The Problem of Social Cost
It is clear that an alternative form of economic organisation which could
achieve the same result at less cost than would be incurred by using the market
would enable the value of production to be raised. As I explained many years
ago, the firm represents such an alternative to organising production through
market transactions. Within the firm individual bargains between the various
cooperating factors of production are eliminated and for a market transaction is
substituted an administrative decision. The rearrangement of production then
takes place without the need for bargains between the owners of the factors of
production. A landowner who has control of a large tract of land may devote
his land to various uses taking into account the effect that the interrelations
of the various activities will have on the net return of the land, thus rendering
unnecessary bargains between those undertaking the various activities. Owners
of a large building or of several adjoining properties in a given area may act
in much the same way. In effect, using our earlier terminology, the firm would
acquire the Legal Rights of all the parties and the rearrangement of activities
would not follow on a rearrangement of rights by contract, but as a result of
an administrative decision as to how the rights should be used.
It does not, of course, follow that the administrative costs of organising
a transaction through a firm are inevitably less than the costs of the market
transactions which are superseded. But where contracts are peculiarly diffi-
cult to draw up and an attempt to describe what the parties have agreed to
do or not to do (e.g. the amount and kind of a smell or noise that they may
make or will not make) would necessitate a lengthy and highly involved docu-
ment, and, where, as is probable, a long-term contract would be desirable, it
would be hardly surprising if the emergence of a firm or the extension of the
activities of an existing firm was not the solution adopted on many occasions
to deal with the problem of harmful effects. This solution would be adopted
whenever the administrative costs of the firm were less than the costs of the
market transactions that it supersedes and the gains which would result from
the rearrangement of activities greater than the firm’s costs of organising them.
I do not need to examine in great detail the character of this solution since I
have explained what is involved in my earlier article.
But the firm is not the only possible answer to this problem. The admin-
istrative costs of organising transactions within the firm may also be high, and
particularly so when many diverse activities are brought within the control of a
single organisation. In the standard case of a smoke Nuisance , which may affect
a vast number of people engaged in a wide variety of activities, the adminis-
trative costs might well be so high as to make any attempt to deal with the
problem within the confines of a single firm impossible. An alternative solution
is direct government regulation. Instead of instituting a legal system of rights
which can be modified by transactions on the market, the government may im-
pose regulations which state what people must or must not do and which have
to be obeyed. Thus, the government (by statute or perhaps more likely through
an administrative agency) may, to deal with the problem of smoke Nuisance ,
decree that certain methods of production should or should not be used (e.g.
that smoke preventing devices should be installed or that coal or oil should not
be burned) or may confine certain types of business to certain districts (zoning
regulations).
The government is, in a sense, a superfirm (but of a very special kind) since
it is able to influence the use of factors of production by administrative decision.
But the ordinary firm is subject to cheeks in its operations because of the
competition of other firms, which might administer the same activities at lower
cost and also because there is always the alternative of market transactions
as against organisation within the firm if the administrative costs become too
great. The government is able, if it wishes, to avoid the market altogether,
which a firm can never do. The firm has to make market agreements with the
owners of the factors of production that it uses. Just as the government can
conscript or seize property, so it can decree that factors of production should
only be used in such-and-such a way. Such authoritarian methods save a lot
of trouble (for those doing the organising). Furthermore, the government has
at its disposal the police and the other law enforcement agencies to make sure
that its regulations are carried out.
It is clear that the government has powers which might enable it to get
some things done at a lower cost than could a private organisation (or at any
rate one without special governmental powers). But the governmental admin-
istrative machine is not itself costless. It can, in fact, on occasion be extremely
costly. Furthermore, there is no reason to suppose that the restrictive and
zoning regulations, made by a fallible administration subject to political pres-
sures and operating without any competitive check, will necessarily always be
those which increase the efficiency with which the economic system operates.
Furthermore, such general regulations which must apply to a wide variety of
cases will be enforced in some cases in which they are clearly inappropriate.
From these considerations it follows that direct governmental regulation will
not necessarily give better results than leaving the problem to be solved by
the market or the firm. But equally there is no reason why, on occasion, such
governmental administrative regulation should not lead to an improvement in
economic efficiency. This would seem particularly likely when, as is normally
the case with the smoke nuisance, a large number of people are involved and in
which therefore the costs of handling the problem through the market or the
firm may be high.
There is, of course, a further alternative which is to do nothing about the
problem at all. And given that the costs involved in solving the problem by
regulations issued by the governmental administrative machine will often be
heavy (particularly if the costs are interpreted to include all the consequences
which follow from the government engaging in this kind of activity), it will no
doubt be commonly the case that the gain which would come from regulating
the actions which give rise to the harmful effects will be less than the costs
involved in government regulation.
The discussion of the problem of harmful effects in this section (when the
costs of market transactions are taken into account) is extremely inadequate.
But at least it has made clear that the problem is one of choosing the appro-
priate social arrangement for dealing with the harmful effects. All solutions
have costs and there is no reason to suppose that government regulation is
called for simply because the problem is not well handled by the market or
the firm. Satisfactory views on policy can only come from a patient study of
how, in practice, the market, firms and governments handle the problem of
harmful effects. Economists need to study the work of the broker in bring-
ing parties together, the effectiveness of restrictive covenants, the problems of
the large-scale real-estate development company, the operation of government
zoning and other regulating activities. It is my belief that economists, and
policy-makers generally, have tended to over-estimate the advantages which
come from governmental regulation. But this belief, even if justified, does not
do more than suggest that government regulation should be curtailed. It does
not tell us where the boundary line should be drawn. This, it seems to me,
has to come from a detailed investigation of the actual results of handling the
problem in different ways. But it would be unfortunate if this investigation
were undertaken with the aid of a faulty economic analysis. The aim of this
article is to indicate what the economic approach to the problem should be.
Conclusion
Notes
See Also
References and Further Reading
About the Author/s and Reviewer/s
Author: international
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