Debunking myths about free-market environmentalism

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A recent post on Grist attempted to dismantle the intellectual foundations of free-market environmentalism -- the application of markets and property rights to solve environmental problems. But far from toppling a burgeoning movement within modern environmentalism, it succeeded only in misrepresenting the subject.

To recap: Clark Williams-Derry claimed that while free-market environmentalism may be effective in some areas of the environment (e.g., fisheries management), its reliance upon unrealistic assumptions about the real world largely relegates it to useless intellectual theorizing. In particular, the Coase theorem -- an important component of market-based environmentalism named for Nobel Prize-winning economist Ronald Coase -- amounts to "a quirky but not particularly relevant bit of theoretical math."

While there is certainly much more to free-market environmentalism than the work of Coase (see Terry Anderson and Donald Leal's book Free Market Environmentalism for more details), I focus here mostly on the misinformed critique of Coase that has been used to discredit free-market environmentalism.

So, who is Coase, what is his theorem, and what does it have to do with free-market environmentalism?

Ronald Coase's 1960 paper "The Problem of Social Cost" [PDF] challenged the way economists thought about competing uses of resources. In short, the Coase theorem states that if property rights are fully specified and the costs of coordinating transactions between agents are zero, bargaining will lead to an efficient outcome, regardless of how rights are initially assigned.

To illustrate: suppose a farmer and a refinery are both located along a river. According to the Coase theorem, as long as property rights to the use of the river are clearly defined and the costs of transacting with one another are zero, the amount of effluent disposed in the river by the refinery will be the same regardless of who has the property right. If the farmer had the right to have the river's water free of the refinery's waste, the refinery could compensate him in exchange for a partial right to discharge effluent into the river. If the refinery had the right to use the river for effluent discharge, the farmer could compensate the refinery in exchange for less effluent released into the river.

In this stylized example, voluntary negotiations between the farmer and the refinery will result in the optimal amount of effluent discharged in the river, as long as property rights are defined to one of them. This would occur without taxes imposed, water-use regulations devised, or subsidies doled out to try to control the use of the river.

But as was correctly noted (and astute readers have no doubt picked up on), the real world is much more complex; negotiation is costly, multiple agents are often affected, and information is diffuse. So, Coase's theorem -- and free-market environmentalism in general -- is irrelevant in the real world, right?

Wrong. Coase's chief accomplishment was to encourage the economics profession to move away from the abstract mathematical tinkering that often bears no resemblance to the real world. He introduced the world to the reality of transaction costs, the costs of coordinating exchanges in the market. For decades, economists had devised policy prescriptions based on faulty assumptions of perfect competition, complete information, and, although it wasn't framed in these terms, zero transaction costs. As Coase later wrote, "What my argument does suggest is the need to introduce positive transaction costs explicitly into economic analysis so that we can study the world that exists."

Despite the claim that his theory is "mathematical," Coase's work lacks even a single equation. Coase's ideas are about reality, not theoretical math -- a reason why he rejects what he calls "blackboard economics" because "it does not study the real world."

Building upon Coase's essay on social cost, economists began focusing attention on property-rights institutions and their ability to lower transaction costs. Free-market environmentalism recognizes that when property rights are well defined, disputes over resource use can often be resolved locally and cooperatively. This is in sharp contrast to the conventional command-and-control approach to environmentalism that is characterized by top-down management, special interests, and zero-sum "I-win-you-lose" outcomes.

This is not to say free-market environmentalists don't believe in the presence of high transaction costs. To be sure, sufficiently high transaction costs can present significant hurdles for market-based solutions. But oftentimes, this presents an opportunity for entrepreneurs to step in and define property rights that lower such costs. These environmental entrepreneurs, call them "enviropreneurs," are the often-unrecognized agents of change that contract with rights holders to keep water instream for fish and wildlife habitat, compensate livestock owners for their losses due to wolf depredation, and develop ecosystem-services markets for water quality and endangered species habitat.

Of course, the transaction costs associated with some environmental problems can be too high for even entrepreneurs to handle. For property rights and markets, the atmosphere is in many ways the new frontier. However, in such instances, the common-law legal system historically played an important role in resolving resource conflicts in a Coasean manner.

Before being shoved aside in the 1970s by the more politically attractive federal statute law, common law made it clear that no polluter had the right to impose unwanted costs on the owners of private property. Centuries of legal precedence affirmed that people had a legal right to have their property free from pollution. Upon examining the history of the common law, economists Roger Meiners and Bruce Yandle concluded that the common law "can protect the environment more effectively and fairly than can congressional statutes and bureaucratic regulations."

When property rights are well defined, the free-market-environmentalism approach is bottom-up, not top-down. This addresses the key knowledge problem that plagues much of environmental policy. How do distant policymakers possess the information necessary to design the "socially optimal" tax, regulation, or subsidy that will result in the optimal level of pollution?

It is here that the ideas of another, perhaps more important, luminary of free-market environmentalism, F.A. Hayek, come to light. Knowledge in society is dispersed and "not given to anyone in its totality," he wrote in his seminal 1945 article. Hayek suggested that the information required to effectively allocate resources depends on very specific circumstances of time and place. Because of this fact, the spontaneous ordering among the many supersedes the special wisdom of the few. Hayek's emphasis on market institutions and decentralized decision making is the essence of free-market environmentalism.

Curiously, many discussions of environmental policy ignore Hayek's knowledge problem, assuming instead that regulators and politicians will yield effective environmental results. But alas, much server space has been occupied by those frustrated with the sad result of political environmentalism.

Critics admonish free-market environmentalism because "complete information is impossible" in markets, but fail to apply the same logic to government. Whereas markets are by their very nature decentralized collectors of knowledge, public officials are far from omniscient or benevolent purveyors of sound environmental policy.

Free-market environmentalism is already working to end overfishing, encourage resource stewardship, and increase stream flows, and the environmental community is beginning to recognize it. Fred Krupp, president of Environmental Defense Fund, recently remarked that "harnessing the power of the market is often the best way to achieve the greatest environmental benefit at the lowest cost." As we work on today's environmental problems, we'd do well to accept free-market environmentalism into the broader environmental movement.

http://www.grist.org/article/2011-03-27-the-misguided-critique-of-free-market-environmentalism