Coase and Environmental Externalities

With the recent passing of Ronald Coase, much tribute has rightly been given to his inordinate contributions to the world of economics, here by Peter Boetkke and here by Patrick Lyons of the NYT.  I’m not an economist and don’t even pretend to be one on TV, but have followed and appreciated Coase’s contributions to the scholarship of environmental policy involving the economic problem of environmental externalities.  Most modern economists, save Coase, believe that environmental pollution is the result of market failure.  Adler has a good piece today on Coase’s rejection of the concept of externalities and corrects those who may misunderstand or misinterpret Coase’s argument.  According to Coase, when property rights are clear and well-defined, contracting parties, including the polluter, will allocate resources effectively and efficiently, as the economic benefits and costs – read environmental – are fully borne by the effected parties.  This idea was coined the Coase Theorem

Let’s apply Coase’s theory – my economist friends no doubt will correct me if I stray or engage in economic heresy.  Take, for example, a factory that discharges water pollution that negatively affects downstream users (e.g., impacts quality of a drinking water source or results in a fishkill reducing the catch size by fishermen).  In this case, the factory does not bear the full cost of its pollution, and the downstream users receive no benefits from being impacted.  Under a Coasean solution, the factory should pay the downstream users for their losses, thereby internalizing all external costspolluted water and benefits within the parties’ transactions.  Coase would argue that because the water quality in the stream and the fish are public goods, that they suffer the malady of the tragedy of the commons.   Coase also argued that transaction costs (i.e., the cost for searching and obtaining information, contract negotiations, and monitoring and enforcement of the agreement) of a theoretical transaction that would make all participants whole in terms of compensating for all benefits and costs, interfere with the transaction and eliminating the externalities.  Therefore, if we were able eliminate or reduce the transaction costs, the market participants would bargain with one another to produce the most efficient distribution of resources, regardless of the initial allocation of property.  Coase conceded, however, that his economic theory only works when property rights are well-defined and tradeable and acknowledged that real-world transaction costs are rarely low.

Terry Anderson and my friends over at the Property and Environmental Research Center (PERC) have done a lot of work in this area, seeking to promote greater clarity and use of property rights to improve environmental results.  Terry has been on a crusade of sorts to eliminate the use of the term externality for the following reasons.

For several years, I have been on a campaign to expunge the term “externality” from the vocabulary of economists, policy makers, and environmentalists. My campaign is not motivated by a belief that markets perfectly account for all costs and benefits. Rather it is driven by the lessons learned from entrepreneurs—the people with a passion for solving problems by finding win-win solutions. Entrepreneurs thrive in the space where there are impacts not accounted for in market transactions. It is in that space that they create gains from trade.

To reinforce Anderson’s entrepreneurial optimism, consider the win-win example I discussed here where the Willamette Partnership and Clean Water Trust worked with the City of Medford to compensate those impacted by the City’s discharge.  And the use of ITQs by our Canadian friends discussed here.  Anderson continues with a stream example of his own,

Consider the example of irrigation water withdrawals reducing stream flows for fish habitat. Viewed through the externality lens, trout fishers might argue that farmers are imposing costs on them and that the government should regulate water use. An environmental entrepreneur, however, sees an opportunity to convince trout lovers to contribute to the cause and to contract with farmers to increase instream flows.

Or consider the desire for open space. Through the externality lens, demanders of open space might say developers are imposing costs on them by building houses and that land use regulations are necessary. Land trust “enviropreneurs,” on the other hand, accept the landowner’s right to develop and obtain conservation easements to determine future land use.

There is a big difference between the externality approach and the entrepreneurial approach to improving environmental quality. Asserting the existence of an externality pits one user of a resource against another in a zero-sum game where property rights are not clear.  California’s Mono Lake is a quintessential example. In the early 1980s, environmentalists filed suit to stop Los Angeles from diverting water out of the Owens Valley even though the city had purchased the water by buying farmland and its accompanying water rights. The environmentalists “won” the suit, but it was not until the late 1990s when the legal wrangling ended and some water started flowing back into Mono Lake.

In contrast, entrepreneurship encourages conflict resolution and results in positive outcomes for all parties involved. Chris Corbin, a PERC enviropreneur fellow, epitomizes entrepreneurship. His firm, Lotic LLC, increases cash flows by encouraging efficient water use, by protecting and maximizing the value of water rights, and by developing water projects with ecological benefits. Rather than promoting conflict like that in the Mono Lake case, Corbin utilizes cooperation to keep more water in streams.

A Coasean view of the environment focuses on who owns the environment. When property rights are well-defined and enforced, markets can work their magic. When property rights are not so clear, environmental entrepreneurs who clarify them do good for the environment while doing well for themselves. In honor of Coase’s 100th birthday, let’s replace externalities with entrepreneurship. The more we do so, the more we will see conflict replaced with cooperation and environmental rhetoric replaced with environmental improvement.

I applaud and whole-heartedly endorse PERC and Anderson’s promotion of the entrepreneurial approach, but suggesting that it’s a better approach than externalities, doesn’t change the fact that externalities exist and the importance of reasonable regulations to define the market in which entrepreneurs should and must navigate.  Nor am I fully persuaded that the entrepreneurship approach by itself is sufficient to solve all environmental problems, but particularly involving national or regional environmental problems, given the shere complexity of the market, the nature and scope of environmental pollution, and the flawed presumption that market participants always act rationally.  In the world of water pollution, this is why the regulatory framework of the Total Maximum Daily Loads is so critical, as it defines the regulatory playing field for the market participants (ie., the polluters, those impacted by the polluters, and other market entrepreneurs).  The TMDL is scientifically premised on the assumption that the level of pollution that is permitted by law is within the limits acceptable to mother nature, i.e., the water will be fishable and swimmable if the TMDL is achieved.

My criticism of EPA under the TMDL program is limited to where the Agency moves beyond merely defining this playing field into micro-managing the market participants in the form of prescribed load and waste load allocations, which limits the space in which entrepreneurship can navigate and cost-effectively solve our water pollution problems.  This is where market-based approaches, such as water quality trading, are an important part of the solution.  EPA and its regulations are also necessary to helping monitor and regulate these types of environmental markets, to enforce against market cheats, and ensure that the water is getting cleaner.

Regardless of whether there’s agreement on the entrepreneurship or externalities approach as being better, there is agreement that a lot more work needs to be done.  And we can thank Ronald Coase for providing us greater insight and ideas toward improving the human condition and getting those things done.

[Update:  Linking to today’s post and tribute to Coase by Terry Anderson]

[Update:  Fair criticism of Coase’s theories here by John Cassidy in the New Yorker.  Cassidy writes:

As a conservatively inclined economist, Coase was instinctively skeptical of government regulations, but he was also an English empiricist who recognized that reality is complicated. He didn’t believe in laissez-faire, and he freely admitted that the Coase theorem didn’t apply to many cases of pollution and other instances of what economists refer to as “negative externalities,” especially those that affect large numbers of people.]