Williamson and Coase: Transactions Costs or Rent-Seeking in the Formation of Institutions

Gary D. Libecap is a Distinguished Professor of Corporate Environmental Management in the Bren School of Environmental Science & Management and Distinguished Professor of Economics at the University of California, Santa Barbara. This post is based on his working paper.

Governance and transaction cost insights of Williamson and Coase provide understanding of firm structures, management strategies, and antitrust. Economizing on transaction costs within firms and markets explains efficient adaptation.  Neither Williamson nor Coase, however, explore political exchange and rent-seeking (Krueger 1974, Tullock 2005) in the policy arena where transaction cost efficiencies play little role.

Coase (1960) argued that automatic imposition of a Pigouvian “polluter pays” tax placed all adjustment costs on the “polluter” and granted disproportionate benefits to the “pollutee.” The resulting differential incentives led “pollutees” to seek unwarranted, nonoptimal outcomes, driving up costs and making marginal net social benefits negative, lowering aggregate welfare. Moreover, because they did not provide a property right, government policy mandates that inflicted differential costs and benefits were not tradable in response to new information.  A government-imposed remedy for externalities could be more costly than the problem. His counter was to acknowledge the reciprocal nature of externalities across polluters and pollutees, assign tradable property rights, and allow for bargaining for mitigation. With exchange, marginal willingness-to-pay would be equated with marginal willingness-to-accept among the trading partners. Through voluntary, open trade, private marginal costs and benefits would become equalized, and serious imbalances in costs and benefits avoided. A more optimal externality level would result with all parties having a tie to negotiated outcomes.

While Coase’s 1960 paper is among the most cited in economics (Medema 2020), his remedies have not been adopted as the primary approach in any major US environmental policy. All US environmental and natural resource laws since 1970 are Pigouvian. Limited Coasean bargaining occurs late and around the edges of the laws (Ellickson 1991; Deryugina et al 2021; Costello and Kotchen 2022). The efficiency advantages, welfare gains, and collaborative responses Coase suggested have not been achieved. The legislative histories of major US environmental and natural resource policies reveal no comparison and selection of a welfare-improving, low-transaction cost remedy, Coasean or Pigouvian. Rather the choice of regulatory arrangements is based upon rent-seeking objectives in the political arena, not upon efforts to economize on transaction costs.

The dominance of Pigou follows from the desire and ability of interest groups, politicians, and agency officials to advance their self-interests through rent-seeking. They benefit from desired policies or preferential, non-tradable property rights, at comparatively lower direct costs than a market approach would entail. Politicians and agency officials can secure reelection and regulatory mandates and budgets. Overall policy benefits are less and aggregate costs more than would have been possible had Coasean approaches been adopted. When policies provide a mix of public goods and narrow-based political returns, it is difficult for citizens to assess general costs and benefits. Rent seeking is hard to disentangle from public goods provision, and rent holders have incentives to blend and distort information on the policy mix.

US legislation does not rely upon taxes, but prescribes emission, discharge, or production standards without compensation. While theoretically aimed at equating marginal private and social costs, lobby benefits and political returns are paramount in legislative histories, and costs are not critical. Indeed, in the Clean Air Act and listings under the Endangered Species Act, cost considerations are prohibited. Ex ante cost/benefit analysis, implicit in Coasean exchange, does not take place. Pigouvian regulation lacks exchangeable instruments so that fluid responses to new cost and benefit information is absent. Moreover, the political negotiations behind Pigouvian controls, provide little incentive for successful lobby groups or their political patrons to engage in such exchange. Hence, Pigouvian regulations are relatively inflexible and static. As Coase warned, the absence of marginal cost/benefit comparisons could lead Pigouvian restrictions to be too broad, too restrictive, and on net, too costly. Their broad net welfare benefits are ambiguous.

Political rents include standard pecuniary net returns from partisan resource assignment, commercially-preferential regulations, and subsidies. They also include value-based or psychic non-pecuniary returns from strongly-desired policies. Under Pigouvian regulation, compensation is not required (Kaldor/Hicks 1939), and in the absence of trades, comparative policy cost and benefit tradeoffs are not clearly revealed to general citizens. Coasean market approaches, by contrast, challenge the rents obtained by advocates by requiring that they pay for them, devoting actual budget outlays, and advertising policy outcomes.

The Clean Water Act sets quality standards for point sources-industrial and municipal wastewater treatment facilities.  The standards are not fixed via negotiation as would be the case with Coase. Weighing marginal costs and economic benefits in setting standards and compliance requirements is not central.  Costs relative to benefits may be high. Tradable, water-quality discharge permits around the standards were not authorized until 2003, thirty years after the CWA was enacted.

The Clean Air Act defines federal government regulation of air pollution through a variety of standards, based on integrated science assessments, and economic considerations are not directly relevant. Source emissions within a regulated area typically are not tradable, which might otherwise take advantage of differences in abatement costs as would occur under Coase. Prevention of Significant Deterioration (PSD) of Air Quality Standards, even for areas well above national standards hinders firm mobility and may lock regions into low levels of economic development. Citizens might have been willing to exchange some air quality for marginally lower levels within national air quality standards to achieve more economic growth. They were not given that option under the law (Pashigian 1985; McCubbins, Noll, and Weingast 1989).

Despite early optimism among some economists that cap and trade would become the template for US greenhouse gas (GHG) emission controls, that too has not been the case. The various federal and state regulatory efforts to address GHGs include a myriad of non-tradable standards and restrictions on emissions and surface transport, along with subsidies and related tariffs for green energy development and electric vehicles. Even the much-heralded California air emissions auction and trading program, AB 32, enacted in 2006, has not been the state’s principal mechanism for addressing greenhouse gases and other pollutants.

The Magnuson-Stevens Fishery Act of 1976 implemented uncompensated, Pigouvian-style controls on fishery inputs and outputs, sixteen years after Coase’s paper and over 20 years after publication of major works on property rights in fisheries (Gordon 1954; Scott 1955). No property rights or bargaining was employed to confront race-to-fish externalities. Centralized regulation did not provide tradable instruments for eliminating excess vessels and labor or to direct production to the most efficient producers. Overall, harvests did not decline, and fish stocks fell. Catch shares were not implemented until 1990 and 1992 in only three US fisheries. Further adoption was placed on hold in 1996 for five more years.  Although there would have been transaction costs in assigning property rights in fisheries, the major factors affecting their design were political objectives to protect traditional fishing operations and communities. Profits and broad economic net benefits implicitly were foregone in fishery rights definition and quota setting.

The Endangered Species Act of 1973 law introduced uncompensated Pigouvian restrictions on land use. Advocates sought strict regulatory controls and penalties, not exchangeable property rights. Targeted properties did not have to be acquired nor did compensation have to be paid to land owners. The political objective was to promote species recovery with low budget expenditures (Wyman 2008). Broader ESA costs and benefits are not advertised to voters. Direct compensatory payment to landholders would have made the costs of the ESA larger and far more observable. Moreover, because costs would have to be weighed across alternatives, focus might have been more on species where recovery was feasible and not on all at-risk species as desired by conservation advocates. Despite being the poster child for US environmental regulation, the law has been politically controversial and not obviously effective. It has become a lightning rod, surrounded by rancorous debate in political competition over policy and the rents it provides. The ESA has not been reauthorized since 1988, and budgets have been more limited than biologists believe necessary for species recovery.

Listings under the law are to be based on biology, “without reference to possible economic or other impacts of such determination.” Driven by lobbying (Ando 1999, 2001, 2003) and litigation (Langpap 2022), listings far exceed recoveries or extinctions. It is not obvious in the data that the law is a success. Only 3% of listed species have recovered. With policy rent seeking it is difficult to answer the question of how far restrictions on private resource use should go. Local costs may be high, including critical habitat declaration, driving up urban land prices (Auffhammer et al 2020) and the loss of logging employment and economic activity in the Pacific Northwest to protect the northern spotted owl. The owl’s population has continued to decline in the face of habitat loss from wildfires and the intrusion of an aggressive competitor, the barred owl.

Because two-thirds or more of endangered or threatened species are found on private land, the effectiveness of the ESA in achieving its recovery goals depends upon cooperation with private land owners. ESA’s Pigouvian approach provides few incentives for active private stewardship of endangered species habitat. Listing and designation of critical habitat can place landowners at risk of lower land values and use options. Listing has led to documented declines in farm land values and employment in affected counties (Melstrom et al 2018; Melstrom 2020). Landowners are motivated to engage in preemptive harvests or other practices detrimental to critical habitat to reduce the risk of ESA controls (Lueck and Michael 2003; Zhang 2004). Further, the law discourages information sharing about the location, number, and state of endangered species on their properties or leased areas by land owners or permit holders. Doing so could invite the onslaught of the law and its penalties.

In 1973 there was potential and precedent for Coasean exchange (Endangered Species Preservation Act of 1966; Endangered Species Conservation Act of 1969). The widespread use of easements and land trusts for voluntary, compensated conservation also was a roadmap (Farmer, et al 2011). With a Coasean approach, conservation would have been a joint effort, not a Pigouvian-style regulatory tax on one party. Both buyers and sellers would have had a stake in the exchange and its outcome. Endangered species could have been assets and worthy of active protection efforts.  Such partnership could have promoted durable government or NGO funding as is required for long-term recovery.  Moreover, the requirement for trade would have forced both parties to confront opportunity costs. Moreover, the two parties would not have to have had the same species or ecosystem values. Conservation would not be primarily a question of ethics or morality.  Such concepts are very difficult to exchange or to adjust in resource-use decisions, and they can be very socially and politically contentious.

A Coasean approach was not taken. Costs and benefits would have been confronted more directly, distributed more equally, and viewed more transparently by general citizens. Listings might have been more directed to species with recovery potential and landowners would have had greater motivation to join the preservation effort. The ESA might have been less divisive and more successful.

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