Economists, trained in the study of markets, learn early of various problems grouped under the heading of "market failure"--situations that, at least potentially, could justify government intervention to solve them. Cartels and monopolies, for example, are thought by many to require government antitrust action; optimal production of public goods like national defense or national highways likewise are frequently said to necessitate government intervention in otherwise private markets.
Almost certainly, however, externalities (or "social costs") are perceived as the greatest market failure problems. (1) Harold Demsetz (2003: 283) (2) recently described the fundamental economic issue:
The short-hand description for this [externality problem] is that
private costs (or benefits), which do influence a resource owner, are
not equivalent to the total of social costs (or benefits) associated
with the way an owner uses his resources. An example ... concerns
the use of soft coal by a steelmaker. The soft coal produces soot.
The soot descends on a neighboring laundry, making it more difficult
for the laundry to clean its customers' clothes, but this cost is
not faced by the owner of the steel mill when he decides to use soft
coal to fuel the steelmaking process.
Perceptions that externalities are ubiquitous have helped produce a generation of large-scale governmental interventions in the form of national environmental legislation and related regulation.
The externality issue has also occasioned rethinking of basic economic principles, particularly in the context of Ronald Coase's (1960) celebrated article, "The Problem of Social Cost." As is now well understood, Coase explained that externalities were themselves manifestations of a more fundamental issue in economies, the costs of transacting over rights to undertake actions that affect other people. Low transaction costs allow internalization of social costs, and so reduce the incidence of externalities; as those costs rise, so does the extent of externalities. Coase's analysis of the problem of social cost has been so powerful that economists, almost automatically, now think of social costs as a problem only when transaction costs are perceived to be relatively high. In the limit, if there were no transaction costs, there seemingly would be no social costs.
Yet, Coasean analysis of externalities has been the subject of much confusion, even disagreement. Demsetz (2003) in particular has pointed to aspects of the Coase approach that, as a matter of both economics and of government policy, he finds problematic. As a matter of economics, Demsetz says, Coase's focus on transaction costs is not helpful in resolving questions concerning externalities. Even in a hypothetical world of zero transaction costs, Demsetz writes, externalities would still exist. Moreover, Demsetz fears, focus on transaction costs as the reason for the persistence of externalities furnishes spurious reasons for undesirable government intervention in markets.
The recent Demsetz objections to Coase's approach concerning externalities are considered further in the next section. I then evaluate those objections. To a considerable extent, Demsetz ignores points that Coase has made, not in "The Problem of Social Cost," but elsewhere. At the same time, Demsetz adds new insights to the Coase Theorem, in particular emphasizing the weakness of arguments for government intervention to solve externality problems even in the presence of high transaction costs. At points, the present article may read like a literary explication de texte. But in fact, the Demsetz critique raises fundamental economic issues, some new and others worth revisiting.
Internalizing External Costs: Demsetz on Coase
The Coasean Model
"The Problem of Social Cost" sought principally to dispel what Coase saw as economists' unquestioning acceptance of A. …