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Bringing Transaction Costs into

Environmental and Resource Problems

Gary D. Libecap

University of Arizona

National Bureau of Economic Research

Hoover Institution, Stanford

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Outline of the Presentation

• The Common Pool Problem.– The “Tragedy of the Commons.”– Transaction costs explain the nature and

timing of response or lack of response.– Despite Coase’s 1991 Nobel Prize and the

prominence of work by Joskow, Williamson and others on transaction cost issues, they have not been widely considered in the literature.

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The Presentation, continued

• Persistent problems: fisheries, air pollution, water allocation and ground water.

• Transaction costs explain why and inform the response.

The Common Pool Problem

Common Pool Problem

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Open access losses

• Environmental and resource problems arise from common-pool externalities, misallocation.

• Over fishing, over harvest of forest, over grazing, over extraction, excessive air and water pollution, misallocation—lack of trade and loss of the gains from trade.

• Usual response is centralized regulation of access and use/tax.

• Absence of ability to “contract.” Gains from trade from closing the externality. No property rights.

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Externalities: Gains from trade

• Private and social net gains from resource use differ, high exploitation relative to some social optimum.

• Waste of various types—under investment, less trade, depletion, overuse, plunder.

• Misallocation. Low-valued uses. Costly policy responses. Contention. Litigation. Inflexible and untimely responses.

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The Tragedy of the Commons

• Garrett Hardin, 1968, The Tragedy of the Commons: “Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit—in a word that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest…”

• Hardin’s solution; “mutual coercion [of individual behavior], mutually agreed upon” to escape the “horror of the commons.”

• Implies a Coasian solution, not developed.• Coase used externality issues to illustrate the role of transaction

costs in “The Problem of Social Cost.”• Yet, the concept has been under employed in understanding the

origins, persistence and solution to environmental and resource problems.

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Transaction costs and remedies to losses of the commons

• Persistence of commons problems; contentious, lengthy negotiations; very imperfect responses--implies that there are transaction costs with the solutions.

• Key to understanding variation and the problems of devising more effective responses lies in investigation of transaction costs.

• Lowering these transaction costs to facilitate private bargaining can be a valuable focus of public policy. Assignment of property rights and the basis for trade.

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Transaction costs, continued.

• Transaction costs: search, negotiation, measurement, enforcement costs—all information costs.

• Coase--beneficial trades will be blocked or molded by transaction costs.

• Literature (Buchanan and Stubblebine, Coase, Cheung, Dahlman, Williamson).

Remedying the Common Pool

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Factors that influence the transaction costs of remedies for the common pool

1. Nature and distribution of information about the externality. (Measurement).• Size of the problem. Uncertainty.• Size of the costs of addressing it.• Uncertainty about size and distribution of the

benefits and costs of addressing the externality. • Opportunism. Free riding.

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Factors that influence the costs of remedies for the common pool (cont’d)

2. Physical characteristics and value of the resource (measurement, bargaining, enforcement). • Larger, more mobile, unobservable resources-

higher measurement and enforcement costs. • More claimants.• More valuable resources the greater the costs

and the returns of bargaining for solutions.

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Factors that influence the costs of remedies for the common pool (cont’d)

3. Number and heterogeneity of the bargaining parties. • Who is relevant? Free riding.• Higher bargaining costs. Compliance problems.• Small groups of similar agents with a history of

interaction can usually agree on community management.

• Shifts in prices and technology invite entry and new competition.

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Factors that influence the costs of remedies for the common pool (cont’d)

4. Equity and Precedent. Bargaining costs. Compliance.• Law or precedent may limit trading. No basis to

contract if there are no property rights.• Long-standing social and legal views regarding

ownership of natural resources/environmental amenities limits the range of options. “Polluter pays” notions.

• Concepts that are vague and strategically used—”Public Trust or Interest.”

• Compensation demands. Issues of who will pay, how much, nature, who will receive.

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Institutional solutions

• Range of institutional solutions• No action, state ownership and allocation of use,

regulation by administrative agencies, property rights—group, individual.

• Generally, private property rights are attractive because they best align individual incentives. Provide the basis for bargaining—market or market-like trades.

• State can reduce the costs of transacting among agents in order to facilitate private solutions.

The Fisheries

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Common pool losses

• Wild ocean fisheries are classic common-pool resources.

• Few restraints on entry, over fishing, and stock depletion.

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Transaction costs issues

• The fugitive nature of off shore species, large distances, multiple political jurisdictions prevent private property rights and blocked effective government controls.

• Limited and asymmetric information about – Stock size. – Effect of fishing and other natural factors; response to regulatory

controls.– Available information disputed by regulators or fishers and interpreted

differently.• Heterogeneity among fishers

– Size, production cost, skill, and fishing history--different expectations regarding the benefits and costs of regulation.

– Distributional conflicts raise the costs of regulation and influence the timing and policies that are adopted.

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Historical responses

• Deny access to certain groups—non citizens, commercial relative to sports, inshore relative to offshore, large relative to small boat owners.

• Fixed seasons or gear restrictions. – Do not upset status quo rankings and minimize on transaction

costs.

• Regulations did not align the incentives of fishers with protection of the stock. – Generally have been unsuccessful.

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Productive Policy Response

• Policy that reduces the costs of bargaining—ITQs. Basis for exchange.

• Valuable use rights that can be exchanged and accumulated by the most productive.

• Better for aligning incentives than other regulations.

• Controversial—must be limited; grant wealth windfalls; distributional conflicts.

Oil

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Oil Pool

• Competitive extraction under the rule of capture. – Incentives to maximize the economic value of individual holdings

rather than the reservoir as a whole. – Rapid extraction, excessive capital investment, lost output, other

waste.

• Information problems about value of individual leases. – Strategic production under open access. – Large numbers. – Heterogeneous holdings of oil and natural gas, size, and cost.

• Limit private agreement to control Losses.

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Historical responses

• State regulation of production. – Compromise—exemptions to spacing and drilling

rules. – Improvement over open access, but not an idealized

alternative (Demsetz).• Unitization.

– Most complete solution, but difficult--6 years or more to agree, information problems, valuation, bilateral monopoly.

– To effectively address, the cost and sharing rule has to have a particular form.

– Prudhoe Bay.

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Dust Bowl

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Commons problem

• Excessive cultivation by small farmers. Wind erosion.

• Little incentive to privately invest in erosion control. Down wind externalities.

• Numbers too large for collective action.

• High transaction costs for joint erosion control.

• Result: 1930s Dust Bowl.

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Productive Policy Response

• Formation of soil conservation districts.

• Lower costs of bargaining.

• Group solution—investment in erosion control.

• Penalties for failure to participate.

• Successful. No similar wind erosion in 1950s and 1970s drought.

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WATER: The Problem of Reallocation and Beneficial Use

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Current Allocation: Agriculture

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Shifting Demand to Urban and Environmental

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Water

• Water rights transfers: agriculture to urban and environmental uses. Limited market activity. Investigation of transaction costs is key to understanding why and devising useful policy responses.

– 60-80% of water in agriculture.• Low-valued use. $15-$25/a.f. (often subsidized crops).• High-valued use. Urban $250/a.f. or more.• Environmental. Instream flows—riparian, endangered species.

– Transfer complicated by: Valuation (Measurement). Bi-lateral monopoly (Negotiation). 3rd party effects (Measurement, Negotiation, Enforcement).

• Community impact and compensation. Other rights holders. Free riding.

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Property rights to water.

• Most efforts to reallocate or to restrict reallocation focus on litigation and/or centralized regulation. Contentious, lengthy, and generally, unsatisfactory—wasteful or very incomplete.

• General absence of clear property rights. Limits the basis for contracting to address allocation and use issues.

• Fluid, inter-connected nature of water means that 3rd party effects are likely—multiple parties potentially affected by any transaction. Complicates the definition of property rights.

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Transaction Costs of Re-allocation.

• Apply to state agency for approval of any trade.• Opportunity to protest/dispute. 3rd parties. Measurement,

verification. Rent seeking.– Delay issuing of permit.– Litigation.– Public Interest/Public Trust.

• State approval can still be followed by court challenges. • Differential incentives within Irrigation Districts. Often

hold property rights to water in trust for users. Decision making authority rules vary. Sharing rules vary.

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Property Rights to water

• Property rights to ground water. Much less well defined—commons. Reasonable and Beneficial use requirement. Vague.– Surface and ground water often linked

geologically. – 3rd party effects.

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Conclusion

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Transaction costs matter

• Transaction costs affect nature and timing of solutions to common pool losses and trade to address them.

• Examine the bargaining issues—variation, timing, policy. • Property rights are generally the preferred solution

because of their flexibility and alignment of incentives. Provide a basis for exchange. Coase.

• But not always possible. Costs of measurement, enforcement, equity.

• Role of the state—reduce bargaining costs—ITQs; greater definition of property rights and reliance on trade.

• Avoid “nirvana” comparisons.