A Furry Externality

August 2, 2010

We’re taking care of my sister’s dog this week, which provides me with the perfect opportunity to write about Coase’s theory of externalities.

This dog, Louis, is very badly behaved (for real, not just for example-making purposes). About an hour ago, we discovered that he had chewed through and destroyed my Dad’s Skype headset. Bad news for my father, and soon to be bad news for my sister, who will receive a bill when she returns from vacation. But as an economist, it is my duty to think about whether such an arrangement is efficient.

The standard description of externalities that you’ll hear in these cases comes from a framework developed by Pigou. In this framework, the dog is imposing a negative externality on my father by eating his headset. Since Louis is my sister’s dog, she is charged with paying for the property that Louis destroys while he is with us.

In “The Problem of Social Cost,” Coase suggested that this reasoning is flawed, and specifically flawed in that it views externalities as one-sided, i.e. one party imposes a cost upon another, when in fact, externalities are always two-sided. This particular situation was brought about by the combination of a dog allowed to roam freely throughout the house, and a headset being left on the ground. If you remove the dog from this scenario, there is no externality, but similarly, if you remove the headset, the externality disappears as well. Thus it is equally correct to say that either the dog or the headset is the “cause” of the externality.

Note that we’re not trying to “blame the victim” here, but rather assert that the whole notion of a “victim” is mistaken. For Coase’s economics, such labels are irrelevant; what matters is how rights can be arranged or behavior can be regulated in order to produce a higher total benefit to all the affected parties.

Now, the rule we have adopted, without my sister’s consent, is a “sister pays” liability rule for dog-sitting. She will have to pay for the “harm” caused by her dog. But such a rule gives my family no incentive to pick up the floor or put Louis in a confined area so as to minimize the damage he causes. Again, though I would try to resist the urge to describe the situation in Pigovian terms, but in our failure to keep items out of the dog’s reach, we are neglecting to take into account the cost imposed on my sister.

Under an alternative system in which we simply suffer the cost of any damage done by Louis, we might take measures to prevent him from destroying our home. If containing the dog and keeping the house picked up costs us, say, $40, but the damage otherwise done by the dog would be $50, it will be worthwhile for us to prevent him from destroying our property.

One last thing to note is that the figures given above indicate the possibility of a mutually-beneficial transaction, even under the “sister pays” liability rule. Given the choice of paying $50 to compensate us for the damage done by her dog, or paying us $40 to engage in preventative measures, she will choose to pay us. Thus, if it is possible to costlessly make and enforce contracts, the utilization of resources will be the same, regardless of liability rule. In this example, preventative measures would be installed under either regime.

That insight, that legal rules do not matter if there are no transactions costs, is the famous “Coase Theorem.” It is important to note, however, that in “The Problem of Social Cost,” the same article from which the “Coase Theorem” derives, Coase himself denies the theorem’s practical importance. In the real world, Coase writes, transaction costs are important. In this case, enforcing a contract like the one described above would be far too costly for my sister. She is on vacation, and cannot easily observe how much effort we are devoting to controlling Louis’s behavior. The cost of enforcement is one important type of transaction cost.

I tentatively conclude that the liability rule we just made up is not an efficient one. Since we are with the dog this week, we have better information than my sister could about what we are doing to prevent him from destroying things. We are also in a better position to take reasonable preventative measures. From an economic point of view, a good arrangement of rights and liability would be set up to take advantage of our special position.

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