Suppose that, in a particular case, the pollution does $100,000 a year worth of damage and can be eliminated at a cost of only $80,000 a year (from here on, all costs are per year). Further assume that the cost of shifting all of the land down wind to a new use unaffected by the pollution—growing timber instead of renting out summer resorts, say—is only $50,000. If we impose an emission fee of a hundred thousand dollars a year, the steel mill stops polluting and the damage is eliminated—at a cost of $80,000. If we impose no emission fee the mill keeps polluting, the owners of the land stop advertising for tenants and plant trees instead, and the problem is again solved—at a cost of $50,000. In this case the result without Pigouvian taxes is efficient—the problem is eliminated at the lowest possible cost—and the result with Pigouvian taxes in inefficient.
This seems to be the only part of the article that argues for what the title says, “Pricing externalities is not necessarily economically efficient”, however it assumes that the Pigouvian tax is set to $100,000 instead of the opportunity cost of the pollution (in this case $50,000) which would be more natural for anyone with an understanding that “cost” ought to mean “opportunity cost” in most situations when thinking about economics. So I think the title is misleading.
Also I think Coase’s choice of terminology “transaction costs” tends to give people the wrong impression about what’s preventing markets from solving externalities, because it seems to suggest that the costs involved in physically doing a transaction is the main problem and if markets could be made more frictionless they would automatically solve externalities. In actuality “transaction costs” includes loses from inefficient bargaining (i.e., lost opportunities for mutually beneficial deals) caused by asymmetric information, which (until we invent mind readers or lie detector) is an inevitable part of how voluntary transactions work in general, so this limits how much the problem of externalities can be solved via voluntary transactions in a fundamental way.
One might ask why asymmetric information isn’t an issue in regular markets, and the answer is that it is (it’s responsible for deadweight loss of a monopoly for example), but the problem is much less serious in competitive markets where having private information about (for example) the cost of making something isn’t very relevant because if you set your price above that, someone else will underbid you anyway.
Another question one could ask is why isn’t asymmetric information a problem for policy makers setting a Pigouvian tax? The answer there is that the policy maker only needs to estimate the total cost (or benefit) of an externality, whereas the market / voluntary transactions approach (to be efficient) requires that the true cost/benefit for each individual affected person to be revealed (which can’t happen because that’s not incentive compatible). See my “government funding of information goods based on measured value” for a concrete example of this difference.
This seems to be the only part of the article that argues for what the title says, “Pricing externalities is not necessarily economically efficient”, however it assumes that the Pigouvian tax is set to $100,000 instead of the opportunity cost of the pollution (in this case $50,000) which would be more natural for anyone with an understanding that “cost” ought to mean “opportunity cost” in most situations when thinking about economics. So I think the title is misleading.
Also I think Coase’s choice of terminology “transaction costs” tends to give people the wrong impression about what’s preventing markets from solving externalities, because it seems to suggest that the costs involved in physically doing a transaction is the main problem and if markets could be made more frictionless they would automatically solve externalities. In actuality “transaction costs” includes loses from inefficient bargaining (i.e., lost opportunities for mutually beneficial deals) caused by asymmetric information, which (until we invent mind readers or lie detector) is an inevitable part of how voluntary transactions work in general, so this limits how much the problem of externalities can be solved via voluntary transactions in a fundamental way.
One might ask why asymmetric information isn’t an issue in regular markets, and the answer is that it is (it’s responsible for deadweight loss of a monopoly for example), but the problem is much less serious in competitive markets where having private information about (for example) the cost of making something isn’t very relevant because if you set your price above that, someone else will underbid you anyway.
Another question one could ask is why isn’t asymmetric information a problem for policy makers setting a Pigouvian tax? The answer there is that the policy maker only needs to estimate the total cost (or benefit) of an externality, whereas the market / voluntary transactions approach (to be efficient) requires that the true cost/benefit for each individual affected person to be revealed (which can’t happen because that’s not incentive compatible). See my “government funding of information goods based on measured value” for a concrete example of this difference.
How are you calculating “opportunity cost”? Is it simply the land use conversion cost ($50,000)?