Environmental Policy Making : Liability for Externalities in the Presence of Transaction Costs

The existence of a theoretical market solution to the problem of externalities has been generally accepted since the seminal contribution of Coase. 1 In the absence of transaction costs, the potential for bargaining between concerned parties has the effect of internalizing any externality. The burden of legal liability for external effects does not therefore affect the attainment of Pareto efficiency. Only when the assumption of zero transaction costs is removed does the question of liability enter upon the agenda. The relevance in such cases of market solutions, and the legal liability rules which they require, are the subjects of this paper. Emphasis is on environmental pollution, where externalities are in general negative. It is shown in Section II that even without transaction cost effects, the market produces a Pareto optimal resource allocation only in a restricted subset of externality examples. In these cases, the introduction of transaction costs means that choosing particular rules of legal liability is necessary for Pareto efficiency. The criteria for choosing these rules are derived in Section III. These criteria are used in Section IV in a wider discussion of how to apportion liability for all types of externality. The paper concludes with a Section V, which argues that transaction costs should nevertheless have only a small role in designing rules for real world situations.