The Problem of Social Cost

The Problem of Social Cost in the United States

It may be argued that the assumed starting point—a herd of 3 steers—was

arbitrary. And this is true. But the farmer would not wish to pay to avoid crop
damage which the cattle-raiser would not be able to cause. For example, the
maximum annual payment which the farmer could be induced to pay could not
exceed $9. the annual cost of fencing. And the farmer would only be willing to
pay this sum if it did not reduce his earnings to a level that would cause him to
abandon cultivation of this particular tract of land. Furthermore, the farmer
would only be willing to pay this amount if he believed that, in the absence of
any payment by him, the size of the herd maintained by the cattle-raiser would
be 4 or more steers. Let us assume that this is the case. Then the farmer would
be willing to pay up to $3 if the cattle-raiser would reduce his herd to 3 steers,
up to $6 if the herd were reduced to 2 steers, up to $8 if one steer only were
kept and up to $9 if cattle-raising were abandoned. It will be noticed that the
change in the starting point has not altered the amount which would accrue to
the cattle-raiser if he reduced the size of his herd by any given amount. It is
still true that the cattle-raiser could receive an additional $3 from the farmer
if he agreed to reduce his herd from 3 steers to 2 and that the $3 represents
the value of the crop that would be destroyed by adding the third steer to the
herd. Although a different belief on the part of the farmer (whether justified
or not) about the size of the herd that the cattle-raiser would maintain in the
absence of payments from him may affect the total payment he can be induced
to pay, it is not true that this different belief would have any effect on the size
of the herd that the cattle-raiser will actually keep. This will be the same as it
would be if the cattle-raiser had to pay for damage caused by his cattle, since a
receipt foregone of a given amount is the equivalent of a payment of the same
amount.
It might be thought that it would pay the cattle-raiser to increase his herd
above the size that he would wish to maintain once a bargain had been made,
in order to induce the farmer to make a larger total payment. And this may be
true. It is similar in nature to the action of the farmer (when the cattle-raiser
was liable for damage) in cultivating land on which, as a result of an agreement
with the cattle-raiser, planting would subsequently be abandoned (including
land which would not be cultivated at all in the absence of cattle-raising). But
such manoeuvres are preliminaries to an agreement and do not affect the long-
run equilibrium position, which is the same whether or not the cattle-raiser is
held responsible for the crop damage brought about by his cattle.
It is necessary to know whether the damaging business is liable or not for
damage caused since without the establishment of this initial delimitation of
rights there can be no market transactions to transfer and recombine them. But
the ultimate result (which maximises the value of production) is independent
of the legal position if the pricing system is assumed to work without cost.
V. THE PROBLEM ILLUSTRATED ANEW
The harmful effects of the activities of a business can assume a wide variety
of forms. An early English case concerned a building which, by obstructing
currents of air, hindered the operation of a windmill. A recent case in Florida
concerned a building which cast a shadow on the cabana, swimming pool and
sunbathing areas of a neighbouring hotel. The problem of straying cattle and
the damaging of crops which was the subject of detailed examination in the
two preceding sections, although it may have appeared to be rather a special
case, is in fact but one example of a problem which arises in many different
guises. To clarify the nature of my argument and to demonstrate its general
applicability, I propose to illustrate it anew by reference to four actual cases.
Let us first reconsider the case of Sturges v. Bridgman which I used as an
illustration of the general problem In my article on “The Federal Communica-
tions Commission.” In this case, a confectioner (in Wigmore Street) used two
mortars and pestles in connection with his business (one had been in opera-
tion in the same position for more than 60 years and the other for more than
26 years). A doctor then came to occupy neighbouring premises (in Wimpole
Street). The confectioner’s machinery caused the doctor no harm until, eight
years after he had first occupied the premises, he built a consulting room at the
end of his garden right against the confectioner’s kitchen. It was then found
that the noise and vibration caused by the confectioner’s machinery made it
difficult for the doctor to use his new consulting room. “In particular … the
noise prevented him from examining his patients by auscultation for diseases of
the chest. He also found it impossible to engage with effect in any occupation
which required thought and attention.” The doctor therefore brought a legal
action to force the confectioner to stop using his machinery. The courts had lit-
tle difficulty in granting the doctor the injunction he sought. “Individual cases
of hardship may occur in the strict carrying out of the principle upon which we
found our judgment, but the negation of the principle would lead even more to
individual hardship, and would at the same time produce a prejudicial effect
upon the development of land for residential purposes.”
The court’s decision established that the doctor had the right to prevent
the confectioner from using his machinery. But, of course, it would have been
possible to modify the arrangements envisaged in the legal ruling by means of
a bargain between the parties. The doctor would have been willing to waive his
right and allow the machinery to continue in operation if the confectioner would
have paid him a sum of money which was greater than the loss of income which
he would suffer from having to move to a more costly or less convenient location
or from having to curtail his activities at this location or, as was suggested as
a possibility, from having to build a separate wall which would deaden the
noise and vibration. The confectioner would have been willing to do this if the
amount he would have to pay the doctor was less than the fall in income he
would suffer if he had to change his mode of operation at this location, abandon
his operation or move his confectionery business to some other location. The
solution of the problem depends essentially on whether the continued use of
the machinery adds more to the confectioner’s income than it subtracts from
the doctor’s. But now consider the situation if the confectioner had won the
case. The confectioner would then have had the right to continue operating
his noise and vibration-generating machinery without having to pay anything
to the doctor. The boot would have been on the other foot: the doctor would
have had to pay the confectioner to induce him to stop using the machinery.
If the doctor’s income would have fallen more through continuance of the use
of this machinery than it added to the income of the confectioner, there would
clearly be room for a bargain whereby the doctor paid the confectioner to stop
using the machinery. That is to say, the circumstances in which it would not
pay the confectioner to continue to use the machinery and to compensate the
doctor for the losses that this would bring (if the doctor had the right to prevent
the confectioner’s using his machinery) would be those in which it would be in
the interest of the doctor to make a payment to the confectioner which would
induce him to discontinue the use of the machinery (if the confectioner had the
right to operate the machinery). The basic conditions are exactly the same in
this case as they were in the example of the cattle which destroyed crops. With
costless market transactions, the decision of the courts concerning liability for
damage would be without effect on the allocation of resources. It was of course
the view of the judges that they were affecting the working of the economic
system-and in a desirable direction. Any other decision would have had “a
prejudicial effect upon the development of land for residential purposes,” an
argument which was elaborated by examining the example of a forge operating
on a barren moor. which was later developed for residential purposes. The
judges’ view that they were settling how the land was to be used would be
true only in the case in which the costs of carrying out the necessary market
transactions exceeded the gain which might be achieved by any rearrangement
of rights. And it would be desirable to preserve the areas (Wimpole Street or
the moor) for residential or professional use (by giving non-industrial users the
right to stop the noise, vibration, smoke, etc., by injunction) only if the value
of the additional residential facilities obtained was greater than the value of
cakes or iron lost. But of this the judges seem to have been unaware.
The reasoning employed by the courts in determining legal rights will often
seem strange to an economist because many of the factors on which the decision
turns are, to an economist, irrelevant. Because of this, situations which are,
from an economic point of view, identical will be treated quite differently by
the courts. The economic problem in all cases of harmful effects is how to
maximise the value of production. In the case of Bass v. Gregory fresh air was
drawn in through the well which facilitated the production of beer but foul
air was expelled through the well which made life in the adjoining houses less
pleasant. The economic problem was to decide which to choose: a lower cost of
beer and worsened amenities in adjoining houses or a higher cost of beer and
improved amenities. In deciding this question, the “doctrine of lost grant” is
about as relevant as the colour of the judge’s eyes. But it has to be remembered
that the immediate question faced by the courts is not what shall be done by
whom but who has the legal right to do what. It is always possible to modify
by transactions on the market the initial legal delimitation of rights. And, of
course, if such market transactions are costless, such a rearrangement of rights
will always take place if it would lead to an increase in the value of production.
VI. THE COST OF MARKET TRANSACTIONS TAKEN INTO ACCOUNT
The argument has proceeded up to this point on the assumption (explicit in
Sections III and IV and tacit in Section V) that there were no costs involved in
carrying out market transactions. This is, of course, a very unrealistic assump-
tion. In order to carry out a market transaction it is necessary to discover who
it is that one wishes to deal with, to inform people that one wishes to deal and
on what terms, to conduct negotiations leading up to a bargain, to draw up the
contract, to undertake the inspection needed to make sure that the terms of the
contract are being observed and so on. These operations are often extremely
costly, sufficiently costly at any rate to prevent many transactions that would
be carried out in a world in which the pricing system worked without cost.
In earlier sections, when dealing with the problem of the rearrangement of
legal rights through the market, it was argued that such a rearrangement would
be made through the market whenever this would lead to an increase in the
value of production. But this assumed costless market transactions. Once the
costs of carrying out market transactions are taken into account it is clear that
such a rearrangement of rights will only be undertaken when the increase in
the value of production consequent upon the rearrangement is greater than the
costs which would be involved in bringing it about. When it is less, the granting
of an injunction (or the knowledge that it would be granted) or the liability to
pay damages may result in an activity being discontinued (or may prevent its
being started) which would be undertaken if market transactions were costless.
In these conditions the initial delimitation of legal rights does have an effect on
the efficiency with which the economic system operates. One arrangement of
rights may bring about a greater value of production than any other. But unless
this is the arrangement of rights established by the legal system, the costs of
reaching the same result by altering and combining rights through the market
may be so great that this optimal arrangement of rights, and the greater value
of production which it would bring, may never be achieved. The part played
by economic considerations in the process of delimiting legal rights will be
discussed in the next section. In this section, I will take the initial delimitation
of rights and the costs of carrying out market transactions as given.

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