7 - REINTERPRETING THE EXTERNALITY PROBLEM

Summary

Coase's reasoning, discussed in essay 6, reaches the conclusion that resource allocation is unaffected by the identity of the person who is assigned the right to control the use of a scarce resource if people can use markets and negotiations freely. Furthermore, he concluded that there can be no difference between social and private cost in such a world. It is a world without inefficiencies (and, by implication, without externalities). However, he reaches a different conclusion for a world if the cost of using the price system is positive. Inefficiency cannot be ruled out in this more realistic world. This contrasting conclusion is now solidly incorporated in economic doctrine. The present essay's objective is to change doctrine in this respect.

Preliminary to doing this, some attention to terminology is needed. In a work of mine, “The Cost of Transacting on the New York Stock Exchange” (Demsetz, 1968), I empirically examined the cost of using the NYSE to execute orders to buy and sell equity shares. I called this cost “transaction cost,” which seemed quite natural for a market in which trading is so active. As my article explained, I meant this to represent the cost of using the price system in the particular case of the NYSE. I continue to use transaction cost to mean the cost of using the price system. Coase means by this cost the value of resources used to obtain information about prices and to engage in exchange at these prices.