Ronald H. Coase was one of the most interesting and influential economists of his century. He was born in 1910 in a suburb of London and recently passed away at the age of 102 in Chicago, close to the economics department that he, Milton Friedman, George Stigler, and so many others helped elevate into the intellectual stratosphere.
Coase's insights were few but great — which deservedly earned him a Nobel Prize in economics in 1991. His dissertation about why firms exist started an entire field of economic inquiry continued by Oliver Williamson who himself won a Nobel Prize in 2009. His paper, "The Federal Communications Commission," eventually influenced governments around the world to sell or lease some bands of the electro-magnetic spectrum. He poked fun at economic orthodoxy by showing that public goods, like lighthouses, were provided by private methods rather than through the government as had been assumed earlier.
His most influential paper was "The Problem of Social Cost," published in the Journal of Law and Economics in 1960. As of 2012, it was still the most cited law review article. The insights of the paper are simple but to understand how revolutionary they are, you must understand what preceded Coase's paper.
Economists have been grappling with externalities for over a century. Externalities are costs or benefits imposed by an individual without their consent. Economists were mostly worried about negative externalities, those that harmed others. A common example is a factory that makes it impossible for a neighboring dry cleaner to clean clothes. The factory's emissions of soot dirty the clothes in the dry cleaner, imposing a significant cost even though they are not interacting voluntarily with the factory.
Using pollution as an example, if negative externalities are imposed on outsiders then polluters will over-pollute. If polluters had to bear the entire cost of their pollution then they would pollute less or until the costs of cleaning up the pollution or just suffering through it is equal to the profit of producing the last widget. But if the costs of pollution are mainly borne by others, the polluter will make more widgets and thus pollute more than he otherwise would — imposing higher costs on others.
Until 1960 the accepted to solution to this problem was a Pigouvian Tax, named after British economist Alfred Cecil Pigou. His idea was simple on the surface but more complex in practice. A Pigouvian Tax would be a tax levied on the polluter. Ideally, the tax would be equal to the harm caused by the pollution, thus internalizing the costs of the pollution to the polluter. In such a situation, the polluter will more carefully evaluate the costs and benefits of extra polluting, decreasing the quantity of pollution. The Pigouvian Tax can also be used to justify command and control style regulations to mandate lower emissions, similar to the Environmental Protection Agency's actions.
A tax on a polluting firm decreases the supply of widgets the firm makes and decreases its pollution through that mechanism. Greg Mankiw of Harvard started a Pigou Club of economists who support carbon taxes. Ideally, a carbon tax would allow the government to impose a cost on firms that would internalize the harm caused by carbon dioxide and create a financial incentive for the firm to innovate or adopt other production techniques to minimize the externality. Those externality reducing technologies or techniques are usually more expensive, otherwise the firm would already be employing them, so they decrease output. The cost of pollution is borne by the polluter through taxes and thus decreasing the production of widgets.
That seems like a simple idea on the surface but it hides an underlying complexity that makes the Pigouvin Tax an unwieldy intervention. One problem is, how much should the firm be taxed? Pigouvians will say, "set the tax equal to the negative externality." How much does an externality cost? Are the costs uniformly imposed? Witness the intense disagreement over a carbon tax. Some disagree that carbon dioxide is even a pollutant, others think it causes harm but via natural emissions rather than human production processes. Others think human production of carbon dioxide imposes small costs on other people so it's not worth taxing while other think the tax is large. Also, different emitters of carbon dioxide has disparate impacts on the environment based on their location, the height of smoke stacks, and other issue complex environmental factors.
Without weighing in on the climate science or other economic issues surrounding the withering debate over carbon taxes, it is difficult to determine whether there should be a Pigouvian Tax or, if economists think there should be one, how big it should be. A one cent tax per ton of carbon dioxide might not even cover the cost of collection while a $100,000 a ton tax imposes too high of a cost on producers.
The government is unable to determine an efficient tax rate to internalize the costs of production. Government agents have their own motivations and incentives that do not coincide with creating efficient Pigouvian Tax rates. Politicians want to get elected, which means they could support tax rates based on their constituent's desires. Those constituents will have complex incentives that have little to do with finding a tax level that minimizes the costs of pollutions to an efficient level. Some bureaucrats will want higher taxes to extend their revenue while others will think it weakens their control if taxes replace command and control regulations. If a tax is imposed on carbon dioxide and it turns out to be based on a faulty understanding of the science of climate change, the government will not surrender a large source of revenue. Public choice theory strikes again.
Not all externalities should be eliminated. In an extreme example, a factory produces goods that create $1 trillion in profits but imposes a $100 negative externality on a neighboring business. In order to eliminate that $100 in pollution, the factory would have to shut down. The efficient solution is clearly not to destroy $1 trillion in profits to protect $100 worth of property elsewhere. Internalizing all of the costs there would impose far greater damage than that done by the pollution. Very few people argue for eliminating all externalities but thinking in terms of these types of extremes help clarify marginal thinking.
The Coase Theorem
Pigou's approach, problems and all, were embraced by the economics profession until Coase's paper in 1960. The Coase Theorem, dubbed by George Stigler, is best explained through examples.
Returning to the factory and the dry cleaner example earlier, the Pigouvin solution would be to tax the factory so its emissions decrease, allowing the dry cleaner to operate. The Coase Theorem states that under certain circumstances, bargains and exchanges can reduce negative externalities by efficiently exchanging property rights between the polluter and polluted. In this case, they can change their behaviors or exchange resources to decrease the damage of an externality or compensate those harmed.
The factory could decrease its emissions but the dry cleaner could also move or install an expensive air filter. The problem is not just the firm's emissions but also the dry-cleaner's location. The dry cleaner could pay the factory to decrease emissions or the factory could compensate the dry cleaner.
The Coase Theorem says that when the costs of negotiating are zero and both parties have property rights, they will reach the least expensive solution and most efficient solution to the externality problem. Let's say the factory made $1 million in profits a year while the dry cleaner would make $50,000 without the pollution. With the pollution, the dry cleaner's profits are $0. A Pigouvin Tax would decrease the factory's profits by $100,000 and let the dry cleaner make $50,000. That means that there is $50,000 less in total profit.
A Coasean bargain could produce a better solution for both parties. The factory owner could buy the dry cleaner a $50,000 air filter so it could still clean clothes and the firm could still pollute. In that situation, the total amount of profit has not decreased and, without the tax, the externality of the pollution was decreased. Since both parties have a better understanding of their own costs and how much pollution could be produced while allowing them both to operate, they are much more likely to reach a mutually beneficial bargain than having one imposed on them by the government.
There are two conditions that are important for Coasean bargains like these to be struck. The first is that transaction costs need to be zero or negligible to allocate all property rights in a way to adjust negative externalities down to an efficient level. When transaction costs are positive, as they always are in the real world, the cost of finding the polluter and victim, negotiating, and enforcing a solution need to be less than or equal to the benefits of the bargain. If those transaction costs are too great, the a Coasean bargain will not occur.
Many Coasean bargains that would decrease externalities cannot be struck in the real world due to those transaction costs. Bilateral monopoly problems, market power, and government rules and regulations raise transaction costs and thus decrease the quantity of bargains that can be struck.
An essential component of Coase's insight on transaction costs is that courts, governments, manners and norms, or other civil institutions can help lower transaction costs and aid both parties in reaching a mutually beneficial and socially efficient bargain. Indeed, many of those institutions evolve to facilitate Coasean bargaining — which is what many claim is Coase's most interesting insight. The bundle of rights in Anglo-Saxon property law, easements and servitudes, and tort actions against trespass and nuisance all serve to decrease the transaction costs of reaching Coasean bargains.
Property rights are also important for the Coase theorem. Both the factory and the dry cleaner need to own their property and be free to exchange it in order to find a bargain. Instead of an air filter, the factory could buy the property from the dry cleaner and essentially pay for him to move far enough away so the costs of pollution won't be borne by him.
One of the main insights here is that if property rights are secure and transferrable and transaction costs are low, people will exchange property and make Coasean bargains to decrease the net-cost of negative externalities to the point where the benefits of pollution equal the costs. Pollution will not disappear, it will decrease or change to the point where the last bit of pollution produced will be equal to the economic value of the last good produced.
The Coase Theorem explains behavior in numerous situations from cattle herders in Northern California to railroad companies in the Rocky Mountains to property developers in Arizona. Even when property rights are relatively insecure, Coasean bargains are discovered. In a paper Pete Leeson and I wrote in the Journal of Economic Behavior and Organization, we discovered that Coasean solutions were even reached in low transaction cost situations where property rights were insecure — like the interaction between privateers and merchantmen on the high seas in the 18th and 19th centuries.
In arriving at Coasean bargains, the main problems are the transaction costs and not necessarily the externality. If the costs of eliminating the externality are greater than the costs of dealing with it, then nothing should be done.
The Coase Theorem and Immigration
Immigration is a topic where the Coase theorem could be profitably applied to increase understanding but seldom is because the costs of explaining it (see above) are so high. Most of the complaints of immigration restrictionists focus on the supposed externalities caused by immigrants. Viewed through a Coasean framework, immigration restrictions are the most damaging and expensive ways to decrease the supposed externalities of immigration. Either other policies should be crafted to deal with the externalities, nothing should be done, or the externalities are likely positive.
Restrictionists often complain about immigrants who bring a different language with them.
"There are now Spanish newspapers that are going beyond the level of amateur ethnic press and becoming serious professional media operations in the United States that operate in another language," said Mark Krikorian of the restrictionist Center for Immigration Studies. "That kind of thing is only possible because of mass immigration of large numbers." Krikorian's solution is stricter immigration controls and removing the unauthorized immigrants already here.
Different languages have always worried Americans. Benjamin Franklin even fretted that the Germans could overrun Pennsylvania and replace English.
Immigrants from the developing world earn incomes three to fifteen times as great as in their home countries. Each additional immigrant in a city increases the housing prices in that city by $.12 cents, redistributing some economic gains to American property owners. Immigration from 1990 to 2006, at worst, decreased wages for a quarter of Americans by around 3 percent but raised them by over 1 percent for 75 percent of Americans. Most economists have found that the incomes for virtually all Americans have increased over that time period because of immigration.
If we forced unauthorized immigrants and other legal immigrants to leave, their incomes would decrease by at least 67 to 93 percent, American property values would fall, and most Americans would likely see a decrease in wage growth or an actual decline. Barring future immigration would trap many potential Americans in poor developing countries even though some want to move to opportunity much like our ancestors did.
Those are just some of the surface costs, not even considering the enormous decrease in freedom that would result from enforcing such an anti-immigrant policy shift. Those costs are not worth bearing just so some prudes won't ever have to bear the sound of a language that don't understand — assuming that no American gets a positive benefit from hearing other languages.
Immigration restrictions, deportations, and removals are the Pigouvian Tax solution to that "problem" and would cause far more damage than the bad feelings some Americans get from hearing another language spoken. Those who are upset by hearing a foreign language spoken should take solace in the fact that language assimilation proceeds very rapidly in the U.S., driven by the roughly 20 percent increase in wages that immigrants can expect from learning English.
Are there Coasean bargains that immigrants and natives could agree to so immigrants learn English faster? Perhaps. There are numerous charities and English as a Second Language classes available at a price of 0 that are, unsurprisingly, crowded. Private companies offer English classes with demand steadily expanding. The transaction costs of bringing together Americans who want to subsidize immigrants learning English are probably prohibitively high except in some special situation. Letting that negative externality continue is efficient.
The economic benefits of a global open borders immigration policy are estimated to be between 50 percent and 150 percent of global GDP — a tremendous gain. Comparing the economic costs and benefits of immigration produces such an unambiguously positive result that I'll merely redirect the reader to other writings on the topic.
An externality of immigration that does impose costs on Americans is the welfare state. Although immigrants are infrequently legally allowed to use welfare and do so much less often than Americans, there is still some cost imposed on American taxpayers of having immigrants using welfare. The welfare costs of immigration are a government imposed externality that can be alleviated by denying immigrants access to welfare.
To be clear, the cost that immigrants impose on Americans through the welfare state is small, tiny in comparison to the economic benefit. Fortunately the cost of denying welfare to immigrants is far smaller than either of those, as I wrote here. Allowing Americans and immigrants to gain from immigration while decreasing the costs imposed upon American taxpayers via the welfare state would lead to a better outcome.
The transaction costs of a political deal to increase immigration and decrease access to welfare are high, as we're seeing with the immigration reform debate, but far lower than not reforming immigration. Politically created externalities like welfare do not justify additional costly immigration restrictions — they justify their own removal.
Crime externalities exist — most visibly when unauthorized immigrants cross private property when entering the United States. Those costs are not decreased by doubling the number of border agents who will trample property or erecting border fences through eminent domain. Changing American immigration laws to allow legal entry will reduce property violations on the border. That's far cheaper than "invading" the border and will likely be more successful at cutting down on that externality.
Some immigrants commit violent and property crimes that have severe externalities. There are more than 40 million immigrants in the U.S., it would be miraculous if none of them was a bad person. But while there have been some dramatic crimes committed by immigrants, they are less likely than U.S.-born Americans to commit crimes. The post-1990 boom in immigration has coincided with a secular decline in violent and property crime in the United States — especially in immigrant receiving cities like New York, Los Angeles, and other cities on the border. Immigration probably doesn't cause a decrease in crime but immigrants certainly choose safe places to live and don't make it worse — on average.
Curtailing legal immigration or declaring every unauthorized immigrant to be a criminal (many aren't, they committed a civil offence), will not solve this problem. Focusing immigration enforcement on property and violent criminals while legalizing those who are neither will allow scarce government resources to focus on actual threats.
There are other externalities caused by immigration, but they are just as likely or more so to be positive than they are to be negative. One insight of the Coase theorem is that our institutions should have evolved to deal with these externalities in more efficient ways. Viewing the machinations of Congress and the President, it's clear that our political institutions are likely making immigration reform of any kind more complicated, less beneficial, and less likely to occur.
So why haven't many Coasean bargains been struck to decrease the negative externalities of immigration? Either the externalities are small and not worth bargaining over in a world of positive transaction costs or the transaction costs are prohibitively high. One thing is certain, the costs of complaining of immigration are low.
The Externalities of Exclusion
What about the enormous harms imposed on Americans and immigrants by immigration restrictions? In order to justify severely restricting the ability of Americans to hire immigrants, sell them goods and services locally, rent them property, or otherwise interact with them in a peaceful and voluntary way, the government must point to a high probability and/or high cost outcome in the absence of such restrictions. Except for the most hysterical people in online chat forums, few are arguing that such an event could occur let alone making a falsifiable prediction.
The harm on immigrants is tremendous. Nonsensical comparisons between the United States and corporations aside, immigrants are human beings with the same moral worth as the rest of us. To kill an immigrant without justification is murder just as much as killing an American without justification is murder. The same ethical and moral rules we apply toward our fellow Americans apply equally to immigrants. Restricting an immigrant's ability to sell their labor and buy goods, services, and property from Americans hurts them quite a bit — more than it hurts Americans. We'd have to anticipate a very negative event to justify restricting immigration as much as our government currently does. Few such events are seriously anticipated and almost none are plausible even with outlandish assumptions.
Using immigration enforcement to weed out some immigrants who are likely to individually impose large costs on Americans is warranted. Excluding immigrants who have been convicted or serious property or violent crimes, are suspected terrorists (.1 percent of those in IAFIS), and could carry deadly communicable diseases into the U.S. are defensible actions that the government should undertake. But just because some immigrants will have those excludable characteristics does not mean other peaceful and healthy immigrants should be excluded.
America significantly curtailed European immigrant to the United States in 1921. From 1900-1913, Jewish emigration from anti-Semitic Russia annually averaged 19.7 per one thousand, meaning that 19.7 Jews per every thousand Russian Jews left every year. That intensity of immigration, 50 percent greater than for Ireland during the famine, was because of Pogroms and persecution by the Russian government. Luckily most of them were able to come to the United States.
As World War II and Communism loomed over Europe, the traditional refuge of America was closed to Jews and those threatened by the new regimes. In embarrassing and cruel episodes, American immigration authorities prevented Jews fleeing Nazi Germany from coming to America. That ultimate cost paid by the victims of the Holocaust and World War II who otherwise would have emigrated was an externality of American immigration laws at the time.
U.S. immigration policy at the time was responsible for the deaths of people who would have fled to America but were stopped due to our immigration laws. If someone is fleeing a burning building and you stop him, forcing him to turn back into that building and then it collapse, you are responsible for that person's preventable death. That's what U.S. immigration policy did to hundreds of thousands or even millions of potential immigrants to the U.S. post 1921. The negative externalities of our immigration policies should receive greater weight than the cultural prudishness or economic ignorance of immigration restrictionists.
One must consider this enormous cost imposed on Americans and immigrants — even if one discounts the harm done to immigrants — in order to justify continuing or increasing the restrictiveness of American immigration laws. The negative externalities of American immigration laws are gigantic.
Our political institutions are not lowering transaction costs enough to facilitate efficient immigration reform. Cheap political biases and poor incentives do not facilitate a bargain between those who will gain from immigration and those who think they will lose. In most cases high transaction costs prevent harmful legislation from being passed but they also prevent harmful laws from being repealed. Coase's insights help illuminate the potential bargains and costs of immigration.