Think about the oldest and most familiar principles of American law, property and proportional liability, in a new and surprising way, and learn to apply economic reasoning to an especially important and interesting aspect of life.
Markets for Goods
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From the course by Wesleyan University
Property and Liability: An Introduction to Law and Economics
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From the lesson
Externality
Exchange involves both benefit and cost – traders take rights from others, imposing costs on them but creating benefit for themselves, but they must compensate the others for their costs by paying for the rights they've taken. External costs are imposed when one person takes another's rights without paying for them, which leads to the taker taking more rights than efficient allocation would allow and leaves the victim uncompensated for the costs of losing the rights. The law's response to this inefficiency and injustice is liability, forcing those who take rights without payment to compensate those whose rights they have taken for the costs they have borne. Thinking about how the law determines these liability prices, and how people might respond to them, reveals the underlying economic logic of liability.
Meet the Instructors
Richard AdelsteinProfessor
Department of Economics
Hi everyone. Welcome back.
Let's extend our discussion of externality by considering the case of a hypothetical
steel plant, which I'll assume exists in an area where it's surrounded by a very
large number of residential neighbors. Here's a schematic picture of the steel
plant. In which I've represented the plant itself
as an empty box. Here, I'll make it look a little bit more
like a steel plant by putting a smokestack on it.
And we'll assume that some smoke is coming out of the smokestack.
But as you can see, in the picture on the right hand side.
The steel plant produces, at least, at this moment, a single output which we'll
call steel. And it produces this output by combining
what we'll call the ordinary input to production inside the factory building in
order to make the steel. That is the factory, the plant buys land
and labor and raw materials like iron ore. It buys the skill of, of managers, it buys
a whole range of other kinds of inputs, and finally it buys the input that I call
willingness to take risk. And that is what is sometimes called
capital. That is, people invest an enormous amount
of money building a plant and stocking it with heavy expensive equipment.
This has to be done before any steel can be produced and therefore it's a risky
venture. Somebody has to take that risk.
In capitalist economies, those are typically the owners of the firm, and
their input is their willingness to take risk.
All of the owners of ordinary inputs are paid for the cost of their inputs as they
are sacrificed by the original owners, and used by the steel plant to make steel.
And the steel plant pays for all of these inputs in ordinary markets characterized
by free exchange between the owners of the inputs and the steel plant itself.
If input and output markets are competitive, then this will result in a
particular result, a particular outcome in terms of the amount of the ordinary inputs
that are used. And the amount of steel, that is produced.
What do we mean by, markets for steel and for the inputs being competitive?
Well, we mean first of all that there are many buyers and sellers of identical
goods. So, for example, in the market for steel
we'll assume that there are many, many different people who want to buy steel.
And there are many, many people who want to sell steel.
And moreover, that all of the steel that is being sold by all of the competing
steel plants is identical. So that any buyer of steel can distinguish
between the different sellers of steel not on the basis of differences in the steel
they're producing because we'll assume here that there are none, but only in
terms of the price at which that individual plant is offering to sell the
steel. Similarly on the other side, the steel
plant faces many competing buyers for the steel.
From the steel plant's point of view, all of the buyers are identical except for the
amount of money that they're waving at the steel plant in order to win the, the
custom, as it were, of the steel plant itself.
So the first element of competitive market is that there are many buyers, and
sellers, each of them trading in an identical good.
There are also, we'll assume, low transactions costs.
So it's easy for buyers and sellers to meet up with one another, negotiate the
terms of trade, and transfer goods after the exchange has been agreed upon.
If all of these conditions obtain then the price of every input and of the steel
output will be driven to a single competitive price at which every
subsequent transfer is made. So for example if one of the steel plants
is trying to sell it's steel at a price higher than other steel plants are able to
meet. Then those other steel plants will offer
the steel at a lower price, and as a result customers will abandon the first
steel producer with his high price and come to the second steel producer with
their lower price. This will force the first steel producer
to lower his prices as well. And this process will continue until the
price at which every steel seller is selling steel is driven down to the same
value, indeed it's driven down under conditions of competition to the cost of
making that unit of steel itself. Okay, if markets are competitive and all
of these conditions obtain, then the dealings between the ordinary input owners
and the steel plant will result in a number of different outcomes.
First of them will be that input owners will be fully compensated for their
contribution to steel production. So, for example, the owners of labor,
workers, trade an hour of labor in exchange for a wage.
The trading away of the hour of labor, their willingness to work for that hour
imposes a cost upon them. Presumably they'd rather be lying around
or perhaps even doing a different kind of work if they could and so it does, in
fact, impose a cost upon them. To take an hour of their time, and use it
to help produce steel, rather than to put it to some other use.
But, the laborers do not make this contribution out of love, or, or
patriotism. They're fully compensated for it by the
payment of their wage. When I say fully compensated, they're paid
the competitive wage for their labor, which means that if they got a better
offer, that is if there were a higher salary, they would go and take that job
that's paying the higher salary. With we assume that they would do that,
and they remain working at the steel plant.
Then we assume that the steel plant is the best opportunity that they have.
The most money that they can earn for that hour of labor.
And therefor when they sacrifice it to steel company, and the steel company pays
that wage, then the input owners can be said to be fully compensated for their
contribution to steel production. And what's true of the laborers is of
course true of the owners of all of the other inputs, as long as those inputs too
are sold in competitive markets. Secondly the plant itself buys only those
inputs that are more valuable to it than to the owners of those inputs or to other
people who might buy the inputs instead of the steel plant.
How does the plant determine how valuable those inputs are to it?
Well, it consults the output price, that is, the price that it can get for the
production of steel. And then it knows how much revenue it can
bring in for the production of each unit of steel.
It can then determine How much it has to pay for each of those inputs.
And then compare whether or not the amount it has to pay in order to purchase those
inputs will or will not be made up as part of the price that the firm receives for
the sale of the output. If the firm decides that the unit of labor
for example is more valuable to it, for the purposes of making steel, than it is
to the laborer him or herself, or whatever other purpose that person might put the
hour of labor to. Then the plant will buy that hour of
labor. But if the plant believes that, that extra
hour of labor will not, as it were, pay for itself by producing enough extra steel
to pay the wage rate for that hour, then the plant will forebear from purchasing
that hour of labor. Because that hour of labor is worth more
to the laborer, for whatever purpose the laborer wants to put it, than it is to the
steel plant, which would put it to use in the production of steel.
So again, resources in competition move to their highest valuing owners.
And the plant will only buy those input resources for which it is the highest
valuing owner. Third, the exchange mechanism thus
allocates an efficient amount of every input to steel production.
As I've just said, free exchange moves all input resources from lower valuing owners
to higher valuing owners. So every unit of every input resource that
is more valuable to the steel plant for the purpose of making steel.
Than it is to its previous owners for some other purpose will through the exchange
system gravitate from those lower valuing original owners to the higher valuing
steel plant. As a result the steel plant will use an
efficient amount of each input in the production of steel.
And finally, the plant will itself produce and sell an efficient amount of steel as a
result of the earlier three points. That is, if markets are working well, if
everyone is perfectly informed about their benefits and the costs of the various
alternatives that face them. If transactions are easy then the plant
will only produce those units of steel which are able, as I put it, to pay for
themselves. That is, the plant will only produce units
of steel such that the value of those units of steel in the output market when
those units of steel are sold to customers.
Exceed the sum of all of the costs that have had to be suffered by all of the
previous resource owners, in order to produce that unit of steel.
So, each unit of steel as it were, has two numbers associated with it, that is, the
value of that unit of steel in the output market.
And on the other side, the total amount of cost that has had to be contributed to the
production of that unit of steel by all of the previous owners of inputs.
And if the value of the steel in the output market is greater than the cost of
all of the inputs that have been used to produce it.
The firm will produce and sell that unit of steel.
If the relationship is in the other direction and the unit of steel is not
worth the value of all the costs that have been incurred in order to produce it, then
the firm will, of its own volition without being told by anybody, simply not produce
that unit of steel. In this sense, every unit of steel that is
produced pays for itself by producing more value for the consumers of the steel than
they have consumed value on the part of the previous input owners who have lost
their inputs in order to help produce the steel.
All well and good. Now let's introduce a complication to the
problem. Again, let's return to our schematic
picture of the steel plant. Let me put the smokestack back in.
Let me put some more smoke in the air. And now we'll assume that the steel plant
has a second output. That it has to produce because it has no
technological alternative at the same time that it produces steel.
So let's assume that in order to produce steel, the firm has to toss smoke into the
air, and the smoke contains a lot of chemicals and other particulate matter,
which people breathe and which makes them ill.
Let's call this stuff that comes out in the smoke that people breathe and make
them ill, crud, okay. So for the steel plant steel and crud are
what economists call joint outputs of the production process.
I'll assume that if the firm makes steel it must make a certain amount of crud
along with the steel. We'll assume that the firm has done the
very best it can to reduce the emissions of dangerous crud into the air.
But we'll also assume that there's an irreducible amount of crud that has to
continue to be produced, and thus breathed by the neighbors of the plant, as long as
steel is being made. So, again, there are two products being
made, steel, which people value as a positive good and crud, which people value
as a bad. That is to say, when the crud is produced,
people will breathe the crud and people will suffer costs as a result of breathing
the crud. I'll assume as well that every person who
breathes the crud is affected differently by breathing the crud.
This is true of all sorts of unhealthy conditions; smoking cigarets, breathing
polluted air of any sort. What it means is that over a period of
time lets say a 100 people will breath the smoke for several years at a time.
All of those people we'll assume will suffer some small detriment to their
health. But some of those people will suffer a
greater detriment to their health. And a few of them will suffer very, very
great problems with their health. Some of which may not appear or become
apparent to anybody for a very long time. So, when people breathe the smoke, some
people don't get very sick at all, even if they breathe the smoke for a very long
period of time. Some people do get pretty sick, but not so
sick as to be completely debilitated. And a third group of people we'll assume
get very, very sick, and therefore bear very large costs in their good health from
breathing the smoke. We'll make one other assumption about the
breathing of the smoke, and that is different people who are suffering
different effects to their health as a result of breathing the smoke will assume
also value, the loss of good health that they do suffer differently from one
another. So if I lose for example 18 months off my
life from breathing the smoke I may attach a particular value to those 18 months.
Which would determine the amount that I'd have to receive in order to trade away
those 18 months of my life if I had the opportunity to do so.
But you may breath the smoke and you may also lose 18 months from you life as a
result of breathing the smoke. But there's no reason why you must value
those 18 months of shorter life at exactly the same level that I value those 18
months. So if you were offered a sum of money in
exchange for the loss of that 18 months of your life, you might well accept a
different sum of money, higher or lower, than the sum of money that I would accept.
In order to compensate me for the loss of precisely the same 18 months of good
health, 18 months off of my life. What all this means is that the good
health of the plant's neighbors, not in equal amounts, but taken from everyone of
the good health of the neighbors of the steel plant the good health of all of
these neighbors. Is also an essential input to the
production of steel. Since steel can't be made without the
production of crud. And since the production of crud produces
ill effects on people's health then, in fact, the good health of the plant's
neighbors becomes just like land, labor, raw materials, management and the
willingness to assume risk. An essential part of the production of
steel. The firm can't make steel without buying
the ordinary inputs from their previous owners.
And it can't make steel without taking some of the good health from every one of
its neighbors that live in the area around the plant.
What's the problem created by the crud? Here it's worth taking note of the
particular perspective that the economic approach places on the problem the general
problem of pollution or the more specific problem of the crud produced by the steel
plant. Note that the problem is not the
production of the crud as such. That is to say if there were no people
living around the plant and if the plant itself were operated completely by robots
and if nobody were around to see or suffer any ill effects from the smoke at all,
then the argument would be that the crud is not a problem at all.
It isn't even a problem if it damages the atmosphere as such.
Because once again, if there were no people around to appreciate the damage
being done to the atmosphere, in one way or another, then there would be nobody to
complain about the crud being tossed in the air.
So the problem, at least from the economic point of view, is not the existence of the
crud, or even the despoiling of the atmosphere that is produced by tossing the
crud into the air. The problem is only the costs that the
crud imposes upon living people. I've reduced, in this example, all of
those costs to the good health of the plant's neighbors, but obviously in the
real world, crud would in, introduce other sources of cost or disutility to human
beings. All of those sources of cost, or
disutility to human beings. Are the problem that the crud creates, and
it's only those costs that are the problem.
And the costs of the crud are a problem only if, unlike the costs borne by the
ordinary input owners, the costs are external.
That is, as we saw in the last lecture, the costs created by the crud, become a
problem only if the steel plant is able to impose those costs.
And thus to take good health of its neighbors without compensating them for
the loss that they've suffered when the plant takes their good health.
And uses it to produce steel. Costs do not become a problem until they
are uncompensated or external costs, and that will happen in this example if two
conditions are met. One of them is, as we saw earlier, that
the law has to step in beforehand and place a property right to be free of the
costs imposed by the crud initially, in the plants neighbors.
As we've seen external costs are imposed only when the law recognizes a right of
the bearer of those costs to be free of them without compensation or consent.
So in this example we'll assume hence forth that the law has already awarded the
relevant property right to individual neighbors good health To those neighbors
themselves. Therefore if the plant were to take that
good health without paying for it, the plant would then in fact have exposed,
imposed an external cost on the plant's neighbors.
So an externality relationship first requires the property right to be placed
in the bearers of the cost. And secondly, that there be high
transactions costs that prevent exchanges between the plant and its neighbors.
Here in red, we can see all of the elements that we saw in the last lecture
that are mixed together and combined to produce the problem of externality.
Property rights, transactions costs and the costs that are actually imposed by the
cost imposing activity. Okay?
So, the question then becomes how are the ordinary inputs alloca, excuse me, the
extraordinary input of good health allocated to the production of steel?
Can there be a market for good health in the same way that there are competitive
markets for the ordinary inputs? If there were markets for good health,
that is to say, if the steel plant had to negotiate with each of its neighbors over
the value of the good health that the plant is going to take from those
neighbors and devote to the production of steel.
Then the rights to those, those property rights, those rights to good health would
in fact be allocated efficiently. That is, all property rights would
gravitate to their highest valuing owners. Free transactions between the owners of
good health and the owners of the plant could be expected to produce an efficient
taking of good health by the plant. In the same way that it produces an
efficient taking of labor or an efficient taking of raw materials by all the other
owners of the ordinary inputs. Notice that if there were a market for
good health, as there is market for labor, or a market for raw materials.
Then that good health might, or might not be used for steel production.
It would depend on the relative value of that good health to it's previous owners,
for whatever purpose they would put that good health to.
And the value of the good health to the steel plant for the purposes of making
steel. If the good health is worth more to the
steel plant for making steel then it is to the previous owners for whatever purpose
they would put it to, then a transaction will move the right to the good health
from the previous owner to the steel plant.
But if that relationship is reversed and the good health owner values the good
health more than the steel plant values the good health for use in steel
production then the good health owner the neighbor is the higher valuing owner.
And the property right will stay with that person because the steel plant won't be
able to offer enough to pry the right from the good health owner in the first place.
Again, notice, again in the case where there is a market for good health, that
markets typically do not produce the absolute deterrents of the cost imposing
an activity. That is, the fact that the owners of good
health and neighbors, have a right to be compensated for the loss of their good
health. Does not mean that their good health will
not be traded away voluntarily in exchange for a payment satisfactory to the neighbor
for the use of the good health in the production of steel.
Markets, therefore, don't predetermine whether the good health will be used for
steel or whether it will be used for other purposes by their original owners.
As I've said, that depends on the relative value of the good health to the steel
plant for making steel. Or to the original owners of the good
health for whatever purposes they wish to put that good health to.
What markets or the exchange system actually do is to force cost imposers.
Here the steel plant to account for the costs that they impose in production, and
thus to impose only those costs that, as we've seen earlier, pay for themselves.
Will there be a market for good health? I'll argue that there won't be, because
the market for good health will be blocked, as it were, exchanges will be
blocked by high transactions costs which prevent rights to good health from flowing
to their highest valuing owners. And if those high transactions costs
prevent exchange, and the plant produces steel anyway.
Then external costs will be imposed upon the plant's neighbors.
Because they will have suffered costs. They will have contributed their good
health to the production of steel. And they will not have been adequately
compensated by the firm in order to win their consent for the sacrifice of their
good health. And if that happens an inefficiently large
amount good health will be used to produce steel precisely because the steel plant is
by hypothesis able to take the good health of its neighbors without paying for it.
And if they can do that, they're almost certain to use more of the good health
than they would have used if they had to pay for it, and thus they will use an
inefficiently large amount of it. And as a result of that, the plant will
produce an inefficiently large amount of steel which it will sell to consumers at
an inefficiently low price. So the question before the floor is, what
are the sources of the transactions costs that might block transactions between the
plant and it's neighbors, and thus produce the situation of externality that I've
just described? Again, if markets worked well, then good
health would be allocated efficiently through free exchange as per the Coase
theorem. But if transactions costs are high then in
fact the good health might be transferred without the opportunity existing for the
owners of good health. To block the transfer by negotiating a
price that the steel plant must pay and giving their consent to the transfer of
their property right to good health to the steel plant.
So the first question again is what the sources of these costs might be that block
these transactions? And secondly, why are these costs greater
in the case of the good health input than they are in the case of the ordinary
inputs? Those are the questions we'll look at next
time.
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