Coase, R. H. (1960). The Problem of Social Cost. Journal of Law and Economics, 3: 1-44.

Seung Hoon Lee

Pigou, A. C. (1920). The Economics of WelfareNegative externalities framed as a problem of restricting the emitter of social cost via civil liability, tax, or exclusion. But… Coase highlights,

The reciprocal nature of the problem:Should A be allowed to harm B (liability attributed to B); or should B allowed to harm A (liability not attributed to B=liability attributed to A)?

Under the assumption that market transactions are costless, the attribution of liability is independent from the ultimate economic result (value of produc-tion).

The Problem of Negative Externalities

1) Assuming there is no cost associated with the operation of the pricing system, even if the liability of damage attributes to the damaging business, the optimal property of resource allocation remains unchanged.

2) In the case liability of damage does not attribute to the dam-aging business (=attributes to the damaged business), there is no alteration in resource allocation, compared to above.

(∵ the social cost is built-in (becomes endogenous) to the mar-ginal reasoning; albeit income or wealth redistribution is plausi-ble, it is outside the realm of such reasoning)Consequently, the calculus of rational choice, and thereby the end-result of production bundle remains unchanged.

3) Therefore, whether the liability of damage attributes to the damaging business or damaged business has no effect on the optimal property of resource allocation (no distortion in market efficiency)

When the Pricing System is Costless…

A stable equilibrium insensitive to initial value (i.e., liability attribu-tion)

Actors behave as-if they were seeking rationally to maximize their expected returns (Friedman, 1953) - Whatever initial decision the court has made, actors can modify

it by market transaction that result into utility (profit) maximiza-tion.

- legal question “Who has the right to do what” vs. - economic question “What shall be done by whom”, answered by marginal reasoning

- Fundamentally, due to the multi-causal nature of the damage, optimal (efficient) resource allocation is achieved when both par-ties take account of the cost of the damage in their decision. And the costless pricing system directs individual behavior in such a manner.

But, When there is Cost for the Pricing Sys-tem…

In real world, there are:Cost of detection, informing, conducting negotiations, under-writing contract, inspection, etc.

Under this reality,Rearrangement of rights will be undertaken only when the in-crease in the value of production of rearranging is greater than the transaction cost involved (c.f., dead weight loss)

Therefore, initial delimitation of legal rights (liability attribution) has significant, long-term effect on eco-nomic efficiency.

An unstable equilibrium dependent upon initial delimitation of legal rights.

Delimitation of Rights and Court Decisions Arising from 1) Common Law Relating to Nui-

sanceDoes the court understand the economic consequence of their decision (legal liability attributes to whom)?

Certainly, in deciding whether a harmful effect is considered a nuisance (=liability attributes to the damaging), American courts (and perhaps English courts too) compare between the utility and harm produced.

- Whether something suffices a nuisance is determined not by abstract logical considerations (i.e., legal), but reference to particular circumstances (i.e., economic).

(“economic planning and zoning by the judiciary” as an out-come)

- Implicit in notions such as “reasonable”, “matter of com-mon sense and degree”.

Delimitation of Rights Arising from 2) Statutory Enactments (State

Authority)The effect of such legislation is to protect lawful business (and thereby public welfare) from the claims of those who is harmed by their actions.

Again, in principle, a matter of weighing up the gains that would accrue from eliminating these harmful ef-fects against the gains that accrue from allowing them to continue.

In general, welfare state often brings extension of immunity from liability for damage. In defense of the “Principle of Private Autonomy”, however, economists are prone to argue for more government regulation (e.g., liability, tax, exclusion) on dam-aging business (Ironically, this very damage is the result of government legislature).

The real problem is with the welfare economists…

The problem of social cost framed as “di-vergence between private vs. social net products”

Therefore, in order to achieve efficient allocation of resource and promote total social welfare, it is necessarily desirable for the producer of social cost should be required to com-pensate those who suffer from that damage.

But when an economist is comparing social arrange-ments, the proper procedure is to compare the total social product yielded by these different arrange-ments, by using the opportunity cost concept.

“The aim of regulation should not be to eliminate smoke pol-lution but rather to secure the optimum amount of smoke pollution, this being the amount which will maximize the value of production”

The Pigovian Tradition Revisited

An Economic Approach on Government Regula-tion

When there is cost for the pricing system, optimal allocation of resource is hampered. Alternatively,Economic Institutions (e.g., firms, government regulatory) could substitute administrative decision or authority for mar-ket transaction at a lower cost (c.f., The Nature of the Firm, 1937)

But at the same time, there is also cost associated with admin-istration and authority.

The problem of social cost is then, one of choosing the appro-priate social arrangements for dealing with negative exter-nalities (i.e., drawing the efficient boundary line of each insti-tution).

To do so, compare a situation approximating that exists against the new situation and assess whether the new is bet-ter or worse than the original.

An Economic Approach on organizational admin-istration

From negative externalities to positive externalities.

From legal authority to administrative decision.

The hallmark of Resource Based View.