Markets and the Environment (Chapter 2)
Coase, Ostrom and the Economics of Government Action
What this theory [mid-century neoclassical welfare economics] demonstrated, in a nutshell, was that perfect markets work perfectly, imperfect markets work imperfectly, and perfect government can cause imperfect markets to also function perfectly.[1]
Steven Medema
The theme of Chapter 1 was how features of some goods and markets mean that the sort of positive tendencies that might be assumed in standard markets don’t apply in situations described by the related concepts of public goods, spillover effects and commons. In these situations – once thought ‘exceptional and unimportant’[2] – the state can intervene, such that the logic of the market is reasserted via policies. In this framework the state is acting to ensure the outcome that the market would did it not have features of public goods or externalities – which could in fact be conceptualised as ‘missing markets’.[3]
The building blocks of economic thinking presented in Chapter 1 are the core of a mid-twentieth-century consensus in mainstream economic thinking about markets, external effects and public goods.[4] This theoretical frame relates to the broader view of the need for state action to tame markets and improve outcomes in situations where the invisible hand is defective or at least inadequate (e.g. via tax or regulation).[5] As with Pigouvian taxation, these interventions often derived from abstractions and not a set of pragmatic policy prescriptions (a theme returned to later). A series of theoretical developments and empirical studies in the intervening decades have undermined the claims of this framework.
This chapter introduces these developments and, in some cases, their misinterpretations. More specifically, it folds in related research that undermines one or multiple parts of the older consensus. First, the work of Ronald Coase – though this is complicated because Coase, like Adam Smith or John Maynard Keynes, is read in different and conflicting ways. On the sixtieth anniversary of the publication of ‘The Problem of Social Cost’, the economist and historian of economic thought Steven Medema considered the many plausible understandings and misunderstandings of the so-called ‘Coase Theorem’.[6]
An interesting facet of the Coase paper is its focus on the foundational issues and its emphasis on the institutional context of markets (including law), which is both defined by individuals and channels their interests. While the paper is something of a fountainhead for all sorts of relevant fields (perhaps most importantly law and economics), it also builds an analytic framework with clear relevance for environmental issues ranging from climate change to nutrient runoff. While it deals most explicitly with bilateral trades, its framework applies to broader externalities.
After introducing the basics of Coase’s paper the following will consider the evidence for the constructions of the last chapter. The illustrative and quaint examples that show the failure of markets provide evidence of the institutional component of markets and their capacity for contracting and bundling to address problems with externalities and public goods. Finally, the chapter turns to analyse the plausibility of state corrective action. This is not done in a comprehensive way but the point is to underline the fact that the assumption that the state is able simply to correct externality issues can be misleading. The point is not that government cannot solve problems in markets (or that market participants will be capable of solving all problems themselves), but to make the case for the comparative approach that Coase sets out in his paper. Chapter 3 brings these together with the recent history of the environmental movement and practical efforts to improve environmental outcomes via policy, including reforms that not only seek to tinker with existing markets but to create new markets.
One of the themes of this chapter and publication is that the specifics of each environmental problem matter greatly for both the analysis of the problem and the assessment of policy for improving outcomes. Deeper insights flow from the pairing of basic economic theory with political and scientific understanding of the problem. Coase and later thinkers argue that much of the basic economic theory invoked to support action stands on weak foundations and misleads citizens and regulators alike.
Coase and ‘The Problem of Social Cost’
Much of modern welfare economics is indeed concerned with the problem of market failure, and the analysis of market failure appears to imply the desirability of administrative intervention. Until recently everybody agreed that where there are externalities, market allocation is bound to be non-optimal; the only point of controversy concerned the frequency and the severity of the external effects and the urgency of administrative action.[7]
Stanislaw Wellisz
In 1960 Ronald Coase published ‘The Problem of Social Cost’ in the Journal of Law & Economics. It challenged what he depicted as the prevailing Pigouvian analytic paradigm outlined in Chapter 1 and familiar to all students of economics. Rather than analysing externalities as being caused by one side, Coase argued that they are caused by both parties; that is, their interaction. This concept of reciprocity fundamentally changed the mechanics of thinking about externalities and ideal policy responses through taxes and subsidies imposed by government, undermining the principle that with environmental issues, the polluter should pay.
Coase demonstrated that harms arise from incompatible resource uses where both parties contribute to the problem. This reciprocal nature means that preventing harm to one party necessarily imposes costs on another, making the central question not how to eliminate externalities but how to minimise total social costs across all parties. This insight shifts the analytical focus from abstract welfare maximisation towards comparative institutional analysis, where different legal rules and property rights arrangements are evaluated based on their ability to facilitate welfare-enhancing exchanges despite transaction costs. The reciprocity framework thus replaces the presumptive need for corrective taxation with a more nuanced assessment that considers whose rights should be protected, whether exchange can resolve conflicts and when regulatory intervention might improve social outcomes – all while recognising that policy itself entails costs and operates within institutional constraints that may prevent theoretically optimal solutions.
Turning to the specific examples that Coase used makes what might seem an arcane point clearer. First, in an example from English law, Sturges v Bridgman (1879), a confectioner operating pestles and mortars in the kitchen of a terraced house backing on to a neighbouring London garden was sued by a doctor whose adjoining consultation room was affected by the noise and vibration of the mortars. The mortars didn’t cause harm until the doctor built an extension to his house. This consultation room abutting the confectioner’s kitchen rendered the noise audible. Standard analysis would depict the confectioner as the one imposing cost, but Coase argued that the social cost of the action relies on the doctor as much as the confectioner.
In abstract terms Coase set out the implication of introducing reciprocity:
The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm.[8]
This distinction sounds pedantic but conceptualising the issue as one of a conflict of uses changes understanding of the problem – and relevant solutions. In this view, issues of ‘external costs’ become part of a broader topic of property rights and exchange like other topics in economics. As Mark Pennington writes: ‘Whether an actor or group of actors is the “victim” or “perpetrator” of an “externality” is fundamentally a question of who has the rights to engage in the activity concerned and if they wish to trade such rights for compensation.’[9] With the focus on reciprocity, Coase argued that the appropriate analytical framework to start analysis was not to assume that one party is a polluter who should automatically pay but one in which a lowest-cost solution is found to address a conflict between those who have competing claims.
To facilitate seeing the logic in the question as lying in whether A to B – or B to A – is the best way to limit social cost, Coase considered cattle and crops:
Another example is afforded by the problem of straying cattle which destroy crops on neighbouring land. If it is inevitable that some cattle will stray, an increase in the supply of meat can only be obtained at the expense of a decrease in the supply of crops. The nature of the choice is clear: meat or crops. What answer should be given is, of course, not clear unless we know the value of what is obtained as well as the value of what is sacrificed to obtain it.[10]
Beyond this is where much confusion about Coase begins.
Coase and the Coase Theorem
(T)he ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost.[11]
Ronald Coase
Coase argued that in a world of zero transaction costs the parties affected would exchange rights such that the initial distribution of rights wouldn’t alter the outcome (or the efficiency). The notion of transaction costs was defined only implicitly by Coase in the quote above (and in his 1937 paper ‘The Nature of the Firm’ in which it originated), although the subject of much debate it can be understood as the cost of defining and enforcing a property right.
To continue with the example, if it is assumed that farmer has the right to be compensated should a rancher’s cattle stray (i.e. the property rights are clear), the rancher will consider the expected damage that cattle will cause and take the optimal amount of precautions (e.g. building fences). The rancher will also rear the optimal amount of cattle. While the property rights might lie with the farmer, the rancher could also bargain with the farmer either by contracting or exchanging. Compensation for lost product only occurs after the farmer has taken on the costs of production so were the rancher to buy from the farmer the land most at risk of being trampled (or pay the farmer not to plant there), both could gain by avoiding the damage that might otherwise occur.
Alternatively, Coase showed that if the property right instead rested with the cattle rancher, the farmer would find it in his interest to take steps to mitigate the damage. Similarly, this could be done by removing land from cultivation, building a fence or bargaining with the rancher to reduce harm by rearing fewer cattle. The optimal solution would also be determined by the profitability of both producers. In fact, Coase demonstrated via example that in both property rights regimes the producers would end up with the same result in a world without transaction costs: an efficient outcome that would simply rely on the costs not the institutional context.
To go back to the earlier example: if the confectioner has the right to make noise but the doctor values quiet more than the former values that right, they will engage in trade to achieve the efficient result in a world with zero transaction costs. The right lying with either the confectioner or the doctor only affects who is paying whom rather than the efficiency of the outcome.
For many, Coase’s insight was some version of the general statement about the efficiency and invariance of outcome: if property rights are well defined and transaction costs are zero, parties will be able to bargain privately to reach an efficient outcome regardless of the initial allocation of rights;[12] that is, the total welfare will not change though the distribution will. This statement – not to mention a formal theorem – doesn’t appear in Coase’s paper but the notion, further pared down, was dubbed the ‘Coase Theorem’ by George Stigler.[13] It has had an enormous impact (by some measures it’s the most cited work in law reviews and among the most cited in social science), but in many ways Stiger’s rendering confuses Coase’s insights.
While the examples seem contrived, the insights they give rise to are useful in addressing problems in the real world – Coase’s main interest – and serve as a prelude to a framework for understanding how social cost is dealt with. This has clear relevance for thinking about environmental issues. Furthermore, within economic theory the Pigouvian framework collapses on its own assumptions, which are the same in Coase and in Pigou rather than some isolated feature of either. As Medema writes, the pitfall for some is to think about the world of the theorem as Coase’s world rather than the standard assumption of orthodox economic theory, including the Pigouvian apparatus he was undermining.[14]
Coase Beyond the Theorem: Institutional Responses to Social Cost
The recognition that environmental problems are a consequence of positive transaction costs is perhaps the central Coasian insight, yet strangely enough this very idea has often led to the dismissal of Coasian policy ideas.[15]
Mark Pennington
The first third of ‘The Problem of Social Cost’ focused on the basic theoretical argument against Pigouvian analysis and forms the basis of the Coase Theorem; the remainder is about application to the real world. It proceeds by tracing out the implications for analysis of the same types of issues in a world with transaction costs. Perhaps the first and most obvious is that if the parties impacting each other can’t exchange the property rights without frictions, who has the right – the rancher or the farmer, for example – matters for efficiency.
To this point Coase remarked on the fact that the reasoning for the legal decision between the confectioner and the doctor, and many others – including ones about polluting factories – that emerged through the common law, dealt with not just the reciprocity of cause but the efficiency of the situation.[16] This shows up, for example, in ideas about the ‘reasonableness’ of precautions. In the ruling on the confectioner, the location and features of the neighbourhood mattered.[17] If the confectioner could be stopped on grounds of nuisance in a residential square, could someone move to an industrial area and stop the operation of externality- generating producers such as tanneries? The judge answered, as Coase quoted: ‘whether anything is a nuisance or not is a question to be determined, not merely by an abstract consideration of the thing itself, but in reference to its circumstances; What would be a nuisance in Belgrave Square would not necessarily be so in Bermondsey.’[18]
More than just being an exercise in abstracted deviations from efficiency, Coase illustrated how the legal system’s assignment of property rights and liability rules shaped bargaining around such externalities as pollution. His analysis highlighted the importance of transaction costs in determining whether parties could successfully negotiate mutually beneficial arrangements if the rights were assigned to the party that valued them less than the other. Coase’s work thus also drew attention to how alternative legal rules and institutions could minimise transaction costs and facilitate bargaining towards more efficient outcomes.
His insight represents a fundamental reimagining of environmental problem-solving. Contrary to simplistic market-based or government-control narratives, he argued that neither markets nor regulatory approaches are universally applicable solutions. Instead he challenged the existing Pigouvian framework – and the twentieth-century regulatory framework – by demonstrating the complexity of addressing environmental issues:
A better approach would seem to be to start our analysis with a situation approximating that which actually exists, to examine the effects of a proposed policy change and to attempt to decide whether the new situation would be, in total, better or worse than the original one. In this way, conclusions for policy would have some relevance to the actual situation.[19]
The crux of Coase’s contribution lies in his recognition that transaction costs are both ubiquitous and central to understanding environmental problems – without them, externalities would simply be another production cost that markets could handle efficiently. But precisely because transaction costs are so pervasive and significant, the choice of policy instruments becomes crucial. This creates a delicate balance: transaction costs are what make environmental externalities a genuine policy problem, yet these same costs call for special care when designing solutions because poorly chosen interventions can make matters worse.
This highlighted the need to properly align institutions and laws to allow efficient private bargaining and resolution of externalities where possible (e.g. by defining tradeable property rights). A benefit of the property rights solution versus a regulatory solution is that the market process would allow the type of knowledge-generating – and innovation-stimulating – relations characteristic of markets to continue.[20] Some argue that over time, regulatory solutions are hard to displace even when new technologies weaken the claims of their superiority over the market.[21]
More generally, Coase suggested that there are four types of responses to social-cost issues.[22] First, property rights can be specified and exchange can take place. In the presence of transaction costs this may not result in the idealised result but must be compared to the relevant alternatives. Second, the decisions can be brought within a single firm: if the same owner owns both the cattle and the crops, the externality is internalised.[23] Third, the state can regulate a solution. This might result in a better outcome in circumstances where it is implausible to expect that either exchange or the firm solution will work well, but the reality of this option must be considered rather than the idealised comparison (more on this later). Finally, the best option may simply be to do nothing.
While Coase undermined the basic theoretical argument for the necessity of corrective regulations, developments in the economics of regulation and political action further frustrate the simple premise of market failure arguments; that is, that they require some underspecified government intervention. Following Coase, economists have studied historic and contemporary examples of contracting solutions to issues. While the nature of the issue varies in each case, which makes it more difficult for the clear-cut property rights seen in standard exchanges to emerge, a large literature both before and after Coase deals with the institutional ingenuity of market participants in coming up with rules that deal with the difficulty of exclusion and the spillover nature of some goods. While debates about the comparative efficiency of different regimes still rages, the point is that the line of inquiry should be comparative and institutional rather than simply potential market failure leading to government intervention. Both the successes and failures of market participants to improve their own outcomes offer insights for social scientists and policy makers.
Distilling Policy Implications from Fables?
Whether or not Keynes was correct in his claim that policy makers are ‘distilling their frenzy’ from economists, it appears evident that some economists have been distilling their policy implications from fables.[24]
Steven Cheung
I think we should try to develop generalisations which would give us guidance as to how various activities should best be organised and financed. But such generalisations are not likely to be helpful unless they are derived from studies of how such activities are actually carried out within different institutional frameworks … by showing us the richness of the social alternatives between which we can choose.[25]
Ronald Coase
In an example towards the end of ‘The Problem of Social Cost’, Coase argued that a famous case Pigou draws on to make the broader argument that government action is needed to deal with externalities is factually erroneous. This is an example of a strand of research that makes a methodological and theoretical point about the need for comparative institutional analysis via empirical study of the very examples that economists use to argue the need for corrective action.
In this instance, the example Pigou used is of sparks thrown off by the friction between train wheels and track, which can cause fires in, say, neighbouring woodland. In Pigou’s rendering this damage is an example of the market not functioning adequately for the same reason as any other negative externality, i.e. train companies didn’t take this damage into account when making decisions. However, Coase showed that the reason they didn’t is because Britain passed an act rendering them not liable for damage resulting from sparks. In this case, then, the externality wasn’t straightforwardly produced by a market setting that failed to address it; it was rooted in an institutional context.
Chapter 1 gave two stock examples – lighthouses and bees – of goods with characteristics that make them difficult for markets to provide adequately. In the case of lighthouses the service provided is both non-rival and non- excludable: passing boats can see the beams of light emitted from the Fresnel lens whether or not they pay for the services of the lighthouse keeper; use of the service by one boat doesn’t diminish use by another. In the case of the bees the stock example is that of the positive spillover effect from apple orchards providing the nectar bees consume. In reality, neither example is as clear-cut as these simple treatments suggest.
Steven Cheung found that beekeepers and orchard owners had in fact developed sophisticated contractual arrangements to internalise the pollination externality.[26] Apple orchards provide little nectar to bees, so Cheung found that not only can markets deal with the externalities involved but the actual payments go the other way as apiarists pay beekeepers for their pollination services. More generally, there is variation in the contracts for these types of arrangements due to variation in the type of crop grown by farmers and whether the bees provided pollination or whether the crops provide nectar (something that differs with the crop grown). This discovery demonstrated that private markets could often solve externality problems without government intervention, provided transaction costs were low and property rights well defined. Cheung’s work reinforced Coase’s insights and highlighted the importance of empirical investigation in understanding how markets function in practice.
Additionally, Coase argued that in England, lighthouses were actually successfully built and operated by private individuals or organisations,[27] highlighting the fact that the services of the lighthouse could be tied with the ports in which ships would dock. His analysis demonstrated that the private provision of lighthouses was feasible under certain conditions, suggesting that the boundaries between public and private goods might not be as clear-cut as previously thought.
Property Rights and Rules of Use: Must the Commons End Tragically?
Garrett Hardin’s (1968) portrayal of the users of a common-pool resource – a pasture open to all – being trapped in an inexorable tragedy of overuse and destruction has been widely accepted since it was consistent with the prediction of no cooperation in a Prisoner’s Dilemma or other social dilemma games.[28]
The classic models have been used to view those who are involved… as always trapped in the situation without capabilities to change the structure themselves… Whether or not the individuals who are in a situation have capacities to transform the external variables affecting their own situation varies dramatically from one situation to the next. It is an empirical condition that varies from situation to situation rather than a logical universality. Public investigators purposely keep prisoners separated so they cannot communicate. The users of a common-pool resource are not so limited.[29]
Elinor Ostrom
The primary influence of Hardin’s famous paper – at least in economics – has simply been the name of the phenomenon and the pastoral example.[30] Hardin presents the tragedy of the commons in a way that doesn’t consider how the issue has been solved historically. Rules of use have emerged in many cases and in different ways. He considers property rights solutions but dismisses them for reasons of practicality. Yet there are clever mechanisms for creating property rights solutions, despite the theoretical problems of collective action, public good provision and externalities. By limiting access indirectly, whether by a licensing system or tying things together with goods that are excludable (e.g. tying lighthouses to ports), market actors limit the race to the bottom. Furthermore, Elinor Ostrom showed how collective governance solutions can also emerge in a decentralised way. Despite this, the conventional wisdom surrounding the tragedy of the commons is familiar: either a) privatise the resource in question or b) regulate its use. I describe the pure property rights and command-and-control solutions before adding Ostrom’s critique of the private-public dichotomy through her work on self-governance and collective property rights.
The Property Rights Solution
Property rights economists argue that the emergence of rights depends in large part on the transaction costs associated with defining, enforcing and exchanging a resource. In the capitalist world at least, if something was held in common in the mid-twentieth century it was usually because establishing property rights was difficult – it was difficult or too costly to exclude others: ‘the reason why some activities are not the subject of contracts is exactly the same as the reason why some contracts are commonly unsatisfactory – it would cost too much to put the matter right.’[31]
While many may dispute just where the extension of property rights with state support is impractical and where necessity dictates more involved regulation, the success of property rights generally is known but always worth repeating. For resources like grazing fields or forests, having an owner who can control access and benefits from the long-term value of the resource often prevents overuse. In England and Wales, for example, riparian fishing rights in rural contexts limit users and lead to legal cases by property owners such as angling clubs against polluters.[32]
As is standard in environmental and resource economics textbooks, Nathaniel Keohane and Sheila Olmstead show how in cases such as timber, where property rights have been established, optimal resource extraction for the owner coincides with the socially optimal outcome of scarce resources being efficiently used. In the past, however, many of these resources would have been open access. This raises the question of how and why property rights emerged, which is relevant to their potential extension as a solution. A foundational paper by Harold Demsetz introduced a simple theory for when property rights emerge,[33] arguing that this occurs when the costs of defining them and enforcing them are lower than the benefit of doing so.
Demsetz offered the example of when animal furs became more valuable to indigenous people in North America. Before the fur trade, the small population of hunters relative to beavers meant there was little to be gained from establishing property rights. After the trade increased the value of beaver pelts, the costly process of establishing rights became worthwhile – an example of a natural resource around which rights emerged because of the cost–benefit relationship, though it is also true of many other examples of natural resources that are relatively excludable.
Gary Libecap argues that the plausibility of property rights being established depends on where along a continuum of transaction costs a particular resource lies.[34] Three main features determine this: the resource value, the physical attributes of the resource in relation to excludability and the attributes of the parties. These features also affect non-property rights methods of preventing the tragedy of the commons.
As the benefit of establishing property rights over environmental goods increases as the goods themselves diminish, or because individuals value them more highly as wealth increases, we should expect more rights to be established.
The cost of establishing property rights is also subject to change. New means of preventing overuse or access, such as surveillance cameras or barbed wire,[35] make it easier to establish rights by making the resource more excludable. While no panacea, the incentives of interested parties are such as to support innovations and take them up once created.
Command-and-Control
A popular response to open-access issues is to have the state set rules. As discussed in Chapter 1 in reference to negative externalities, a command-and-control regulatory approach seeks to address the tragedy of the commons by imposing strict rules and regulations on common- pool resource use. Important for any comparison is analysis of just how governments implement these strategies through laws, permits and enforcement mechanisms. An example is the establishment of fishing quotas to limit the number of fish that can be caught in a particular area, preventing overfishing and ensuring sustainable resource management. While effective in some cases, such command-and-control can be costly to implement and enforce. The specific rules are full of trade-offs. Monitoring the number of fish caught is more difficult than monitoring when fishermen are operating, so regulation sometimes governs the number of operational months or days. This can result in dramatic unintended costs, such as seafood rotting on docks before it can be processed and even the death
of workers in accidents caused by exhaustion.[36] Alternative regulatory approaches that more efficiently limited access to commons are discussed in Chapter 3; first it is worth considering empirical examples of emergent common property rights.
Self-Governance and Common Property Rights
It is crucial to recognize that common property is shared private property … Common property regimes are a way of privatizing the rights to something without dividing it into pieces … Historically, common property regimes have evolved in places where the demand on a resource is too great to tolerate open access, so property rights in resources have to be created, but some other factor makes it impossible or undesirable to parcel the resource itself.[37]
Margaret McKean and Elinor Ostrom
Ostrom’s book Governing the Commons[38] offered a critique of earlier economic theories that advocated for either individual private property rights as a solution to common resource management or for centralised regulation. Her research demonstrated that communities often develop effective self-governing institutions to manage common-pool resources sustainably, without resorting to private rights or centralised control. It emphasised the importance of local knowledge, communication and context-specific rules in successful resource management.
However, there are difficulties with generalising from the outcomes she surveyed, connected with two main types of variation: the type of resource being managed and the scale and type of group governing the common- pool resource. In cases such as long-standing grazing practices in rural Switzerland, there are features of the resource itself that make it difficult to establish private property rights, and features of the parties that make coordination easier – including a common culture and small scale.
This publication’s analysis of regulatory policy has so far focused on whether state action is necessary for dealing with the inadequacies of markets as compared to idealised alternatives. Apart from a short discussion of the weaknesses of command-and-control regulation and the need for comparative institutional analysis instead of knee-jerk ‘polluter pays’ approaches, it hasn’t considered the political process behind state action or the incentives of political actors. The next section considers the motivations and information problems associated with government action.
Politics Without Romance: Can Governments Do Better?
Inquiring how far the free play of private self-interest makes for social advantage, we find that it frequently fails to do this, but that there are many different forms and many different degrees in its failure. Inquiring how far Government is fitted to take action against these failures, we find that its fitness to do this varies, not only in different places and different times, but also as between interventions directed against different kinds of failure.[39]
Arthur Pigou
The mid-century developments in thinking on formal market failure bore little relation to detailed policy analysis. Both the practical and political dimensions of policy development were ignored, and instead much on state alternatives was couched in idealised terms, especially where theorists were more distant from real-world policy questions. This is not true of the applied economists thinking about policy directly (as discussed in Chapter 3), but even there the conception of political economy assumed that regulators would act in the public interest.
Beginning in the 1960s, economists began formally to study political processes with the same methodological assumption as that held about individuals in other domains of economic research, namely self-interest. This politics without romance approach would later be termed ‘public choice’.[40] Public choice is useful for understanding the real incentives of interested parties in public decision-making processes, and is crucially important for environmental issues because public agencies – from conservation agencies to planning authorities – are intimately involved in many issues. The basic Coasean point is that alternatives must be understood and compared.
Despite Pigou’s reputation among many public choice economists as simply an avatar of a politically naïve Cambridge don, his work exhibited more realistic – if not formalised – thinking about the constraints of state action than much of what came later. While later thinkers were only interested in the formal models, Pigou makes it clear that the pure theoretical ‘blackboard economics’ he engaged in was a conceptual basis for pragmatic intervention by experts.[41]
An understanding of the bureaucratic and political processes is clearly relevant for thinking about regulatory outcomes. At a most basic level, a difference between the market process and the political process is that, as Pennington writes: ‘Absent the profit-and-loss signals to which individuals and firms have access in markets, decisions by the state to impose taxes, subsidies or regulations are not subject to any obvious feedback mechanism that can weed out erroneous interventions and lead over time to an improved set of decisions.’[42]
As in the example of the rotting fish caused by regulation of fishermen’s operational hours, some of the more perverse environmental outcomes occur in settings where state involvement is anything but shallow. Some argue in line with Pennington that: ‘In many cases it is the intellectual dominance of the belief that markets cannot work that has locked in institutions which prohibit the emergence of private, contractual solutions.’[43]
Even ignoring questions about the incentives of legislators and regulators, in the absence of markets and their attendant prices, rational decision-making becomes more complex. Formal cost–benefit analysis emerged in the early twentieth century and has become more central to policy analysis and policymaking since. Firms make decisions based on profit, but cost–benefit analysis seeks to inform rational policymaking and government provision. As the size and scope of state provision increased, new bureaucratic forms and procedures were invented by experts to assess policy alternatives (considered in Chapter 3).
While expert cost–benefit analysis is necessary for contemporary practitioners, the world is rife with examples of public projects that wouldn’t stand up to rigorous analysis – while others that would are not pursued. In some cases this has been due to the beliefs of the broader public, as filtered through democratic institutions, which has meant that a project was politically worthwhile regardless of its ability to pass a cost-benefit analysis, while in others it has resulted from special interests. Any discussion of how the government hopes to step in to alter outcomes must be informed by a deeper, more realistic understanding of how and why policies succeed and fail.
Government failure, a concept emphasising potential inefficiencies in public sector interventions,[44] receives comparatively less attention than market failure. While the latter is often thoroughly explored, study of the former – including bureaucratic inefficiencies, rent-seeking behaviour and unintended policy consequences – is much less prominent in economics education and policy discussions.[45]
Conclusion
[T]he problem is to devise practical arrangements which will correct defects in one part of the system without causing more serious harm in other parts.[46]
Ronald Coase
The contributions of Coase, Ostrom and public choice theorists provide a more nuanced framework that challenges simplistic assumptions about the necessity and effectiveness of state action. Coase’s emphasis on transaction costs and property rights demonstrates that the real question isn’t whether government should intervene but which institutional arrangement – market, government or community-based – best addresses specific circumstances. His insight demands comparative institutional analysis rather than theoretical absolutes. Ostrom’s groundbreaking research revealed that communities often develop sophisticated self-governance systems for managing common-pool resources, providing viable alternatives to both state control and privatisation. Meanwhile, public choice theory reminds us that government actors respond to incentives and may pursue self-interest rather than public welfare, making government failure a real possibility when addressing market failures. This chapter has critiqued abstract theory but also established a framework for comparative institutional analysis – necessary for evaluating alternatives in environmental governance and determining which approaches will truly serve the public interest.
Such applied work is beyond the scope of this publication but provides a fruitful way to have rational public policy debates. Chapter 3 outlines the existing system of American environmental policy alongside applied methods of economic analysis. The second half of the chapter combines the foundational work on the economic nature of environmental problems with applied work to show how environmental policy can be improved.
Notes to Chapter 2
[1] Steven G. Medema, The Hesitant Hand: Taming Self-Interest in the History of Economic Ideas
(Princeton, NJ: Princeton University Press, 2009), p. 76.
[2] Tibor Scitovsky, ‘Two Concepts of External Economies’, Journal of Political Economy 62, no. 2 (1954), pp. 143–51; Steven G. Medema, ‘“Exceptional and Unimportant”? Externalities, Competitive Equilibrium, and the Myth of a Pigovian Tradition’, History of Political Economy 52, no. 1 (February 2020), pp. 135–70, doi:10.1215/00182702-8009583.
[3] Kenneth J. Arrow, ‘The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Nonmarket Allocation’, The Analysis and Evaluation of Public Expenditure: The PPB System 1 (1969), pp. 47–64; Nathalie Berta, ‘On the Definition of Externality as a Missing Market’, The European Journal of the History of Economic Thought 24, no. 2 (March 2017), pp. 287–318, doi:10.1080/09672567.2016.1169304.
[4] Francis M. Bator, ‘The Anatomy of Market Failure’, The Quarterly Journal of Economics 72, no. 3 (1958), pp. 351–79, doi:10.2307/1882231.
[5] Medema, The Hesitant Hand.
[6] Steven G. Medema, ‘The Coase Theorem at Sixty’, Journal of Economic Literature 58, no. 4 (December 2020), pp. 1045–1128, doi:10.1257/jel.20191060.
[7] Stanislaw Wellisz, ‘On External Diseconomies and the Government-Assisted Invisible Hand’, Economica 31, no. 124 (November 1964), p. 345, doi:10.2307/2550514. Cited with emphasis in Medema, The Hesitant Hand, p. 102.
[8] R. H. Coase, ‘The Problem of Social Cost’, The Journal of Law & Economics 3 (1960), p. 2.
[9] Mark Pennington, ‘Coase on Property Rights and the Political Economy of Environmental Protection’, in Forever Contemporary: The Economics of Ronald Coase, ed. Cento Veljanovski (London: The Institute of Economic Affairs, 2015), p. 95; L. Lynne Kiesling, The Essential Ronald Coase (Vancouver, BC: Fraser Institute, 2021), p. 31.
[10] Coase, ‘The Problem of Social Cost’, p. 2.
[11] Coase, ‘The Problem of Social Cost’, p. 8.
[12] Medema, ‘The Coase Theorem at Sixty’.
[13] George J. Stigler, The Theory of Price, 3rd edn (New York: Macmillan, 1966), p. 113.
[14] Medema, The Hesitant Hand, p. 107.
[15] Pennington, ‘Coase on Property Rights’, p. 97.
[16] Coase, ‘The Problem of Social Cost’, p. 19.
[17] Coase, ‘The Problem of Social Cost’, p. 21
[18] Coase, ‘The Problem of Social Cost’, p. 21
[19] Coase, ‘The Problem of Social Cost’, p. 43
[20] Gary D. Libecap and Terry L. Anderson, Environmental Markets: A Property Rights Approach, Cambridge Studies in Economics, Choice, and Society (New York: Cambridge University Press, 2014), p. 54.
[21] Fred E. Foldvary and Daniel B. Klein, eds, The Half-Life of Policy Rationales: How New Technology Affects Old Policy Issues (New York: NYU Press, 2003).
[22] Medema, The Hesitant Hand, pp. 115–17.
[23] R. H. Coase, ‘The Nature of the Firm’, Economica 4, no. 16 (1937), pp. 386–405, doi:10.2307/2626876.
[24] Steven N. S. Cheung, ‘The Fable of the Bees: An Economic Investigation’, The Journal of Law & Economics 16, no. 1 (1973), p. 32.
[25] R. H. Coase, ‘The Lighthouse in Economics’, The Journal of Law & Economics 17, no. 2 (1974),p. 375.
[26] Cheung, ‘The Fable of the Bees’.
[27] Coase, ‘The Lighthouse in Economics’.
[28] Elinor Ostrom, ‘Beyond Markets and States: Polycentric Governance of Complex Economic Systems’, The American Economic Review 100, no. 3 (2010), pp.641–72, at p.648.
[29] Ostrom, ‘Beyond Markets and States’, p. 417.
[30] Garrett Hardin, ‘The Tragedy of the Commons: The Population Problem Has No Technical Solution; It Requires a Fundamental Extension in Morality’, Science 162, no. 3859 (December 1968), pp. 1243–8, p. 1248, doi:10.1126/science.162.3859.1243. See Brett M. Frischmann, Alain Marciano and Giovanni Battista Ramello, ‘Retrospectives: Tragedy of the Commons after 50 Years’, Journal of Economic Perspectives 33, no. 4 (November 2019), pp. 211–28, doi:10.1257/jep.33.4.211. It is lost to most who come across the term that Hardin’s short 1968 piece was about overpopulation and the need for state control of reproduction: ‘The only way we can preserve and nurture other and more precious freedoms is by relinquishing the freedom to breed, and that very soon’ (p. 1244).
[31] Coase, ‘The Problem of Social Cost’, p. 39; Libecap and Anderson, Environmental Markets, p. 73.
[32] Roger Bate, Saving Our Streams: The Role of the Anglers’ Conservation Association in Protecting English and Welsh Rivers (London: The Institute of Economic Affairs, 2001), https://iea.org.uk/ publications/research/saving-our-streams/.
[33] Harold Demsetz, ‘Toward a Theory of Property Rights’, The American Economic Review 57, no. 2 (1967), pp. 347–59.
[34] Gary D. Libecap, ‘Coasean Bargaining to Address Environmental Externalities’, in The Elgar Companion to Ronald H. Coase, ed. Claude Ménard and Elodie Bertrand (Cheltenham and Northampton, MA: Edward Elgar, 2016), pp. 101–2, https://www.elgaronline.com/edcollchap/ edcoll/9781782547983/9781782547983.00017.xml.
[35] Terry L. Anderson and P. J. Hill, ‘The Evolution of Property Rights: A Study of the American West’, The Journal of Law & Economics 18, no. 1 (1975), pp. 163–79.
[36] Nathaniel O. Keohane and Sheila M. Olmstead, Markets and the Environment, 2nd edn,
Foundations of Contemporary Environmental Studies (Washington, DC: Island Press, 2016),
- 159.
[37] Margaret McKean and Elinor Ostrom, ‘Common Property Regimes in the Forest: Just a Relic from the Past?’, Unasylva 46, no. 180 (1995), p. 6; Also cited by Mark Pennington, ‘Elinor Ostrom, Common-Pool Resources and the Classical Liberal Tradition’, in Elinor Ostrom with Mark Pennington, Christina Chang and Vlad Tarko, The Future of the Commons: Beyond Market Failure and Government Regulation (London: The Institute of Economic Affairs, 2012), p. 40.
[38] Elinor Ostrom, Governing the Commons: The Evolution of Institutions for Collective Action
[39] Arthur C. Pigou, ‘State Action and Laisser-Faire’, in Economics in Practice: Six Lectures on Current Issues (London: Macmillan and Co., 1935), 127. See: Medema, The Hesitant Hand, p. 71.
[40] Peter Boettke and John Kroencke, ‘The Real Purpose of the Program: A Case Study in James M. Buchanan’s Efforts at Academic Entrepreneurship to “Save the Books” in Economics’, Public Choice 183, no. 3 (June 2020), pp. 227–45, doi:10.1007/s11127-020-00798-2.
[41] Roger E. Backhouse and Steven G. Medema, ‘Economists and the Analysis of Government Failure: Fallacies in the Chicago and Virginia Interpretations of Cambridge Welfare Economics’, Cambridge Journal of Economics 36, no. 4 (July 2012), pp. 981–94, doi:10.1093/cje/ber047.
[42] Pennington, ‘Coase on Property Rights’, p. 99.
[43] Pennington, ‘Coase on Property Rights’, p. 100; emphases original.
[44] William R. Keech and Michael C. Munger, ‘The Anatomy of Government Failure’, Public Choice 164, nos 1–2 (July 2015), pp. 1–42, doi:10.1007/s11127-015-0262-y.
[45] Rosemarie Fike and James Gwartney, ‘Public Choice, Market Failure, and Government Failure in Principles Textbooks’, The Journal of Economic Education 46, no. 2 (April 2015), pp. 207–18, doi:10.1080/00220485.2014.1002962.
[46] Coase, ‘The Problem of Social Cost’, p. 34; Medema, The Hesitant Hand, p. 121.