Lakhasly

The article "The Problem of Externality" by Carl J. explores the concept of externalities and their connection to transaction costs. It highlights the divergence between private and social costs when externalities are present, leading to market inefficiencies that require government intervention or the creation of new markets. The author emphasizes that transaction costs are the key driver behind externalities, as they prevent the internalization of side effects through bargaining.

The paper examines two contrasting approaches to externalities: the modern welfare theory based on general equilibrium analysis and the Coase theorem view. While the former focuses on evaluating economic performance against optimal solutions, the latter suggests that the presence of externalities is not easily identifiable when considering bargaining and side payments.

The author then analyzes the nature of transaction costs, arguing that existing classifications are inadequate and proposes a new categorization specifically for externalities. The article also criticizes the concept of externalities as a normative judgment, rather than a proven market failure, suggesting that the government may not be better equipped to handle externalities than the market.

Finally, the paper explores the relationship between the Coase theory and the Pigou tradition, challenging the common misconception that the former advocates for minimal government intervention, while the latter supports government intervention through taxation. The author concludes that the Pigou tradition, in its pure form, actually suggests no government intervention, while the Coase analysis, taking into account individual wealth maximization, offers a more nuanced perspective on the role of government in addressing externalities.

Carl J.

The Problem of Externality

Journal of Law and Economics, Vol. 22, No. 1. , pp. 141-162.
Stable URL: http://links.jstor.org/sici?sici=0022-2186%28197904%2922%3A1%3C141%3ATPOE%3E2.0.CO%3B2-D
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CARL J .

I. INTRODUCTION the modern research agenda externalities occupy a rather prominent position. The increasing complexity of modern technology and society seems to create yet additional unwanted side effects that require classification on a lengthening list of externalities. However, externalities are of interest not only as current policy issues but also from a more theoretical point of view.
Using Pigou's terminology, we say that when a n externality is present there is a divergence between private and social cost. We interpret this to mean that when all voluntary contractual arrangements have been entered into by market transactors, there still remain some interactions that ought to be internalized but which the market forces left to themselves cannot cope with.
This is the basis, for example, for the assertion of Buchanan and Stubblebine that «externality has been, and is, central to the neoclassical critique of market organization.»' Without interference in the price mechanism, some transactions that would be beneficial are not carried out. Two conclusions follow: first, that since market forces by themselves are unable to eliminate the remaining inefficiencies, some government action is automatically necessitated; second, a conceptually feasible alternative to government action is that, through a suitable establishment of appropriate markets, economic agents can be made to take into account the side effects they generate.*
One may then inquire why market transactors are unable to make the emittor of a n externality internalize the costs of his actions.

UCLA and the Applied Welfare Workshop at the University of Wisconsin, Madison. Any remaining errors are, of course, my responsibility.
I James M. Buchanan & W. C . Stubblebine, Externality, 29 Economica 371 .
See, for example, Kenneth J. Arrow, The Organization of Economic Activity: Issues Pertinent to the Choice of Market vs. Non-market Allocation, in Public Expenditure and Policy
Analysis 59-73 .
than the expected benefit. Ultimately, the relevance of externalities must lie in the fact that they indicate the presence of some transaction costs. For if there were no costs of transacting, then the potential Pareto improvement could be realized by costless bargaining between self-interested economic agent^.^ Transaction costs are therefore a necessary condition for the persistence of unwanted effects from externalities, for with zero transaction costs side effects will be internalized and will not negatively affect resource allocation. The conclusion is thus unambiguous: in the theory of externalities, transaction costs are the root of all evil. But for transaction costs, such perversions of the invisible hand could not even occur much less persist.
However straightforward this may seem, in contemporary literature there appear to be two radically different approaches to the problem of externalities, delineated from each other both by conflicting theoretical foundations and by the policy implications derived from them. On one hand, there is the modern welfare theory, based on general equilibrium analysis, -' Calabresi puts this point nicely: «Thus if one assumes rationality, no transaction costs, and no legal impediment to bargaining, all misallocations of resources would be fully cured in the market by bargains. Far from surprising, this statement is tautological, at least if one accepts any of the various definitions of misallocation. These ultimately come down to a statement akin to the following: A misallocation exists when there is available a possible reallocation in which all of those who would lose from the reallocation could be fully compensated by those who would gain, and, at the end of this compensation process, there would still be someone who would be better off than before. . . . If people are rational, bargains are costless, and there are no legal impediments to bargains, transactions will ex hypothesis occur to the point where bargains can no longer improve the situation; to the point, in short of optimal resource allocation. We can, therefore, state as an axiom the proposition that all externalities can be internalized and all misallocations, even those created by legal structures, can be remedied by the market, except to the extent that transactions cost money or the structure itself creates some impediments to bargaining.» Guido Calabresi, Transaction Costs, Resource Allocation, and
Liability Rules: A Comment, 11 J. Law & Econ. 67, 68 . Stigler's remark on this is worth repeating: «If this proposition strikes you as incredible on first hearing, join the club. The world of zero transaction costs turns out to be as strange as the physical world would be without friction. Monopolies would be compensated to act like competitors, and insurance companies would not exist.» George J. Stigler, The Law and Economics of Public Policy: A Plea to the
Scholars, 1 J. Legal Stud. 1, 12 .
Francis M. Bator, The Anatomy of Market Failure. i 2 Q. J. Econ. 351, 357 , makes a distinction between three classes of market failure: externalities, monopoly, and public goods. I t is therefore interesting to note that both monopoly and public goods can be treated as subcategories of externalities. Demsetz makes the following observation: «A world in which negotiating costs are zero is a world in which no monopolistic inefficiencies will be present, simply because the buyer and seller both can profit from negotiations that result in a reduction and elimination of inefficiencies.» Harold Demsetz, Why Regulate Utilities?, 11 J. Law & Econ. 55, 61 .
Guido Calabresi, supra note 3 , at 70, makes this same point: «Assuming no transaction costs, those who lose from the relative underproduction of monopolies could bribe the monopolists to produce more.» The point is that the negative effects of monopolies occur because market power allows a producer to deviate from the competitive allocation, and the result is a lower level of satisfaction for consumers. This is an externality in consumption: the utility of the consumers is affected by the utility-maximizing behavior of the monopolist and transaction costs prevent a change in the activities of the monopolist. The case is the same with respect to public goods.
which attempts to evaluate actual economic performance by the measuring rod provided by the maximum welfare solution derived from a Walrasian general equilibrium system. On the other, there is the view of externalities, originating with the Coase theorem, according to which it is neither possible to identify the real source of a n externality nor to establish uniquely the fact that there even is a n externality if the possibility of bargaining and side payments is taken into account.
The task attempted in this paper is essentially twofold. First, although the role of transaction costs in the generation of externalities is well understood, no systematic analysis as yet exists of exactly what kinds of transaction costs are necessary to generate externalities. Thus, this paper will analyze the concept of transaction costs as it pertains specifically to externalities. Section
I1 attempts a suitable classification of transaction costs, and Section I11 extends the analysis to the modern general equilibrium approach to externalities.
second, that the concept of externalities-insofar as the word is intended to connote, as Buchanan and Stubblebine would have it, the existence of a n analytically proven market failure-is void of any positive content but, on the contrary, simply constitutes a normative judgment about the role of government and the ability of markets to establish mutually beneficial exchanges. That is to say, it cannot be shown with purely conceptual analysis that markets do not handle externalities: any such assertion necessitates a n assumption that the government can do better. That this assumption is valid cannot be proved analytically, and it follows that market failure is a n essentially normative judgment.
The second task attempted in this paper is to draw the conclusions implicit in the analysis of Section I11 about the relationship between the Coase theory of externalities and the standard Pigou tradition. A widespread misconception exists that the Coase analysis implies that no government policy is desirable and that the Pigou tradition shows the optimality of certain taxes. I t is shown in Section IV that, if the implications of individual wealth maximization under known constraints are drawn correctly, it is really the Pigou tradition that logically suggests no policy, whereas the Coase analysis does give rise to positive suggestions which could assign a n important role to the government.
In view of the crucial role of transaction costs in generating externalities, it is remarkable that no systematic analysis exists of the nature of transaction costs. In recent years the concept has achieved a rather prominent place. On the one hand, it has become a catch-all phrase for unspecified interferences with the price mechanism; on the other, it has been shown that an understanding of this concept is necessary for the foundations of monetary theory.5 In current literature there appear to be three possible interpretations of the nature of transaction costs: the immediate question is if any or all of these interpretations generate externalities as deviations from an otherwise attainable optimum. We proceed by assuming the existence of some side effects, namely, a difference between social and private costs, and ask what sort of transaction costs are consistent with the origination and perpetuation of this situation.
The perhaps most common notion of transaction costs among mathematical economists is one which is comparatively simple to handle with mathematical tools: a fixed proportion of whatever is being traded is assumed to disappear in the transaction i t ~ e l fThis. ~ idea is then employed to show that a specific medium of exchange may have lower transaction costs than any other good in the economy so that a smaller amount of real resources is consumed in the exchange process by switching from barter to money.
What is noteworthy about this concept of transaction costs is that in no significant way does it differ from a regular transportation cost. In the process of moving resources from one location to another-in this particular context from one person to another-a certain amount of the goods to be traded is used up. The conditions that are put on transaction costs, in order to prove existence of a transaction-cost-constrained equilibrium, are then just the same as those normally put on transportation costs: a well-defined convex production set is assumed. Just as self-interested individuals will select the cheapest mode of transportation, it is possible to show that they may choose to use a medium of exchange as an alternative to barter if less resources are used as a consequence. I t is difficult to see, however, that anything significant is added to the traditional treatment of transportation costs in the already existing literature: the strictly proportional costs of transaction convey nothing of significance that is not already known from earlier analysis. The specific applicatiox to money is new, and that is all.
This was brought to the attention of modern eyes by Robert W.
Monetay Theory, reprinted in Monetary Theory, , and his introduction to the same.
See, for example, Duncan K. Foley, Economic Equilibrium with Costly Marketing, 2 J.
Econ. Theory 276 ; F. Hahn, On Transaction Costs, Inessential Sequence Economies, and Money, 40 Rev. Econ. Stud. 449 ; Mordecai Kurz, Equilibrium with Transaction
Costs and Money in a Single Market Exchange, 7 J. Econ. Theory 418 ; Jiirg Niehans, Money and Barter in General Equilibrium with Transactions Costs, 61 Am. Econ. Rev. 773
; id., Interest and Credit in General Equilibrium with Transactions Costs, 65 Am. Econ.
Rev. 548 .
Furthermore, it is difficult to see in what significant way ordinary transportation costs or proportional transaction costs differ from regular costs of production. Moving resources from one location to another or from one person to another will presumably only be done if there is a net increase in the evaluation of the resources a t the two different locations. Fundamentally, therefore, both transportation costs and proportional transaction costs are productive in precisely the same way that resources used up in the physical transformation of inputs into outputs are productive-indeed, they could be treated in a n identical manner with no loss of information. All that is required is to interpret a n exchange as a productive activity requiring certain resources in a specified technological relationship.