In the theory of externalities—that is, costs imposed involuntarily on others—there have been exactly two great ideas. The first, forever associated with the name of Arthur Cecil Pigou (writing about 1920) is that things tend to go badly when people can escape the costs of their own behavior. Factories pollute too much because someone other than the factory owner has to breathe the polluted air. Nineteenth century trains threw off sparks that tended to ignite the crops on neighboring farms, and the railroads ran too many of those trains because the crops belonged to someone else. Farmers keep too many unfenced rabbits when they don’t care about the lettuce farmer next door.
Pigou’s solution—and it’s often a good one—is to make sure that people do feel the costs of their actions, via taxes, fines, or liability rules that allow the victims to sue for damages. Do a dollar’s worth of damage, and you’re charged a dollar.
Pigou endorsed this policy not because it seems fair, though it does seem fair to many, but because it yields, under what he believed to be very general conditions, the optimal amounts of damage. We don’t want too much pollution, but we don’t want too little, either, given that pollution is a necessary by-product of a lot of stuff we enjoy. Pigou offered a proof—now standard fare in all the textbooks—that his policies lead to the perfect compromises, in a sense that can be made precise.
The second great idea about externalities sprang full-blown from the mind of a law professor and subsequent Nobel prize winner named Ronald Coase, who stunned the profession in 1960 by pointing out that Pigou’s argument runs both ways. If you breathe the pollution from my factory, I’m imposing a cost on you—but at the same time, you’re imposing a cost on me. After all, if you lived somewhere else, you wouldn’t be complaining about the smoke and I wouldn’t be getting punished for it.
This insight—so simple once stated, but thoroughly astonishing to the economists of 1960 (I’ve heard tales of this astonishment from several of the participants in Coase’s historic seminar)—means that in a case of externalities, pure theory can never tell you who should bear the costs; you’ve got to look at the specifics of the case. Take those spark-throwing railroad trains. Pigou says: There are too many fires because the railroads don’t care; let’s make them reimburse the farmers for all the crop destruction, and then they’ll care. Coase says: Wait a minute. Often, farmers can prevent fires at very low cost by not planting quite so close to the tracks. True, the railroads don’t currently care about the crop damage. But if you reimburse the farmers, then the farmers won’t care, and you’ll get too many crops planted too close to the tracks. The best way to prevent fires might (or might not) be to grant the railroads complete legal immunity.
And as for that rabbit farmer—the one who lives next to the lettuce farmer and lets his rabbits run wild—Pigou would have insisted that the rabbit farmer cover the damages. Coase is more evenhanded. There are a lot of ways for the rabbit farmer to solve this problem: Put the rabbits in cages, or file their teeth down, or raise a different breed of rabbit, or move away, or switch to keeping geckos. There are also a lot of ways for the lettuce farmer to solve this problem: Fence the lettuce, or spray it with rabbit repellent, or move away, or switch to growing barley. If the rabbit farmer is immune from lawsuits, he’ll have no incentive to implement his solutions. But if the lettuce farmer is routinely reimbursed for lost lettuce, then he’ll have no incentive to implement his solutions. Which outcome is worse? That depends on whose solutions are better. Pure theory can’t answer that question.
How did Pigou—and every other economist in the world—manage to miss this point until Coase came along? According to Coase, it’s because they were obsessed with the faulty notion of “fault”—the idea that if there’s a problem, it must be someone’s fault, and we should begin by identifying that someone. But in the rabbit/lettuce example, who’s really at fault? It’s true that if there were no rabbits, the lettuce wouldn’t get eaten. But it’s equally true that if there were no lettuce the lettuce wouldn’t get eaten. The problem is that rabbit farmers should not be next to lettuce farmers, and when you put it that way, you’re forced to recognize the fundamental symmetry of the situtation.
What, then, should courts and legislators do? Coase had a lot to say about this also, beginning with the observation that it’s sometimes a really really good idea to encourage antagonists to talk to each other. From this beginning sprang the entire intellectual framework usually called Law and Economics.
Coase’s Nobel Prize winning paper is surely one of the landmark papers of 20th century economics. It’s also entirely non-technical (which is fine), and (in my opinion) ridiculously verbose (which is annoying). It’s littered with numerical examples intended to illustrate several different but related points, but the points and the examples are so jumbled together that it’s often difficult to tell what point is being illustrated. I frequently assign my students the task of distilling all of the main ideas into two or three pages, and they frequently succeed. But pioneering work is rarely presented cleanly, and Coase was a true pioneer.