Observation
In a world where the Government efficiently and effectively facilitates the enforcement of all property rights, the benefits or costs of externalities will not exist.
Namely if there are benefits or costs to third parties not part of the transaction, such parties can be readily adjoined to the transaction via Government enforcement of their property rights. As a corollary, in order to avoid Government interference, the parties may amongst themselves append to the initial agreement or transaction additional terms reflecting the impacted third party property costs. In this case the Government becomes the enforcer of property rights if, and only if, the parties cannot attain a remedy between and amongst themselves.
Discussion
Externalities are benefits or costs incurred by third parties when parties to a transaction take actions which result in benefits or costs to those third parties, who themselves are not parties to the initial transaction.
A classic example is the case of a railroad which obtains a right of way to run its tracks across some piece of land. The parties may be the railroad and say the state Government which has leased the right of way for some period. A third party is the farmer whose land is adjacent to the tracks. Now from time to time the train sends out sparks which ignite the corn field and destroy the corn.
In a world of free markets protected by well-defined and readily enforceable property rights, the farmer would be able to seek remedies for the losses. Alternatively the farmer could enter into a transaction with the farmer.
Basis
This is the essence of Coase’s Theorem. In effect the Coasean world would have fully enforced property rights and at no transaction costs and such a world would flush out any third parties who may not have been part of the initial agreement and costs associated with the impacts of the initial transaction could be ascribed and collected.
Examples
There are a plethora of examples of the construct of externalities. Coase initially considered them in the context of the FCC’s actions. The FCC functioned for decades as the rate setter for AT&T the Government mandated telecom monopoly. Rather than allowing the market to set the rates, the FCC established a complex Government controlled process which was in a continual state of flux.
Pollution is another classic example. There is well over a thousand years of English Common Law regarding such things as the flow of water over property resulting from the actions of the party upstream or downstream who may have interfered with the flow. Thus if flooding occurs the party taking the actions causing the flood is at fault. If water is redirected and the party downstream deprived then the damaged party can seek remedies under classic tort laws. These have been extended to cover pollution effects. Thus following the Coase paradigm one can seek remedies in the absence of Government interference if the role of the Government is that of enforcing property rights between parties.
Implications
The most direct consequence from the Coase analysis is that the Government can by regulating the interaction between parties of transactions where externalities exist may cause new externalities and also more importantly distort the true price setting mechanism of a free market as to the value of the externality.
Counter Examples
One may try to look at the antitrust laws as a model of a counter example. Indeed they were looked at in that very manner at the turn of the 19th century when they were developed. There was a fear of larger and larger monopolies and the destruction of the fair and competitive markets. That is the monopolies could set their own prices and consumers would pay whatever they set the price at. This would be especially true in such markets as steel, oil, railroads where alternatives just did not exist. Posner, Bork, Areeda and others have studied this areas without any clear set of conclusions. Every time the Government tries to create competition in certain markets, say telecommunications services, somehow there results a new amalgamation. Then the Government steps in to regulate, and the cycle begins anew.
Model
A good example and model for the externality issue is that of interconnection or access fees between networks. The third party is the consumer of the service and the consumer has no part of the transaction between the two network providers. Yet the consumer bears the cost.
For years economists such a Baumol, Willig, Tirole, and others have promulgated the idea that there is some welfare model for establishing access fees. Unfortunately none of these individuals ever looked at the consumer welfare for they looked solely at the welfare of the incumbent. Thus the Government established rules to protect the original network operator, to insure that their network would not be disintermediated. If one were to maximize consumer welfare, then the conclusion would be disaggregated networks with zero access fees between them. Unfortunately the FCC mandates a contrary position, thus allowing incumbents to maximize their returns and to effect quasi monopoly pricing.
Conclusions
Externalities have both costs and benefits. The pricing of the externality using a Coase model can be effected if the Government defines and enforces property rights with de minimis transactions costs. However, there are cases where the parties to the externality do not have a balanced ability to transact the costs of those property rights effectively and equitably, such as monopoly players of large players with small players where the transaction costs tend to overwhelm the ability to clear the market and establish an equitable price.
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