Academic journal article Harvard Journal of Law & Public Policy

A Coasean Approach to Cost-Benefit Analysis

Academic journal article Harvard Journal of Law & Public Policy

A Coasean Approach to Cost-Benefit Analysis

Article excerpt

Many federal regulators are required to perform cost-benefit analysis of rules proposed to correct the failure of private markets to efficiently allocate society's resources owing to so-called "externalities." Yet, as Ronald Coase showed decades ago, social inefficiencies cannot persist if the "costs of market transactions" are zero, putting the entire notion of market failure on shaky ground. Transacting is of course costly, but these are real costs that must be factored into the social welfare calculus. What kind of failure is it when the parties affected by an apparent externality could resolve the inefficiency but in practice decline to do so because the costs of transacting outweigh the net benefits? This article proposes a relatively simple Coasean approach to cost-benefit analysis. Where the parties deal face-to-face in competitive markets, a rule is justified only if the regulator can show it is likely to reduce the relevant transaction costs. If so, the parties can be relied on to adjust their private arrangements to maximize the net gains from trade out of self-interest. There is no need for the regulator to quantify costs and benefits. This is information the parties--the men and women "on the spot"--are best able to identify on their own.

INTRODUCTION
I.   OVERVIEW OF COST-BENEFIT ANALYSIS OF
     FEDERAL REGULATION
     A. Brief History
     B. Executive Agency CBA
     C. Independent Agency CBA
     D. The Scholarly Literature
II.  OVERVIEW OF TRADITIONAL COST-BENEFIT
     ANALYSIS
     A. Assessing Welfare in the Basic Neoclassical
        Model
     B. Market Failure as a Basis for Corrective
        Rules
III. A CLOSER LOOK AT MARKET FAILURE
     A. From Pigou to Knight to Coase
     B. Externalities Everywhere and Nowhere
IV.  WHAT ARE TRANSACTION COSTS?
V.   SUMMARY AND CONCLUDING REMARKS

"[W]hatever 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." (1)

"What I think will be considered in future to have been the important contribution of [The Nature of the Firm] is the explicit introduction of transaction costs into economic analysis."2 --R.H. Coase

INTRODUCTION

Economists have struggled for decades over how to do reliable cost-benefit analysis (CBA).3 During this time, Reagan-, Clinton-, and Obama-era executive orders and federal case law have increasingly required executive agencies to address "material failures of private markets" by integrating CBA into the rule-making process, with the stated objective being to "maximize net benefits" to society. (4) Federal statutes and case law have recently extended the CBA mandate to include independent agency rulemaking, primarily by financial regulators. Yet substantial controversy continues to swirl over the feasibility of CBA in a variety of settings and for a host of reasons, the most important among them being uncertainty in quantifying costs and benefits. (5)

The neoclassical model of market exchange provides the theoretical foundation for traditional CBA. It illustrates the welfare effects of trade embedded in market demand and supply assuming, among other things, that people behave "as if" they are rational maximizers, (6) that the affected parties face zero transaction costs, and that there are no externalities. In equilibrium, the model hypothesizes that market prices reflect marginal benefits and costs, and that the parties will capture all possible gains from trade in the form of consumer and producer surplus, which together constitute net social benefits or "social welfare."

The neoclassical model's main scientific function is to predict the direction of affected parties' response to parametric shocks, a method known as comparative statics. If the tax on cigarettes increases, for example, will the price, quantity traded, and quality of tobacco increase or decrease? The model makes no predictions about the magnitude of these changes, only their direction. …

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