Acceptance—with Qualifications

If one were to judge by the literature of this period, the Coase theorem had almost limitless potential. Scholars suggested that, in theory at least, Coase’s solution could be applied to problems as diverse as water pollution (Kneese and Bower Reference Kneese and Bower1968); urban transport, schools, and public utilities (Davies Reference Davies1965); commuter railroad financing (Bowman Reference Bowman1966); noise externalities (Hirsch and Shapiro Reference Hirsch and Shapiro1967); hospital congestion (Long and Feldstein Reference Long and Feldstein1967); road congestion (Moore Reference Moore1968); air pollution (Ayres and Kneese Reference Ayres and Kneese1969); driving safety (Lave Reference Lave1968); and knowledge externalities (Baldwin Reference Baldwin1969). That these economists were on board with the possibility of efficient negotiated settlements to externality problems under certain conditions is very clear from their comments on their respective subjects. For example, Robert Baldwin (Wisconsin), when discussing the claim that firms lack sometimes the incentive to acquire new productive knowledge (because competitors would immediately copy it without having to incur the R&D costs), noted that “in industries where there are a small number of firms, interfirm negotiations are likely to result in arrangements that offset the [knowledge] externality problem” (1969, pp. 297–298). John H. Moore (Virginia) argued that Coase had shown that the market can effect Pareto improvements in the presence of externalities “if the costs of using it were sufficiently low” (1968, p. 163). Ward Bowman (Yale Law School) asserted that “private negotiation has much to recommend it” over remedies such as taxes, subsidies, or regulations in externality situations “because it leads to the ‘right’ amounts of output,” and such a result “is most likely when the beneficiaries or sufferers from the private conduct are few and identifiable and where the cost of carrying out the necessary negotiating process is not excessive” (1966, p. 51).

Though the foregoing illustrations went only to the idea of efficiency-enhancing negotiations, Coase’s invariance claim was very much in the mix. Witness the discussion of Werner Hirsch and David Shapiro of the University of California, Los Angeles (UCLA), who instanced the case of a boisterous alcoholic neighbor. An efficient resolution of this conflict, they said,

Perhaps the most extreme invocation of Coase’s negotiation result during this period came from Lester Lave of Carnegie-Mellon, who informed his readers in his commentary on automobile safety that, “As noted by Coase, I can enhance my safety by driving more carefully, by protecting my property, and by bribing others to cause fewer accidents. If making and enforcing contracts were costless, and if all individuals knew their preferences, contracts would arise which would tend to optimize safety” (1968, p. 517). To illustrate this process at work, he continued by noting that, “As Coase argues, those drivers who might be struck by cars with bad brakes would be motivated to bribe the offending drivers to fix the brakes” (p. 518).^{Footnote 24} Of course, Coase said no such thing, but Lave’s comments provide us with an excellent illustration of how far some people were willing to push Coase’s logic in this formative period.

The clear impression conveyed by this literature is that the authors believed Coase’s analysis to be correct, both in theory and in the sense that if transaction costs were low enough, efficient bargains would regularly be consummated in situations of externality. The alert reader will have noted that Moore and Bowman explicitly allowed for the possibility that efficient bargains will be struck even in the presence of positive transaction costs, so long as these costs are sufficiently low,^{Footnote 25} and that Baldwin seems to suggest the same for situations in which there are a small number of involved firms. Coase had not gone this far in “The Problem of Social Cost,” but this was a wedge that others, slowly but surely, introduced into the literature on negotiated solutions to externality situations. The reasons for this departure from Coase’s assumption of costless transacting are unclear, though it may have been to make the negotiation result operational by allowing for its functioning when the gains are significant relative to the costs of attaining them. But whatever the underlying reason, there seems to have been a sense that Coase’s negotiation result would hold true in a world that was not too far removed from the world of costless transacting—perhaps not unlike economists’ sense, reflected in Stigler’s above-noted position, that competitive market outcomes can obtain even outside of the rarified assumptions of perfect competition.^{Footnote 26}

The oddity here, though, is that while each of these authors thought the negotiated solutions could work, when it came to the actual utilization of this framework to deal with the specific policy issues that concerned these authors, they were all of the mind that the costs of transacting (due mainly to large numbers and information costs) posed a nearly insuperable obstacle, making the possibility of negotiated settlements, in the words of Hirsch and Shapiro (1967, p. 1315) “rather remote.”^{Footnote 27} Allen Kneese and Blair Bower of Resources for the Future provided what is perhaps the most representative assessment of the felt problems with implementing Coase’s negotiation result when they wrote that,

As Hirsch and Shapiro (1967, p. 1316) pointed out, if private mechanisms were able to internalize the externalities, “there would be no need for the city planner;” yet, these planners are consistently required to manage externality-related issues in urban settings.^{Footnote 29} Thus, despite the many claims that Coase’s result did, in fact, have some measure of applicability, none of these authors was able to identify an actual situation to which they were willing to apply it.^{Footnote 30}

Although large numbers of affected parties and the costs of information were said to be common impediments to negotiated solutions, David Davies of Duke University suggested a further obstacle, one that would pose problems for Coase’s result even in situations of zero or negligible transaction costs: human nature, or, at least, the “American” version of it. Whereas Coase and others had assumed, implicitly or explicitly, that people will pursue opportunities for gain when they present themselves, Davies countered that, in America at least, “our mores seem to dictate against” negotiated solutions to the type of problems described by Coase. Rather than negotiate a mutually satisfactory agreement to resolve a dispute over, say, noise levels, as posited by Werner Hirsch and David Shapiro (1967), Davies argued that people tend to either call in the police or “grin and bear it,” even though, strictly speaking, there may be some “price that the raucous group would be willing to pay in order to buy the disturbed individual’s acquiescence, or vice-versa, depending on the status of the legal property right in noise” (1965, p. 133). Though not putting it in these terms, Davies was essentially suggesting that social norms often impact behavior in the realm of nuisance.^{Footnote 31} The underlying argument here, however, was much larger—that the economist’s assumptions regarding behavior in the marketplace for goods and services do not migrate smoothly to non-market contexts, an issue that was to loom large in the coming debates over ‘economics imperialism’ as well as in the debates over the Coase theorem.

Acceptance—and Extension

While most of the commentary on Coase’s result presented transaction costs as a barrier to the attainment of efficient negotiated or market solutions to externality situations, this view was not universally held. The logic underlying Coase’s result was utilized by Harold Demsetz and by Steven Cheung to suggest that transaction costs were not necessarily or inevitably the impediment to efficiency that many thought them to be. Though the voices actually promoting this use of Coase’s result during the 1960s were few in number, at least in the published literature, the work of Demsetz and Cheung had a significant bearing on subsequent reactions to the Coase theorem—in part because of the support lent to Coase’s result per se, but perhaps even more for the use that they made of it in a context outside of the zero-transaction-costs domain in which Coase had embedded it. Put slightly differently, though the voices were few, they were loud enough, and the conclusions drawn radical enough, to fundamentally impact the literature in the 1970s—particularly within the emerging field of environmental economics.

Where Coase’s result (and Stigler’s Coase theorem) had emphasized the possibility of efficient negotiated solutions in a frictionless world, Demsetz devoted much of his effort during the 1960s to probing the implications of Coase’s framework for a world in which transaction costs are positive—all with the goal of illuminating the role played by property rights and transaction costs in operation of markets.^{Footnote 32} Educated at Northwestern, Demsetz had spent several years at UCLA prior to coming to Chicago in 1963. Until penning his first article on property rights in 1964, Demsetz had worked almost exclusively on problems of market structure and industrial organization. Though it is difficult to discern what caused Demsetz to shift gears into the study of the impact of property rights and transaction costs, we do know that UCLA economist Armen Alchian (Reference Alchian1961) began applying economic analysis to property rights issues in the early 1960s and that the Lilly Endowment made a significant grant to UCLA during this time to support research on property rights and behavior. This funding extended well into the 1970s, and it supported some of the earliest work on property rights, including that undertaken by Alchian, Demsetz, and Steven Cheung. But it is equally clear that Demsetz’s Chicago sojourn, which ran from 1963 to 1971, had an important influence on his thinking, with George Stigler in particular prodding him to continue the development of this line of analysis (Demsetz Reference Demsetz1968, p. 33).

Demsetz was convinced of the validity of Coase’s result, a point that he made on multiple occasions^{Footnote 33}—going so far as to assert that Coase had “shown” that “divergencies [sic] between private and social cost cannot exist in a regime of zero contracting cost” (1969, p. 171, emphasis added). But he had noted in his 1964 article “The Exchange and Enforcement of Property Rights” that “the provision of a market is itself a costly service” (1964, p. 13) and focused his efforts on developing a framework for analyzing the influence of transaction costs and property rights on market outcomes. Demsetz’s genius lay in the integration of these two insights and in the conclusions that he was able (or willing) to draw from them, taken in combination—both in terms of theoretical analysis and in the evaluation of market outcomes.

Both Demsetz and Coase stressed the necessity of property rights for Coase’s negotiation result to work its magic, but Demsetz, even more than Coase, emphasized how the absence of property rights or the incomplete specification thereof worked as a barrier to the development or full flowering of the exchange process generally. In the essay “Some Aspects of Property Rights” in 1966, Demsetz noted that, “Although the proposition that property rights will find their most valuable use turns out to be a standard deduction from economic theory [note the echo of Stigler here], it is a very important variant.” Specifically, this proposition “calls to our attention the possibility that the solution of many problems may be arrived at by a more complete [or more appropriate] specification of property rights” (1966, p. 64). Demsetz’s invocation of the military draft in this context is just one example of the expansive domain that he ascribed to Coase’s negotiation result (1967, pp. 348–349). The draft, he argued, represented a basic externality situation in that it did not impose the full costs of military service on the taxpayers. A voluntary system, a bribe to enter a system, or a system that conscripts everyone but allows people to buy their way out, in contrast, would all serve to internalize these costs. The problem here was not transaction costs per se, according to Demsetz, but a property rights structure that effectively forbad negotiation and so made the cost of transacting infinite.

But a focus on property rights alone was not sufficient, said Demsetz. The costs of transacting must also be part of the theoretical mix: “A world without exchange or police costs can only be a starting point for analyzing the implications of alternative property right systems,” the reason being that when these costs are positive, “alternative assignments of property rights will generally imply different mixes of output” (1966, p. 64). Demsetz, though, did not see the presence of exchange and enforcement costs as an inherent barrier to negotiation or even to efficient and invariant negotiated solutions.^{Footnote 34} Neither, he argued, are these costs exogenous, as more complete specifications of property rights may well reduce the costs of transacting and thus make negotiated solutions more feasible. Reciprocity lay at the heart of Demsetz’s approach here, as he rejected the idea of privileging one set of interests (e.g., ‘victims’ of pollution) over others a priori in the analysis of policy questions. Efficiency analysis, for Demsetz, mandated an empirical approach, as there could be no other way to determine the least-cost method of resolving externality issues.

This, though, was only one part of the story. Where his former Chicago colleague Stanislaw Wellisz (Reference Wellisz1964) had suggested that the propensity of disputants to file lawsuits in order to resolve claims provided evidence against the feasibility of Coasean bargaining, Demsetz argued that the prospective opportunities afforded by Coase-theorem-type bargains drive the emergence of new property rights (which often emerge only through and because of lawsuits) and reflect “the desires of interacting persons for adjustment to new benefit-cost possibilities” (Demsetz Reference Demsetz1967, p. 350). This led him to conjecture that the origins of rights can be explained using basic price theory—that these rights emerge out of the actions of private agents acting on incentives. Specifically, he said, “property rights develop to internalize externalities when the gains of internalization become larger than the cost of internalization” (p. 350). The establishment of such rights would in itself resolve certain of the externality problems, and the cost of negotiating over those that remain “will be reduced greatly” (p. 356), meaning that, under a private property regime, “most externalities” can be internalized “at rather low cost” (p. 357, emphasis added).

The culmination of this line of analysis came in Demsetz’s Reference Demsetz1968 article “The Cost of Transacting”—an article that he wrote only after Stigler’s “incessant prodding” (1968, p. 33). Here, Demsetz moved beyond the relationship between property rights and transaction costs to the implications of transaction costs for the application of welfare judgments to market outcomes and, in doing so, effectively expanded the domain of the Coase theorem’s logic. Against the argument that high transaction costs preclude bargaining and thus necessitate the use of Pigovian instruments to deal with externalities, Demsetz made the rather bold assertion that “the existence of positive transaction costs has no direct relevance to economic inefficiencies.” Instead, he said, the appropriate question is “whether or not the cost is appropriately economized” (p. 33, emphasis added). Demsetz’s logic here was straightforward. Once we allow for the presence of transaction costs, it becomes clear that negotiated solutions to problems traditionally conceived of as market failures—e.g., externalities or monopoly—are efficient in some cases and not in others, the operative issue being the relative magnitudes of transaction costs and the gains from exchange (net of transaction costs). Where negotiated changes are not efficient, the persistence of externalities or monopoly is “consistent with efficiency” if the costs associated with remedial government action are greater than the transaction costs that are precluding negotiation (pp. 33–34). In short, the absence of a bargain that takes us to the ostensibly optimal (nirvana) solution provides a signal that what is may well be efficient. Coase’s message that efficiency-enhancing bargains will be consummated is simply applied in reverse here: the failure of parties to consummate bargains suggests that the status quo is efficient in the sense of representing the most cost-effective way of managing the situation in question.

While Demsetz had focused on the development of a theoretical framework for evaluating the efficiency of market outcomes in the face of positive costs of transacting, Steven Cheung attempted to assess the extent to which the predictions that one would associate with Coase’s result held true in reality. Cheung, like Demsetz, also had close links to UCLA and Chicago, and became one of the most forceful proponents of the Coase theorem and its explanatory utility. Cheung wrote his PhD thesis on the theory of share-tenancy contracting under the direction of Armen Alchian and Jack Hirshleifer at UCLA, which, by this point, was developing a reputation as something of a ‘Chicago West,’ and his thesis, with its emphasis on property rights, transaction costs, and negotiated solutions to the externalities that accompany tenancy situations, bore an unmistakable Coasean imprint. Coase’s article had resonated with Alchian, who referenced it approvingly in his 1965 essay on the economics of property rights, and with Hirshleifer, who was attempting to nudge policy makers toward the use of market instruments for allocating water resources, just as Coase had done with broadcast frequencies in his 1959 article on the Federal Communications Commission that was a prelude to “The Problem of Social Cost.”^{Footnote 35} It is reasonable to assume that one or the other of them introduced Cheung to Coase’s analysis, and the article obviously struck a chord with Cheung, who later reported that he, upon meeting Coase for the first time in 1967, informed Coase that “I spent three years reading your paper on social cost.”^{Footnote 36}

Cheung left UCLA in 1967 and spent 1967–68 as a post-doctoral fellow at Chicago. He became quite close to Coase during that time and also credits Demsetz and Stigler with having a significant role in helping him develop the 1969 article “Transaction Costs, Risk Aversion, and the Choice of Contractual Arrangements,” which became one of the foundational chapters of the book The Theory of Share Tenancy that emerged from his UCLA thesis (Cheung Reference Cheung1969a, p. xiv). Like Coase and Demsetz, Cheung was convinced of the need to integrate the effects of transaction costs and property rights into economic analysis, but, more than either of them, he also found significant explanatory power in the Coase theorem.

Cheung’s analysis of land tenancy shares with “The Problem of Social Cost” the attempt to overturn a story of ostensible market failure long-entrenched within economic analysis. The traditional economic story here was that sharecropping leads to inefficient outcomes, largely because the incentive structure engendered by share tenancy inhibits productivity-enhancing agricultural investments. Cheung believed otherwise, and his first foray on this front was an article entitled “Private Property Rights and Sharecropping,” published in the Journal of Political Economy in 1968.^{Footnote 37} Against the received view, Cheung (1968, p. 1107) argued that the claims of inefficiency are “illusory”—that under a private property regime, the same allocation of resources will emerge regardless of whether “the landowner cultivates the land himself, hires farmhands to do the tilling [i.e., a wage contract], leases his holdings on a fixed rent basis, or shares the actual yield with his tenant” (pp. 1107–1108).^{Footnote 38}

The connection between Cheung’s analysis of tenancy arrangements and Coase’s negotiation result is straightforward. Under land tenancy, the two basic types of contract that can be employed are fixed rent and share tenancy. The former fixes the level of rent that the tenant will pay to the landlord, meaning that the tenant has every incentive to invest in improvements to the land that will allow him to increase the amount of output, as all of the surplus accrues to the tenant. Under a share-tenancy contract, in contrast, the landlord and the tenant negotiate over the share of the produce that will accrue to the landlord and who will make what investments in the land. While the received (neoclassical) view argued that share tenancy results in underinvestment, Coase’s negotiation result suggests otherwise, that the structure of law—in this case, the form of the contract—will not impact the final allocation of resources and thus that we should observe the same amount of investment in the land under fixed- and share-tenancy contracts (assuming that the relevant assumptions are satisfied).

To demonstrate the validity of his assertion, Cheung assumed a system in which private property rights obtain, agents attempt to maximize wealth, and the costs of contracting are zero (1968, p. 1110).^{Footnote 39} Given his assumed framework, Cheung was able to make his case for the equivalence of fixed-rent and share contracting in straightforward fashion. The set of constraints under which agents make decisions is the same for fixed-rent and share contracts in a world of costless contracting. As there is a unique wealth-maximizing farm size and employment of inputs, the presence of identical constraints means that “the same resource use is implied,” regardless of the contract structure employed (1968, p. 1119)—an outcome that Cheung demonstrated using a bit of differential calculus. The landlord thus will structure the tenancy contract to accomplish that wealth-maximizing result and, in doing so, overcome the problems associated with the potential for tenant underinvestment (pp. 1118–1119). Given this, said Cheung, “[i]t does not matter whether the landowner stipulates that the tenant is to invest more in land and charges a lower rental percentage or whether the landowner invests in the land himself and charges a higher rental percentage; the investment will be made if it leads to a higher rental annuity” (p. 1121).^{Footnote 40}

Of course, all of this analysis was done under the assumption of costless transacting. The problem, as Cheung allowed, is that “transaction costs exist in the real world” (1969b, p. 23). But, unlike those authors discussed elsewhere in this paper who saw transaction costs as a barrier to the attainment of efficient and invariant outcomes, Cheung’s study of land-tenancy arrangements in Asia led him to conclude that Coase’s result had a significant measure of real-world applicability. His data on agricultural productivity showed that share-tenancy arrangements generated output levels and other production characteristics equivalent or superior to ostensibly more efficient contracting arrangements (1969a, ch. 3), and this led Cheung to assert that his theory of land tenancy “succeeds in explaining much of the observed farming behavior” that he had encountered in his study of actual tenancy arrangements (1969a, p. 157, emphasis added). While one could reasonably counter that Cheung was claiming too much for his evidence—essentially suggesting that data consistent with his theory gave his theory explanatory power—the validity of his claim is not what is important for present purposes. What matters, rather, is that Cheung was asserting that Coase’s negotiation result was operative even when transaction costs are non-zero.

Having established, at least to his own satisfaction, that efficiency can obtain under varying contractual arrangements, the next question that Cheung faced was why, within a competitive system characterized by private property rights, we observed both fixed-rent and share-tenancy contracts. Drawing on Stigler’s (Reference Stigler1961) work on information and Demsetz’s (Reference Demsetz1964) analysis of property rights, Cheung suggested in a follow-up article, “Transaction Costs, Risk Aversion, and the Choice of Contractual Arrangements” (1969b), that the answer lay in the transaction costs associated with negotiating and enforcing contracts, and in the presence of risk and the agents’ attitudes toward it.

As far as transaction costs are concerned, Cheung’s position (reasonably enough) was that negotiation and enforcement costs (particularly the latter) are higher for share contracts than for fixed-rent and wage contracts. Share contracts tend to have more terms over which to haggle and they bring with them monitoring costs for the landlord that are not present when the tenant’s payment to the landlord is fixed. Thus, share contracts will never be preferred to fixed-rent contracts in a world of positive transaction costs (1969b, pp. 25–26). How, then, does one explain their real-world prevalence? The introduction of risk, and of risk-averse agents, into the analysis provided Cheung with a possible solution. Under a fixed-rent contract, the tenant bears the largest share of the risk, while the landlord bears most of the risk under a wage contract. The conclusion that Cheung drew from this was that the share contract can be explained as a device for risk sharing in a situation where both parties are risk-averse (1969b, pp. 26–27).

Having established transaction costs as a basis for explaining the existence of fixed-rent contracts and risk aversion as a basis for explaining the existence of share tenancy, Cheung was able to derive a rationale for the simultaneous existence of multiple forms of tenancy contracts through the interaction of transaction costs and risk. When one allows for the presence of both risk and positive costs of transacting, he said, “the choice of contracts is determined by weighing the gains from risk dispersion and the costs of contracting associated with different contracts” (1969b, p. 29).^{Footnote 41} When transaction costs are high, relative to the degree of perceived risk, we would expect to observe fixed-rent contracts, whereas when risk is the larger issue, we expect to observe share contracts. Cheung marshaled various pieces of empirical data to provide support for this hypothesis—for example, that wheat yields were more variable than rice yields in China (implying greater risk in wheat farming), and share tenancy was more common in wheat regions than in rice regions. Share rents in China also tended to be slightly greater than fixed rents, which he suggested could be explained as a premium to landlords associated with the assumption of the additional risk that attends share contracts (1969b, pp. 28–29). All of this led Cheung to conclude that “Different contractual arrangements do not imply different efficiencies of resource allocation as long as property rights are exclusive and transferable” (1969b, p. 41)—a conclusion that is little more than a restatement of the basic conclusions of Coase’s result.

The beauty of Cheung’s analysis lies in the integration of the insights drawn from the frameworks of costless transacting and positive transaction costs. The ‘zero transaction costs tenancy’ theory shows the efficiency and invariance that attends share and fixed-rent contracts. The ‘positive transaction costs’ framework shows that there are efficiency-based reasons for the choice of one form of contract over another. When one combines the second insight with the first, the conclusion that emerges is that the choice of contractual arrangements that is efficient for the agents in question is, in fact, efficient for society as a whole. In short, the ostensible market failure associated with share tenancy is shown to be non-existent. The implications of this analysis, though, go beyond a century-plus debate over the efficiency of alternative tenancy arrangements. As Cheung (1969a, p. 161) pointed out, share contracts are found in a wide range of areas, including “retail stores, beauty salons, gasoline stations, amusement-park rentals, and even the much-regulated oil and fishing industries,” suggesting to Cheung that presumed inefficiencies across the economy needed to be re-evaluated.

There are various problems with Cheung’s analysis, including a seeming confusion of correlation and causation (often wrapped in language to the effect that the data “cannot falsify” his hypotheses), the somewhat casual or less than thorough empiricism, the tendency to ignore competing explanations or to deeply probe data that are not consistent with his hypotheses (e.g., why are not all wheat-tenancy contracts share contracts?), and to tautologically use the theory to explain what others might perceive as deviations from the theory.^{Footnote 42} Our concern, however, is not with the validity of the claims made by Cheung, or by Demsetz, but with how they attempted to use Coase’s negotiation result. What emerged from their respective analyses was the extension of Coase’s assertions regarding negotiations over rights in a world of costless transacting to one in which transaction costs are positive. In the process, another blow had been landed for the view that economists had erred significantly in their proclamations of market failure.

Invariance in Theory

Interestingly, however, the origins of the increased focus on invariance in the mid-1960s had little to do with any of this, though the ideological cast no doubt added to the topic’s attractiveness once the debate got rolling. The unwitting source of one of the controversies over the invariance proposition was Allen Kneese, who, in his 1964 book The Economics of Regional Water Quality Management, claimed that there was no efficiency-based reason to prefer the use of either taxes or subsidies to deal with externalities—that the effects of properly specified taxes and subsidies on the level of the externality and on levels of output in the relevant industries would be identical (1964, pp. 56–62, 90–98).^{Footnote 46} Though Kneese made this argument in the context of Pigovian instruments, when Morton Kamien, Nancy Schwartz, and F. Trenery Dolbear, all of the Carnegie Institute of Technology, took on Kneese’s conjecture in an article published in Water Resources Research in 1966, they expanded the scope of the discussion to “bribes and charges” generally, including those attending alternative assignments of rights in a Coasean bargaining context (Kamien, Schwartz, and Dolbear Reference Kamien, Schwartz and Trenery Dolbear1966).

Kamien, Schwartz, and Dolbear admitted that bribes and charges are formally equivalent in theory, but they argued that, under reasonable assumptions regarding the knowledge possessed by the relevant agents, the adoption of a bribes scheme will result in a greater level of the externality and would obtain under a system of charges. The explanation for this asymmetry, in simple terms, is that the bribe scheme—which equates to victim liability in a Coasean bargaining context—may, under certain conditions, give the polluter the incentive to increase its output in order to secure a larger bribe. As such, the level of the externality under a victim liability will be at least as high (and perhaps higher) than that which will obtain under a system of polluter liability.^{Footnote 47} The upshot of this argument, then, was that the invariance claimed by Coase is not guaranteed, even if transaction costs are zero.

As it happened, however, there was more to Kamien et al.’s analysis than the authors themselves seem to have realized, as David Bramhall and Edwin Mills (1966) pointed out in a note that appeared in Water Resources Research in that same year. Kamien et al. had demonstrated that bribes and charges schemes give rise to different profit levels for the affected firms, even in situations in which all parties have full information—that is, even under conditions where, according to their analysis, the invariance result would hold true. As Bramhall and Mills pointed out, however, the differing levels of profit that accompany these alternative assignments of rights have important implications for long-run behavior in a competitive industry. Translating their findings into Coasean bargaining language, victim liability will result in higher profits for polluters than would obtain under a system in which polluters were liable, owing to the revenue that accrues from the bribes. Moreover, these profits will exceed those that obtained prior to any assignment of liability. As such, they will trigger entry into the polluting industry in the long run, driving down the price of the good in question. Likewise, the higher costs (due to compensation payments/bribes paid to victims or the installation of abatement equipment) that attend an assignment of liability to the polluters will reduce polluter profits and thus trigger exit from that industry in the long run. This, in turn, will drive up the price of the good in question. Because relative prices differ under these alternative assignments of liability, said Bramhall and Mills, so, too, will equilibrium output levels. As such, Coase’s claim of invariance appeared to be refuted at a second, and one might say stronger, level.^{Footnote 48}

The critique of the Coase theorem based on long-run entry effects became a debate when University of Virginia professor G. Warren Nutter entered the fray in 1968 with his brief article “The Coase Theorem on Social Cost: A Footnote” (1968). Nutter had been Milton Friedman’s first PhD student in the late 1940s at the University of Chicago, and his career’s work focused largely on the study of monopoly-related issues and on the Soviet economic system. What led Nutter to take up the Coase theorem is something of a mystery, though it could simply be a manifestation of exchange-based ideas such as Coase’s negotiation result's being very much in the air at Virginia during the late 1950s and the 1960s.^{Footnote 49} The story behind the actual content of Nutter’s article, while perhaps apocryphal, is humorous and worth relating here.

Nutter arrived at the University of Virginia from Yale in the mid-1950s, and so had been a colleague of both Coase and Buchanan—the latter of whom had cited Coase’s article approvingly on several occasions in the early 1960s. Their collegiality apparently did not extend to agreement on the Coase theorem, however, for it seems that Nutter was engaged to give a seminar at the University of Rochester during which he would explain why the Coase theorem was wrong. On the first leg of his flight to Rochester, he happened to be seated next to Milton Friedman and the two of them discussed Nutter’s critique of the theorem. As the story goes, by the time that the plane had landed, Friedman had convinced Nutter of the error of his argument and Nutter continued on to Rochester to give a seminar showing that the Coase theorem was correct.^{Footnote 50} That it was Friedman who was the source of Nutter’s conversion makes the story just that much more interesting; he was Coase’s fiercest critic in the debate over the negotiation result that took place in Aaron Director’s living room nearly a decade earlier, but, like the biblical Saul/Paul, the persecutor had turned evangelist.^{Footnote 51} As for Nutter himself, he said nothing beyond an introductory note to the effect that he was “grateful” to Coase, Friedman, and Stigler “for helping to get [his] thinking straight on the problem discussed here” (1968, p. 503).

Nutter’s analysis is interesting for the entry debate not only because of the result produced or because he was only the third person to label Coase’s result a ‘theorem’ in print, but because it illustrates the many layers that can attend price-theoretic arguments and how the simple elegance of price theory can lead one astray if one fails to probe deeply enough—an issue that is not uncommon in the debates over the Coase theorem. His focus was the suggestion made by Bramhall and Mills, and also in the legal literature by Guido Calabresi (Reference Calabresi1965), that bribes and charges have effects on entry and exit that produce asymmetric results. Nutter’s insightful parry here involved backing up a step to examine the origin of an externality. He asserted that an externality cannot come into existence in a perfectly competitive system unless the value of output rises by at least enough to compensate for it, and he proceeded to demonstrate as much by reference to a situation in which a single owner controls all relevant resources—e.g., the two adjoining plots of land in Coase’s farmer-rancher example. If the activity on one plot of land negatively impacts that on another plot, the willingness of the owner to continue to work both plots of land demonstrates that there are rents being earned from each of them. Whether the owner charges the damage to one plot or to the other does not impact the allocation of resources between them or the total rent—only the distribution of rent as between the two plots.^{Footnote 52}

But what of the case in which the two plots are owned by different individuals? Nutter argued that the result is unaffected. If, under competitive conditions, there are two owners rather than one, he said, it must be because “the sum of managerial and transaction costs are lower for two entrepreneurs than managerial costs alone are for a joint enterprise” (1968, p. 507).^{Footnote 53} But again, the assignment of liability will have no impact on resource allocation—only on the distribution of rents. In short, the assignment of liability has no effect on the allocation of resources as long as rents exist. Stanislaw Wellisz (Reference Wellisz1964) had previously argued the necessity of rents for the Coase theorem to hold in long-run competitive equilibrium,^{Footnote 54} but whereas Wellisz had used this as an argument against the Coase theorem because of the presumed absence of rents in the long run, Nutter showed just the opposite. This result, said Nutter, is perfectly consistent with a competitive environment involving an externality because, absent rents, the externality would not exist in the first place in a competitive market. So, for the time being, at least, Nutter had rescued the theorem from questions about its validity in interfirm externality contexts.^{Footnote 55}

The other significant critique of the invariance during this period went to externalities to which consumers are party and dealt with the role played by income effects. This line of argument—which, like the entry/exit debate, was not to disappear quickly—picked up steam in 1967 following the publication of articles by the London School of Economics’ (LSE) Ezra J. Mishan and by F. T. Dolbear of the Carnegie Institute of Technology. While Chicago and LSE bloodlines seemed to generate a predisposition toward the Coase theorem during the 1960s, Mishan was a prominent exception. Mishan, who received his PhD from Chicago in 1952 and spent most of his subsequent career at the LSE, was to become one of the Coase theorem’s strongest critics between the mid-1960s and the mid-1970s. But this attitude was not much in evidence when, only two years earlier, he penned a set of “Reflections on Recent Developments in the Concept of External Effects” for the Canadian Journal of Economics and Political Science (1965). “The Problem of Social Cost” was treated alongside several other works on the subject that had appeared over the previous two-plus decades, and Mishan found very little in Coase’s analysis with which to quibble—describing Coase’s article as “A learned paper, replete with case law” (p. 29). Indeed, Mishan virtually ignored Coase’s negotiation result and focused instead on his emphasis on the costs of transacting and on the importance of finding the least-cost method of dealing with externalities.

Two years later, however, we see a very different Mishan, one who took on Coase’s invariance proposition directly in an article entitled “Pareto Optimality and the Law” (1967a). Here, Mishan devoted some thirty pages to arguing that property rights do, in fact, impact the allocation of resources. Though two of his arguments—the presence of positive transaction costs and the impact of different rights assignments on long-run costs, and thus output levels—dealt with issues that had already been raised by others (including, in the case of transaction costs, by Coase himself), a third went to the concern that alternative property rights assignments have differential impacts on the consumer’s willingness to pay (WTP) and willingness to accept payment (WTA). Both the supporters of Coase’s result and its detractors had recognized from the outset that the assignment of rights impacts the distribution of income. As Mishan pointed out, however, changes in the distribution of income affect the involved parties’ respective WTP and WTA (or compensating and equivalent variations, to use Mishan’s terminology). Moreover, Mishan continued, the value that individuals place on a right will differ according to how it is assigned, with WTA exceeding WTP for any particular right. Taking the case of the victim of pollution, the amount that he will demand in payment to allow the polluter to foul his air will be greater than the amount that he is willing to pay to induce the polluter to reduce emissions. As such, the price at which a bargain is made will likely differ, depending on to which party rights over the air are assigned, and this price difference, in turn, will give rise to different equilibrium output and externality levels. These divergences between WTA and WTP, then, give rise to different Pareto-optimal solutions under different assignments of rights, thereby negating Coase’s invariance proposition. Of course, this critique depends on the presence of income effects, meaning that it is relevant only for externalities to which consumers are a party. Nevertheless, it had the effect of invalidating, at least in the minds of some, Coase’s invariance claim when the externality is not of the interfirm variety (1967a, pp. 256–257, 269ff; 1965, p. 29n45).^{Footnote 56}

Dolbear took a similar tack in his 1967 article “On the Theory of the Optimum Externality,” pointing out that for externalities to which consumers are party, the assignment of rights may generate “an ‘income effect’ which will be of some consequence vis-a-vis the amount of the externality” (1967, pp. 90–91). To get at this issue, Dolbear employed a modified form of the Edgeworth box analysis—he was the first to illustrate Coase’s result using this tool—and used it to show that different starting points/different assignments of rights affect the final allocation of resources via income effects (pp. 95–97).

The analytics here are straightforward. The budget line GG in Figure 1 reflects the distribution of income between X, who produces heat (with smoke as a byproduct), and Y, who produces bread. If the law prohibits X from producing smoke, then the initial equilibrium is at E ₂, the inefficiency of which is revealed by the absence of a tangency between the indifference curves of X and Y. The gains from exchange are indicated by the shaded lens between E ₂^X and E ₂^Y, and the parties will negotiate to some efficient position within this range. If X has the right to pollute, however, the starting point for negotiation is E ₁—X’s profit-maximizing output of heat (and thus smoke). The gains from exchange associated with this equilibrium position are shown by the shaded area between E ₁^X and E ₁^Y, and the negotiated solution will lie somewhere within this range. Because these areas of potential gains from trade do not overlap, invariance will not obtain here.

Figure 1. Dolbear’s Negotiation Diagram.

Source: Dolbear (1967, p. 95).

Thus, Dolbear concluded, the invariance result cannot bear the weight of the claims made for it, since “only as a special case would the amount of externality … be unaltered” by alternative assignments of rights (p. 97).^{Footnote 57} That said, Dolbear was not willing to write off entirely the idea of utilizing negotiated solutions to externalities on these grounds alone. Like virtually every other commentator on Coase’s result, Dolbear acknowledged that bargaining can be problematic in large numbers situations. In the two-person case, however, he argued that “negotiations (bilateral bargaining) would seem to be the most appropriate method for ameliorating the effects of an externality” (p. 97, emphasis added), even though the resulting outcomes are likely to be impacted somewhat by the decision as to which party is to bear the liability for the harm.^{Footnote 58}

Invariance in Practice: Equity and the Hostility to the Notion of Reciprocity

The attention given to the Coase’s invariance proposition went beyond its theoretical validity to encompass much more charged questions of equity, derivative of an increasing sense that Coase’s result had the potential to move beyond the realm of theoretical curiosity and into that of policy. As noted above, the invariance proposition raised the specter of victims’ having to buy off harm-causing agents in order to get them to reduce damage levels, and this, in turn, led to a discussion of whether it was appropriate to use the invariance result and the attendant notion of the reciprocal nature of harm as a grounding for decisions to hold, or to even countenance holding, those widely considered to be “victims” of externalities liable for the harms they incurred.

The idea of victim liability for externality damage was something not generally contemplated by those working within the Pigovian framework. While the literature gave a nod of the head to the possibility of utilizing Pigovian subsidies, the fact is that economists generally contemplated remedies for negative externalities in terms of regulating or (if feasible) taxing the offending activity.^{Footnote 59} Yet, when Coase argued, against the Pigovian view, that the externality problem is inherently reciprocal, he was not the first to do so.^{Footnote 60} John R. Commons (Reference Commons1924), perhaps the foremost exponent of the institutionalist approach to law and economics during the interwar period, had emphasized the reciprocity notion in his work,^{Footnote 61} but the tenor of the Pigovian approach shows that Commons’s sentiments did not make their way into the neoclassical approach to externalities. Even so, it might seem that in the wake of the publication of Lionel Robbins’s Essay on the Nature and Significance of Economic Science (1932), which had pushed the subject increasingly away from the realm of value judgments, economists would have been more willing to countenance the notion of reciprocity raised by Coase and thus offer less in the way of normative objections to victim liability than one might have seen a half-century earlier—particularly given that the reciprocity notion and its invariance principle cousin do not say that victims should be made liable. While one finds some evidence of what one might call the “modern scientific attitude” reflected in the 1960s literature on Coase’s result,^{Footnote 62} the passage of time brought more and more in the way of normative critique of the reciprocal view. What may or may not be significant here is that the early criticisms on this front came from the UK.

One of the concerns raised regarding the use of negotiated solutions to externalities was the prospect of different degrees of bargaining power across parties to the negotiations. David W. Pearce and S. G. Sturmey (1966, p. 156) of the University of Lancaster, for example, were troubled by this possibility, arguing that it could result in what they deemed “exploitation”—specifically, insufficient compensation to the victims of the externality. This problem, they suggested, may be exacerbated by the difficulty of properly monetizing certain reductions in utility caused by harmful acts,^{Footnote 63} which could result in the failure of victims to demand payment at least sufficient to compensate them for the totality of their perceived losses—monetary and otherwise. This, of course, represented a view of the exchange process that was very different from that laid out by Coase or subscribed to by those who were on board with the theorem.

Pearce and Sturmey also expressed significant qualms about the very idea of victims compensating those causing harm in order to induce them to forgo further harmful acts. Where Demsetz (1964, p. 25) had gone to some lengths to equate pollution-induced harms and other types of externalities with more benign market-related impositions of costs, Pearce and Sturmey went in the opposite direction, arguing that “we cannot speak of compensating someone for not creating further trouble any more than we could speak of compensating a murderer for not committing a second or third crime” (p. 155). It may seem a rather extreme leap for Pearce and Sturmey to draw a parallel between negotiations among parties to an externality and between a murderer and his potential victims, but their analogy is illustrative of the difficulty that some economists had in coming to grips with even the discussion of victim liability, to say nothing of fully divorcing ethical concerns from the evaluation of analytic constructs.^{Footnote 64} Moreover, this was by no means the last time that this comparison to criminals and their victims was made in the Coase theorem literature. Needless to say, Pearce and Sturmey’s position represented an out-and-out rejection of Coase’s idea that harm is inherently reciprocal in nature and that this reciprocity should inform economists’ understanding of externalities and externality policy.

Mishan, too, assailed Coase’s result on equity grounds, raising two further equity-related objections to the possibility of victim liability. First, he suggested that those goods whose production generates significant externalities are often “purchased by and earn income for the wealthier groups in the community” (1967, p. 278). As such, these groups, rather than the victims (who would be less wealthy on average) should be assigned liability for externality damage. But even more important, he said, “is the inequity per se” of laws that would allow one party to inflict harm on others without providing for compensation of the victims (p. 278)—a prospect that he labeled “a depressing fact” (p. 279).

For Mishan, as for Pearce and Sturmey, the concept of reciprocity, so central to Coase’s result and to its application, was offensive.^{Footnote 65} The “conflict of interests” that characterizes externalities, he said, “does not arise … from reciprocal effects and does not imply equal culpability.” Rather, it “arises from the damage inflicted by only one of the parties on the other” (p. 280). It goes almost without saying that, in adopting this position, Mishan was not negating Coase’s reciprocity claim per se, but instead was pushing it to the side by effectively privileging one set of interests over another—ascribing zero weight to the harm caused to, say, the polluter, if its costs are increased by being held liable for damage imposed on others through its actions. Of course, this same perspective informed the Pigovian approach, as Coase had pointed out. For Mishan, though, the case was clear, as were the implications for Coase-theorem-related value judgments:

The market outcome, then, could be legitimate only if it flowed out of what he considered to be the proper initial structure of rights. And, for Mishan, the proper course was clear: the cause of equity (and efficiency) would be served only by “putting the burden of compensation squarely on the incidental destroyers of amenity without exception” (p. 278).

The challenge to received thinking caused by the reciprocal view was to play no small part in the debates over the Coase theorem in the ensuing decades. While some of this went to issues of theoretical logic—as with the debate over the symmetry of bribes and charges—the ethical issues that it raised loomed much larger. Indeed, it is fair to say that the reciprocity issue—and, by extension, the invariance thesis—did more than anything to bring the ideological element into the debates over the Coase theorem. University of Toronto economist John H. Dales, who drew upon aspects of Coase’s analysis (though not his negotiation result)^{Footnote 66} in his development of a theory of marketable pollution permits in the late 1960s,^{Footnote 67} was well aware of the inertia generated by the traditional views of harm-causing activities—perhaps because he ran into similar issues when promulgating his own ideas:

The irony in the value-laden critiques of reciprocity and invariance is that Coase’s negotiation result did not suggest that liability should be placed on victims. In fact, its logic suggested that one could indulge ethical preferences of the Mishan variety without efficiency-related sacrifices. Moreover, when it came to real-world issues, Coase had not overlooked the import of issues of equity, esthetics, and morals, either in “The Federal Communications Commission” (1959, p. 27n54) or in “The Problem of Social Cost” (1960, p. 43). That economists overlooked these aspects of Coase’s negotiation result and of his larger discussion speaks to the attention-grabbing power of his negotiation result in the professional mind and to the profound challenge that it posed to the traditional analysis of externalities—as well as to the ways in which others were attempting to use Coase’s result.^{Footnote 68}