauty of prices is that they have an impetus to confront reality, sooner or later, and transmit information.  So yes, the prices can be wrong.  But would government action be any less wrong?  Would a bureaucrat know the magnitude, applicability, and timing of ‘proper’ price changes in order that prices be more correct?  And more importantly, is there an impetus for such a convergence between the regulated price and economic reality?  Excuse my public choice doubts here.

Even if the poor Northern Nigerian is completely ill informed about future productivity and is a complete imbecile, he will act AS IF he knew the effects of climate change.  Over years and even generations, land productivity changes, lifespan changes, lifestyles change.  Does this require externalities? Not at all!  It is part of living in a dynamic world.  The person who suffers or benefits from externalities will see proportions of their expenditures change, their discounts rates will change, any number of choices will be made differently.  No one needs to know the workings and models of climate change for economic efficiency.  It is only necessary that a system of dynamic feedback be permitted to function so that the effects of climate change are realized insofar as they affect the levels of agent satisfactions.  The more feedback there is, the more behaviors change, and the more people will get what they want in the face of physical and economic constraints.

Coase meant well by introducing transaction costs to the consideration of externalities.  However, he opened the door for government to determine the outcomes which are most ‘preferred’.  In effect, he gave theoretical license to the state so that it could choose winners and losers.  Coase ignored that people respond to prices.  He neglected the natural law that all matter responds to stimuli.  A rich theory of externalities implies more liberty – not less.  It is unfortunate that Coase’s contribution remains the representative theory in property rights when a more complete and liberal field has developed.

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