Today’s Quote of the Day…

…comes from pages 149-150 of Carl Dahlman’s 1979 Journal of Law & Economics article The Problem of Externality (emphasis added, footnote omitted):

In case I, the laundry owner correctly anticipates the costs of bargaining to be low enough for him to gain from reducing the smoke outpour from the steel mill: the externality becomes internalized by the steel operator. In case II, he correctly anticipates the cost of smoke reduction would be too high: he thus lives with the smoke. The externality is now internalized by the laundry operator, and there is no inoptimality problem. In case III, the laundry owner decides to bargain for reduction in smoke outpour but finds in the process of bargaining and policing the agreement that it cost him too much to do so. In case IV, he decides to live with the smoke in the belief that it would cost too much to reduce it but is incorrect: he would have gained from reducing it in view of the costs of transacting with the steel operator.

We have already noted that in cases I and II there is no Pareto-relevant externality remaining; the question remains whether there is one in cases III and IV. In case number III there is obviously no Pareto-relevant side effect remaining; on the contrary, there is too little smoke. The laundry owner lost by having the smoke reduced, so total income is lower in case III than it would have been if the smoke had been endured. In case IV, however, the laundry owner should have bargained for a reduction in smoke outpour but failed to do so. This is then the only case that can qualify as a potential externality.
From the point of view of the laundry owner, it would not appear that it is a mistake to endure the smoke: given the information that he has at his disposal, he performs his constrained optimization and does nothing. His information is incomplete or wrong, so he makes the wrong decision: given the correct information there is a loss of income from the enduring of the smoke, and the situation looks very much like  that we associate with an  externality. Yet that interpretation is fundamentally incorrect, for, with the information that the laundry owner has at his disposal when he makes the decision, he decides correctly, as constrained optimization procedures would have it. It is only later that he may realize that he has made a mistake, in view of additional information that was not available at the time. This can be regarded as an externality only if you assume that “he should have known better” or that there is someone else who does know better.

Once the logical implications of bargaining under transaction costs are fully accepted, it is seen that all existing side effects are internalized one way or the other. An assertion that externalities represent a deviation from an optimal allocation of resources then implies that the analyst considers himself in possession of superior information than what is available to market transactors: he knows the “true” probabilities, as it were. The issue of whether an alternative and improved allocation of resources exists is then seen to hinge on whether there is available relevant information about better alternatives.

People will act on the best information they have at the time.  That information may be incorrect; they may make mistakes, and mistakes that were obvious in retrospect.  But they are exactly that: retrospect.  Unless we assume the policymaker has superior knowledge of everyone’s costs and benefits (possible but not probable), we cannot say ex ante that some policy prescription is necessary or beneficial for solving externalities or other societal ills.  It’s quite probable, given people’s subjective costs and benefits, that all costs of an externality have already been internalized, that is to say, an optimal level has already been achieved.

Any political policy that alters how a market works, anything ostentatiously designed to correct a “market failure” runs into the same problem Dahlman discusses here: a knowledge problem.  The analyst or policymaker must either prove he has superior knowledge (itself a high hurdle to clear) or merely assume he does.  But it is only by retrospect can we determine if there actually is a market failure; it is damn near impossible to see one in real time.

Coase, Transaction Costs, and Environmental Entreprenureship

Today’s Quote of the Day comes from pages 7-8 of Ronald Coase’s 1988 book The Firm, the Market, and the Law [emphasis added]:

Markets are institutions that exist to facilitate exchange, that is, they exist in order to reduce the cost of carrying out exchange transactions.  In an economic theory that assumes transaction costs are nonexistant, markets have no function to perform and it seems perfectly reasonable to develop the theory of exchange by an elaborate analysis of individuals exchanging nuts for apples on the edge of a forest or some similar fanciful example.

Many readers of Coase (including economists!) misunderstand him.  This is evident in the improperly named Coase Theorem (it’s improper in that it’s not a theorem).  In fact, Coase is so often misunderstood, he felt compelled to write the book this quote is from to clarify his point!  Coase is often understood to say that, absent transaction costs (or sufficiently low transaction costs), externality issues (eg pollution, noise, etc) can be solved by an allocation of property rights and, regardless of their initial allocation, will result in a Pareto-efficient outcome.  This is correct, but only a partial understanding of Coase.

Much of Coase’s work (and work that spun off from him, such as with Armin Alchian, Harold Demsetz, Gordon Tullock, and many others including my own) focus on the role of the market in addressing externality issues.  Detractors from Coase argue that his insights, that markets for externalities can exist only if there are no/low transaction costs, are not applicable to the “real world,” since transaction costs abound and, therefore, government intervention is necessary.  But this argument represents a misreading of Coase.  In a purely ideal world, there would be no transaction costs, but then no market would be necessary.  As Coase says in the above quote, it is in the world of transaction costs that the market is most useful!  The existence of transaction costs gives rise to firms and other means of human collaboration, which in turn reduce transaction costs, and increase the market exchange of individuals (see The Nature of the Firm (1937) for a more in-depth conversation on this point).

Expanding the idea of markets, firms, and transaction costs to environmental issues, we see the rise of “enviropreneurs” (to use the phrasing of PERC), that is people who seek out and find ways to mitigate these transaction costs in order to achieve desired environmental ends; in short, a market process of environmental concerns (for a detailed look at many different kinds of enviropreneurs, see Free Market Environmentalism for the Next Generation, especially Chapter 9).  The fact transaction costs exist is not a detriment to free market environmentalism, like the detractors of Coase argue, but rather what allows it to come about!

Like Coase (and Buchanan and many others) before me, I realize the market is not a panacea.  There may be conditions for government to get involved (namely where involvement by the firm or an individual are too costly).  But the work of Coase (and Alchian and Demsetz and Buchanan and Tullock and Anderson and many others) show us that the mere existence of an externality and transaction costs is not enough to justify intervention.

Cleaned by Capitalism, Mold Edition

In humid climates such as Virginia, mold can be a real problem in homes and other poorly-ventilated areas.  There are lots of health issues associated with household mold, but fortunately, there are many ways provided to us by capitalism to fight mold.  Dehumidifiers, both large and small, can prevent mold from forming.  Should mold form, there are lots of products that make cleaning mold easy and cheap.  So, for less than an hour’s worth of work for the average American laborer, s/he can clean their bathroom from mold and prevent it from growing again.

This is just another small example of how our world is becoming a cleaner and better place.

Make Sure the Cure Isn’t Worse Than the Disease

TANSTAAFL.  Every action taken has costs, and sometimes those costs are borne by those who had no say in the matter (“negative externalities” to use the technical term).  The existence of externalities is often used to justify government involvement in markets (pollution tends to be the common example).  Lately, however, protectionists scarcityists have begun using that argument to promote their policies, noting job loss as an externality.  Some, more generally, claim “practical people not tied to free trade dogma understand that trade sometimes is good and that it’s bad other times.”

It certainly is possible that, any given transaction, may have enough unforeseen negative consequences as to have negative net benefits.  However, the bar needed to justify government action is high:

From a purely economic perspective*, protectionists have two tasks before them:

1) Prove that imports cause greater net harm than domestic production

and

2) Prove the proposed solution minimizes the net loss (or, inversely, maximizes net benefits). This is where comparative institutional analysis comes in.

The mere existence of condition (1) is neither necessary nor sufficient to justify government intervention. If the cost of government intervention exceeds the benefits therefrom, then even though the free market option has a net loss, it is the optimal solution because the resulting intervention would make matters worse!

The existence of condition (1) may require collective action to solve, but it may be more cheaply solved via non-government collective decision making (ie, a firm).**

There may be cases where government decision making is the lowest cost option.  However, it is very much a case-by-case basis.  Blanket legislation (like a tariff) does not allow for the necessary flexibility to make such decisions.  In order to minimize costs (and thus maximize net benefit), freedom must be given first preference, with the burden of proof upon protectionists.

*There could be many other arguments for protectionism, such as legal, or national defense.  I shan’t get bogged down in a discussion here.  I’ll leave that to the experts.

**For a more in-depth discussion on this point, read The Calculus of Consent by James Buchanan and Gordon Tullock, in particular Chapter 5.

Water, Water Everywhere

This morning at Cafe Hayek, Don Boudreaux writes on water, responding to a radio program describing water as “our most precious resource.”  Don says (emphasis added):

While it’s true that water is a scarce resource, it is simply untrue that water is a precious resource.  Potable water is sufficiently abundant today in most places where human beings live that it can be acquired at a low price.  Indeed, given modern techniques for delivering and safely storing potable water, water is widely available today even in some desert areas, such as Las Vegas and Tucson.  And while I don’t defend (quite the contrary!) government subsidies that make water more available where and to whom it would be less available, it remains silly-talk to say that water is “our most precious resource.”  The market price of water testifies powerfully to the contrary.

Don’s comment is true for most of the US.  But what about places it’s not?  Third-World countries and the like?  Why is it we can produce water in Las Vegas, Phoenix, and Tucson, but not Venezuela, Zaire, and Somalia?  It’s clearly not the environment; the US has harsh deserts and tundras and yet no water issues (in fact, water to spare!).  I suspect it has more to do with the free market institutions of the United States that allows us to bring water everywhere.  There’s a lot of private water here (think bottled water).  It is sold (mainly) at market prices, so places that have abundant water (like Maine) can bottle it and sell it to Arizona, where it is more scarce.  The areas where there are no functioning price systems and lots of trade controls (like Venezuela, Zaire, and Somalia) are facing water crises.

In short: water is precious in places where it is not treated as a commodity (and, in some cases like Venezuela, called a “right”).  It is abundant in places it is treated as a commodity.

Toward a Better World

According to the organizers of Earth Day: “Education is the key to advocacy and advocacy is the key to change.”  I agree.  Toward that end, allow me to explain why free markets, and in particular secure private property rights, help make the world a better, cleaner, and more environmentally friendly place.

Property rights are important because they encourage the owners of that property right to maximize the property’s uses.  Property rights do this by having the owners incur the costs of their property (its upkeep, its development, etc), but also confers the benefits onto its owner; in other words, the greater concentration of costs and benefits means each person’s success is dependent on his/her activities.  As such, the property owner is incentivized to minimize costs and maximize benefits over the life of the property.

While there are many kinds of property rights, the type of right matters for environmentalism.  Contrary to many popular claims, public ownership of natural resources (national parks, nature preserves, and the like) may be counter to the goals of environmentalism; in other words, state-produced environmental efforts may make the situation worse, not better!  The reason for this is the incentive may not be as strong to maximize effort on the part of the property owner.

Allow me to explain by way of paraphrasing an example Armen Alchian gives in his 1965 Il Politico article Some Economics of Property Rights:

Suppose there is a community with 100 people in it, and 10 enterprises.  Further suppose that each person, by devoting 1/10th of his time to some enterprise as an owner, he can generate a gain of $1,000 for the enterprise.  If ownership of each enterprise is divided equally among the populace (that is, all the enterprises are “publicly owned,”), then he will produce a gain of $100 for himself each day (1/100th part owner and 10 firms) and the rest of his product ($9,900) going to the other members of the community.  If the other 99 people in the community act the same way, he will get $9,900 from them, bringing his total wealth gain to $10,000.

Now suppose that each person owns 1/10th of a single enterprise.  The individual now works to produce $10,000, of which he keeps $1,000 and the other $9,000 goes to the other owners.  If the other owners do the same, all end up with $10,000.

If we go to the extreme end and each enterprise is owned by a single person, then he gets to keep all $10,000 of his own hard work.

As we can see, in each case above, the reward to the property owner depends partly on his own effort and partly on the effort of others (except the last option).  In the first of the cases, the incentive for him to maximize his efforts is minimal: no matter how hard he works, he’ll only get $100 direct benefit from it.  The other $9,900 must come from someone else who may or may not have the same work ethic as him.

So, if a person is most incentivized to act when s/he absorbs the costs and the benefits, how will that help the environment?  Well, it’ll help by incentivizing the person to keep their property in working order.  A person who owns a home will do her best to keep the house neat, to keep the fixed costs (heating, cooling, water, etc) low.  They may, if they have time and money, plant a garden or maintain a yard in order to keep the house pretty.  Larger groups with common goals could pool money to maintain a park.  Firms, seeking to minimize their costs, are constantly looking for ways to reduce waste and increase output.  Owners of farms, of mines, and the like are always looking for ways to extend the life of their sources of wealth.

In short, people will look to take care of their own little plot of the world.  Environmentalists often urge us to “think globally, act locally.”  I can’t think of anything better than property rights to accomplish this task.

There are objections some might raise to the above discussion, and those I will address in another post as this one, at nearly 700 words, is already too long.

Earth Day 2017

Today is Earth Day.  Protecting and improving the environment is a big thing for me; in fact, it is one of the many reasons I love free markets.  One of the major champions of free market environmentalism is the Property and Environment Research Center (PERC) located in Bozeman, Montana.  I highly recommend checking out their blog and publications.

In the interest of full disclosure, I have no financial ties to PERC, but there are academic ties.  One of my professors, Thomas Stratmann, is a senior fellow.