Source: R.H. Coase, “The Problem of Social Cost.” Journal of Law and Economics, Vol. 3 (Oct., 1960), pp. 1-44.

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I. THE PROBLEM TO BE EXAMINED

THIS paper is concerned with those actions of business firms which have harmful effects on others. The standard example is that of a factory the smoke from which has harmful effects on those occupying neighboring properties. The economic analysis of such a situation has usually proceeded in terms of a divergence between the private and social product of the factory, in which economists have largely followed the treatment of Pigou^[1] in The Economics of Welfare. The conclusions to which this kind of analysis seems to have led most economists is that it would be desirable to make the owner of the factory liable for the damage caused to those injured by the smoke, or alternatively, to place a tax on the factory owner varying with the amount of smoke produced and equivalent in money terms to the damage it would cause, or finally, to exclude the factory from residential districts (and presumably from other areas in which the emission of smoke would have harmful effects on others). It is my contention that the suggested courses of action are inappropriate, in that they lead to results which are not necessarily, or even usually, desirable.

II. THE RECIPROCAL NATURE OF THE PROBLEM

The traditional approach has tended to obscure the nature of the choice that has to be made. 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? . . .

III. THE PRICING SYSTEM WITH LIABILITY FOR DAMAGE

I propose to start my analysis by examining a case in which most economists would presumably agree that the problem would be solved in a completely satisfactory manner: when the damaging business has to pay for all damage caused and the pricing system works smoothly (strictly this means that the operation of a pricing system is without cost).

A good example of the problem under discussion is afforded by the case of straying cattle which destroy crops growing on neighboring land. Let us suppose that a farmer and a cattle-raiser are operating on neighboring properties. Let us further suppose that, without any fencing between the properties, an increase in the size of the cattle-raiser’s herd increases the total damage to the farmer’s crops. What happens to the marginal damage as the size of the herd increases is another matter. This depends on whether the cattle tend to follow one another or to roam side by side, on whether they tend to be more or less restless as the size of the herd increases and on other similar factors. For my immediate purpose, it is immaterial what assumption is made about marginal damage as the size of the herd increases.

To simplify the argument, I propose to use an arithmetical example. I shall assume that the annual cost of fencing the farmer’s property is $9 and that the price of the crop is $1 per ton. Also, I assume that the relation between the number of cattle in the herd and the annual crop loss is as follows:

Given that the cattle-raiser is liable for the damage caused, the additional annual cost imposed on the cattle-raiser if he increased his herd from, say, 2 to 3 steers is $3 and in deciding on the size of the herd, he will take this into account along with his other costs. That is, he will not increase the size of the herd unless the value of the additional meat produced (assuming that the cattle-raiser slaughters the cattle), is greater than the additional costs that this will entail, including the value of the additional crops destroyed. Of course, if, by the employment of dogs, herdsmen, airplanes, mobile radio and other means, the amount of damage can be reduced, these means will be adopted when their cost is less than the value of the crop which they prevent being lost. Given that the annual cost of fencing is $9, the cattle-raiser who wished to have a herd with 4 steers or more would pay for fencing to be erected and maintained, assuming that other means of attaining the same end would not do so more cheaply. When the fence is erected, the marginal cost due to the liability for damage becomes zero, except to the extent that an increase in the size of the herd necessitates a stronger and therefore more expensive fence because more steers are liable to lean against it at the same time. But, of course, it may be cheaper for the cattle-raiser not to fence and to pay for the damaged crops, as in my arithmetical example, with 3 or fewer steers.

It might be thought that the fact that the cattle-raiser would pay for all crops damaged would lead the farmer to increase his planting if a cattle-raiser came to occupy the neighboring property. But this is not so. If the crop was previously sold in conditions of perfect competition, marginal cost was equal to price for the amount of planting undertaken and any expansion would have reduced the profits of the farmer. In the new situation, the existence of crop damage would mean that the farmer would sell less on the open market but his receipts for a given production would remain the same, since the cattle-raiser would pay the market price for any crop damaged. Of course, if cattle-raising commonly involved the destruction of crops, the coming into existence of a cattle-raising industry might raise the price of the crops involved and farmers would then extend their planting. But I wish to confine my attention to the individual farmer.

I have said that the occupation of a neighboring property by a cattle-raiser would not cause the amount of production, or perhaps more exactly the amount of planting, by the farmer to increase. In fact, if the cattle-raising has any effect, it will be to decrease the amount of planting. The reason for this is that, for any given tract of land, if the value of the crop damaged is so great that the receipts from the sale of the undamaged crop are less than the total costs of cultivating that tract of land, it will be profitable for the farmer and the cattle-raiser to make a bargain whereby that tract of land is left uncultivated. This can be made clear by means of an arithmetical example. Assume initially that the value of the crop obtained from cultivating a given tract of land is $12 and that the cost incurred in cultivating this tract of land is $10, the net gain from cultivating the land being $2. I assume for purposes of simplicity that the farmer owns the land. Now assume that the cattle-raiser starts operations on the neighboring property and that the value of the crops damaged is $1. In this case $11 is obtained by the farmer from sale on the market and $1 is obtained from the cattle-raiser for damage suffered and the net gain remains $2. Now suppose that the cattle-raiser finds it profitable to increase the size of his herd, even though the amount of damage rises to $3; which means that the value of the additional meat production is greater than the additional costs, including the additional $2 payment for damage. But the total payment for damage is now $3. The net gain to the farmer from cultivating the land is still $2. The cattle-raiser would be better off if the farmer would agree not to cultivate his land for any payment less than $3. The farmer would be agreeable to not cultivating the land for any payment greater than $2. There is clearly room for a mutually satisfactory bargain which would lead to the abandonment of cultivation. But the same argument applies not only to the whole tract cultivated by the farmer but also to any subdivision of it. Suppose, for example, that the cattle have a well-defined route, say, to a brook or to a shady area. In these circumstances, the amount of damage to the crop along the route may well be great and if so, it could be that the farmer and the cattle-raiser would find it profitable to make a bargain whereby the farmer would agree not to cultivate this strip of land.

But this raises a further possibility. Suppose that there is such a well-defined route. Suppose further that the value of the crop that would be obtained by cultivating this strip of land is $10 but that the cost of cultivation is $11. In the absence of the cattle-raiser, the land would not be cultivated. However, given the presence of the cattle-raiser, it could well be that if the strip was cultivated, the whole crop would be destroyed by the cattle. In which case, the cattle-raiser would be forced to pay $10 to the farmer. It is true that the farmer would lose $1. But the cattle-raiser would lose $10. Clearly this is a situation which is not likely to last indefinitely since neither party would want this to happen. The aim of the farmer would be to induce the cattle-raiser to make a payment in return for an agreement to leave this land uncultivated. The farmer would not be able to obtain a payment greater than the cost of fencing off this piece of land nor so high as to lead the cattle-raiser to abandon the use of the neighboring property. What payment would in fact be made would depend on the shrewdness of the farmer and the cattle-raiser as bargainers. But as the payment would not be so high as to cause the cattle-raiser to abandon this location and as it would not vary with the size of the herd, such an agreement would not affect the allocation of resources but would merely alter the distribution of income and wealth as between the cattle-raiser and the farmer.

I think it is clear that if the cattle-raiser is liable for damage caused and the pricing system works smoothly, the reduction in the value of production elsewhere will be taken into account in computing the additional cost involved in increasing the size of the herd. This cost will be weighed against the value of the additional meat production and, given perfect competition in the cattle industry, the allocation of resources in cattle-raising will be optimal. What needs to be emphasized is that the fall in the value of production elsewhere which would be taken into account in the costs of the cattle-raiser may well be less than the damage which the cattle would cause to the crops in the ordinary course of events. This is because it is possible, as a result of market transactions, to discontinue cultivation of the land. This is desirable in all cases in which the damage that the cattle would cause, and for which the cattle-raiser would be willing to pay, exceeds the amount which the farmer would pay for use of the land. In conditions of, perfect competition, the amount which the farmer would pay for the use of the land is equal to the difference between the value of the total production when the factors are employed on this land and the value of the additional product yielded in their next best use (which would be what the farmer would have to pay for the factors). If damage exceeds the amount the farmer would pay for the use of the land, the value of the additional product of the factors employed elsewhere would exceed the value of the total product in this use after damage is taken into account. It follows that it would be desirable to abandon cultivation of the land and to release the factors employed for production elsewhere. A procedure which merely provided for payment for damage to the crop caused by the cattle but which did not allow for the possibility of cultivation being discontinued would result in too small an employment of factors of production in cattle-raising and too large an employment of factors in cultivation of the crop. But given the possibility of market transactions, a situation in which damage to crops exceeded the rent of the land would not endure. Whether the cattle-raiser pays the farmer to leave the land uncultivated or himself rents the land by paying the land-owner an amount slightly greater than the farmer would pay (if the farmer was himself renting the land), the final result would be the same and would maximize the value of production. Even when the farmer is induced to plant crops which it would not be profitable to cultivate for sale on the market, this will be a purely short-term phenomenon and may be expected to lead to an agreement under which the planting will cease. The cattle-raiser will remain in that location and the marginal cost of meat production will be the same as before, thus having no long-run effect on the allocation of resources.

IV. THE PRICING SYSTEM WITH NO LIABILITY FOR DAMAGE

I now turn to the case in which, although the pricing system is assumed to work smoothly (that is, costlessly), the damaging business is not liable for any of the damage which it causes. This business does not have to make a payment to those damaged by its actions. I propose to show that the allocation of resources will be the same in this case as it was when the damaging business was liable for damage caused. As I showed in the previous case that the allocation of resources was optimal, it will not be necessary to repeat this part of the argument.

I return to the case of the farmer and the cattle-raiser. The farmer would suffer increased damage to his crop as the size of the herd increased. Suppose that the size of the cattle-raiser’s herd is 3 steers (and that this is the size of the herd that would be maintained if crop damage was not taken into account). Then the farmer would be willing to pay up to $3 if the cattle-raiser would reduce his herd to 2 steers, up to $5 if the herd were reduced to 1 steer and would pay up to $6 if cattle-raising was abandoned. The cattle-raiser would therefore receive $3 from the farmer if he kept 2 steers instead of 3. This $3 foregone is therefore part of the cost incurred in keeping the third steer. Whether the $3 is a payment which the cattle-raiser has to make if he adds the third steer to his herd (which it would be if the cattle-raiser was liable to the farmer for damage caused to the crop) or whether it is a sum of money which he would have received if he did not keep a third steer (which it would be if the cattle-raiser was not liable to the farmer for damage caused to the crop) does not affect the final result. In both cases $3 is part of the cost of adding a third steer, to be included along with the other costs. If the increase in the value of production in cattle-raising through increasing the size of the herd from 2 to 3 is greater than-the additional costs that have to be incurred (including the $3 damage to crops), the size of the herd will be increased. Otherwise, it will not. The size of the herd will be the same whether the cattle-raiser is liable for damage caused to the crop or not.

It may be argued that the assumed starting point-a herd of 3 steers-was arbitrary. And this is true. But the farmer would not wish to pay to avoid crop damage which the cattle-raiser would not be able to cause. For example, the maximum annual payment which the farmer could be induced to pay could not exceed $9, the annual cost of fencing. And the farmer would only be willing to pay this sum if it did not reduce his earnings to a level that would cause him to abandon cultivation of this particular tract of land. Furthermore, the farmer would only be willing to pay this amount if he believed that, in the absence of any payment by him, the size of the herd maintained by the cattle raiser would be 4 or more steers. Let us assume that this is the case. Then the farmer would be willing to pay up to $3 if the cattle raiser would reduce his herd to 3 steers, up to $6 if the herd were reduced to 2 steers, up to $8 if one steer only were kept and up to $9 if cattle-raising were abandoned. It will be noticed that the change in the starting point has not altered the amount which would accrue to the cattle-raiser if he reduced the size of his herd by any given amount. It is still true that the cattle-raiser could receive an additional $3 from the farmer if he agreed to reduce his herd from 3 steers to 2 and that the $3 represents the value of the crop that would be destroyed by adding the third steer to the herd. Although a different belief on the part of the farmer (whether justified or not) about the size of the herd that the cattle-raiser would maintain in the absence of payments from him may affect the total payment he can be induced to pay, it is not true that this different belief would have any effect on the size of the herd that the cattle-raiser will actually keep. This will be the same as it would be if the cattle-raiser had to pay for damage caused by his cattle, since a receipt foregone of a given amount is the equivalent of a payment of the same amount.

It might be thought that it would pay the cattle-raiser to increase his herd above the size that he would wish to maintain once a bargain had been made, in order to induce the farmer to make a larger total payment. And this may be true. It is similar in nature to the action of the farmer (when the cattle-raiser was liable for damage) in cultivating land on which, as a result of an agreement with the cattle-raiser, planting would subsequently be abandoned (including land which would not be cultivated at all in the absence of cattle-raising). But such maneuvers are preliminaries to an agreement and do not affect the long-run equilibrium position, which is the same whether or not the cattle-raiser is held responsible for the crop damage brought about by his cattle.

It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximizes the value of production) is independent of the legal position if the pricing system is assumed to work without cost. . . .

VI. THE COST OF MARKET TRANSACTIONS TAKEN INTO ACCOUNT

The argument has proceeded up to this point on the assumption (explicit in Sections III and IV and tacit in Section V) that there were no costs involved in carrying out market transactions. This is, of course, a very unrealistic assumption. In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on. These operations are often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost.

In earlier sections, when dealing with the problem of the rearrangement of legal rights through the market, it was argued that such a rearrangement would be made through the market whenever this would lead to an increase in the value of production. But this assumed costless market transactions. Once the costs of carrying out market transactions are taken into account it is clear that such a rearrangement of rights will only be undertaken when the increase in the value of production consequent upon the rearrangement is greater than the costs which would be involved in bringing it about. When it is less, the granting of an injunction (or the knowledge that it would be granted) or the liability to pay damages may result in an activity being discontinued (or may prevent its being started) which would be undertaken if market transactions were costless. In these conditions the initial delimitation of legal rights does have an effect on the efficiency with which the economic system operates. One arrangement of rights may bring about a greater value of production than any other. But unless this is the arrangement of rights established by the legal system, the costs of reaching the same result by altering and combining rights through the market may be so great that this optimal arrangement of rights, and the greater value of production which it would bring, may never be achieved. The part played by economic considerations in the process of delimiting legal rights will be discussed in the next section. In this section, I will take the initial delimitation of rights and the costs of carrying out market transactions as given.

It is clear that an alternative form of economic organization which could achieve the same result at less cost than would be incurred by using the market would enable the value of production to be raised. As I explained many years ago, the firm represents such an alternative to organizing production through market transactions.^[2] Within the firm individual bargains between the various cooperating factors of production are eliminated and for a market transaction is substituted an administrative decision. The rearrangement of production then takes place without the need for bargains between the owners of the factors of production. A landowner who has control of a large tract of land may devote his land to various uses taking into account the effect that the interrelations of the various activities will have on the net return of the land, thus rendering unnecessary bargains between those undertaking the various activities. Owners of a large building or of several adjoining properties in a given area may act in much the same way. In effect, using our earlier terminology, the firm would acquire the legal rights of all the parties and the rearrangement of activities would not follow on a rearrangement of rights by contract, but as a result of an administrative decision as to how the rights should be used. . . .

But the firm is not the only possible answer to this problem. The administrative costs of organizing transactions within the firm may also be high, and particularly so when many diverse activities are brought within the control of a single organization. In the standard case of a smoke nuisance, which may affect a vast number of people engaged in a wide variety of activities, the administrative costs might well be so high as to make any attempt to deal with the problem within the confines of a single firm impossible. An alternative solution is direct government regulation. Instead of instituting a legal system of rights which can be modified by transactions on the market, the government may impose regulations which state what people must or must not do and which have to be obeyed. Thus, the government (by statute or perhaps more likely through an administrative agency) may, to deal with the problem of smoke nuisance, decree that certain methods of production should or should not be used (e.g. that smoke preventing devices should be installed or that coal or oil should not be burned) or may confine certain types of business to certain districts (zoning regulations).

The government is, in a sense, a super-firm (but of a very special kind) since it is able to influence the use of factors of production by administrative decision. But the ordinary firm is subject to checks in its operations because of the competition of other firms, which might administer the same activities at lower cost and also because there is always the alternative of market transactions as against organization within the firm if the administrative costs become too great. The government is able, if it wishes, to avoid the market altogether, which a firm can never do. The firm has to make market agreements with the owners of the factors of production that it uses. Just as the government can conscript or seize property, so it can decree that factors of production should only be used in such-and-such a way. Such authoritarian methods save a lot of trouble (for those doing the organizing). Furthermore, the government has at its disposal the police and the other law enforcement agencies to make sure that its regulations are carried out.

It is clear that the government has powers which might enable it to get some things done at a lower cost than could a private organization (or at any rate one without special governmental powers). But the governmental administrative machine is not itself costless. It can, in fact, on occasion be extremely costly. Furthermore, there is no reason to suppose that the restrictive and zoning regulations, made by a fallible administration subject to political pressures and operating without any competitive check, will necessarily always be those which increase the efficiency with which the economic system operates. Furthermore, such general regulations which must apply to a wide variety of cases will be enforced in some cases in which they are clearly inappropriate. From these considerations it follows that direct governmental regulation will not necessarily give better results than leaving the problem to be solved by the market or the firm. But equally there is no reason why, on occasion, such governmental administrative regulation should not lead to an improvement in economic efficiency. This would seem particularly likely when, as is normally the case with the smoke nuisance, a large number of people are involved and in which therefore the costs of handling the problem through the market or the firm may be high.

There is, of course, a further alternative, which is to do nothing about the problem at all. And given that the costs involved in solving the problem by regulations issued by the governmental administrative machine will often be heavy (particularly if the costs are interpreted to include all the consequences which follow from the government engaging in this kind of activity), it will no doubt be commonly the case that the gain which would come from regulating the actions which give rise to the harmful effects will be less than the costs involved in government regulation.

The discussion of the problem of harmful effects in this section (when the costs of market transactions are taken into account) is extremely inadequate. But at least it has made clear that the problem is one of choosing the appropriate social arrangement for dealing with the harmful effects. All solutions have costs and there is no reason to suppose that government regulation is called for simply because the problem is not well handled by the market or the firm. Satisfactory views on policy can only come from a patient study of how, in practice, the market, firms and governments handle the problem of harmful effects. Economists need to study the work of the broker in bringing parties together, the effectiveness of restrictive covenants, the problems of the large-scale real-estate development company, the operation of government zoning and other regulating activities. It is my belief that economists, and policy-makers generally, have tended to overestimate the advantages which come from governmental regulation. But this belief, even if justified, does not do more than suggest that government regulation should be curtailed. It does not tell us where the boundary line should be drawn. This, it seems to me, has to come from a detailed investigation of the actual results of handling the problem in different ways. But it would be unfortunate if this investigation were undertaken with the aid of a faulty economic analysis. The aim of this article is to indicate what the economic approach to the problem should be.