THE PROBLEM OF SOCIAL COST subdivision of it. Suppose, for example, that the cattle have a well-defined route, say, to a brook or to a shady area. In these circumstances, the amount of damage to the crop along the route may well be great and if so, it could be that the farmer and the cattle- raiser would find it profitable to make a bargain whereby the farmer would agree not to cultivate this strip of land But this raises a further possibility. Suppose that there is such a well defined route Suppose further that the value of the crop that would be ob- tained by cultivating this strip of land is $10 but that the cost of cultivation is $11. In the absence of the cattle-raiser, the land would not be cultivated However, given the presence of the cattle- raiser, it could well be that if the strip was cultivated, the whole crop would be destroyed by the cattle. In which case, the cattle-raiser would be forced to pay $10 to the farmer. It is true that the farmer would lose $1. But the cattle raiser would lose $10. Clear- ly this is a situation which is not likely to last indefinitely since neither party would want this to happen. The aim of the farmer would be to induce the cattle-raiser to make a payment in return for an agreement to leave this land ultivated. The farmer would not be able to obtain a payment greater than the cost of fencing off this piece of land nor so high as to lead the cattle- raiser to abandon the use of the neighbouring property. What payment would in fact be made would depend on the shrewdness of the farmer and the cattle- raiser as bargainers. But as the payment would not be so high as to cause the cattle-raiser to abandon this location and as it would not vary with the size of the herd, such an agreement would not affect the allocation of resources but would merely alter the distribution of income and wealth as between the cattle-raiser and the farmer. I think it is clear that if the cattle- raiser is liable for damage caused and the pricing system works smoothly, the reduction in the value of production elsewhere will be taken into account in computing the additional cost involved in increasing the size of the herd. This cost will be weighed against the value of the additional meat production and, given perfect competition in the cattle industry, the allocation of resources in cattle-raising will be optimal. What needs to be emphasized is that the fall in the value of production elsewhere which would be taken into account in the costs of the cattle-raiser may well be less than the damage which the cattle would cause to the crops in the ordi nary course of events. This is because it is possible, as a result of market transactions, to discontinue cultivation of the land. This is desirable in all to change his crop(since this would reduce damage liability from $3 to $1)and it would be profitable for the farmer to do so if the amount received ore than $1(the redue tion in his return caused by switching crops). In fact, there would be room for a mutuall bargain in all cases in which a change of crop would reduce the amount of more than it reduces the value of the crop(excluding dam which a change in the crop cultivated would lead to an increase in the value of
THE PROBLEM OF SOCIAL COST 5 subdivision of it. Suppose, for example, that the cattle have a well-defined route, say, to a brook or to a shady area. In these circumstances, the amount of damage to the crop along the route may well be great and if so, it could be that the farmer and the cattle-raiser would find it profitable to make a bargain whereby the farmer would agree not to cultivate this strip of land. But this raises a further possibility. Suppose that there is such a welldefined route. Suppose further that the value of the crop that would be obtained by cultivating this strip of land is $10 but that the cost of cultivation is $11. In the absence of the cattle-raiser, the land would not be cultivated. However, given the presence of the cattle-raiser, it could well be that if the strip was cultivated, the whole crop would be destroyed by the cattle. In which case, the cattle-raiser would be forced to pay $10 to the farmer. It is true ,tha,t the farmer would lose $1. But the cattle-raiser would lose $10. Clearly this is a situation which is not likely to last indefinitely since neither party would want this to happen. The aim of the farmer would be to induce the cattle-raiser to make a payment in return for an agreement to leave this land uncultivated. The farmer would not be able to obtain a payment greater than the cost of fencing off this piece of land nor so high as to lead the cattleraiser to abandon the use of the neighbouring property. What payment would in fact be made would depend on the shrewdness of the farmer and the cattleraiser as bargainers. But as the payment would not be so high as to cause the cattle-raiser to abandon this location and as it would not vary with the size of the herd, such an agreement would not affect the allocation of resources but would merely alter the distribution of income and wealth as between the cattle-raiser and the farmer. I think it is clear that if the cattle-raiser is liable for damage caused and the pricing system works smoothly, the reduction in the value of production elsewhere will be taken into account in computing the additional cost involved in increasing the size of the herd. This cost will be weighed against the value of the additional meat production and, given perfect competition in the cattle industry, the allocation of resources in cattle-raising will be optimal. What needs to be emphasized is that the fall in the value of production elsewhere which would be taken into account in the costs of the cattle-raiser may well be less than the damage which the cattle would cause to the crops in the ordinary course of events. This is because it is possible, as a result of market transactions, to discontinue cultivation of the land. This is desirable in all to change his crop (since this would reduce damage liability from $3 to $1) and it would be profitable for the farmer to do so if the amount received was more than $1 (the reduction in his return caused by switching crops). In fact, there would be room for a mutually satisfactory bargain in all cases in which a change of crop would reduce the amount of damage by more than it reduces the value of the crop (excluding damage)-in all cases, that is, in which a change in the crop cultivated would lead to an increase in the value of production
THE JOURNAL OF LAW AND ECONOMICS cases in which the damage that the cattle would cause, and for which cattle-raiser would be willing to pay exceeds the amount which the fa would pay for use of the land. In conditions of perfect competition, the amount which the farmer would pay for the use of the land is equal to the difference between the value of the total production when the factors are employed on this land and the value of the additional product yielded in their next best use (which would be what the farmer would have to pay for the factors). If damage exceeds the amount the farmer would pay for the use of the land, the value of the additional product of the factors employed elsewhere would exceed the value of the total product in this use after damage is taken into account. It follows that it would be desirable to abandon cultivation of the land and to release the factors employed for production elsewhere. a procedure which merely provided for payment for damage to the crop caused by the cattle but which did not allow for the possibility of cultivation being discontinued would result in too small an employment of factors of produc- tion in cattle- raising and too large an employment of factors in cultivation of the crop but given the possibility of market transactions, a situation in which damage to crops exceeded the rent of the land would not endure. Whether the cattle-raiser pays the farmer to leave the land uncultivated or himself rents the land by paying the land-owner an amount slightly greater than the farmer would pay(if the farmer was himself renting the land), the final resul would be the same and would maximise the value of production. Even when the farmer is induced to plant crops which it would not be profitable to culti vate for sale on the market, this will be a purely short- term phenomenon and ay be expected to lead to an agreement under which the planting will cease The cattle-raiser will remain in that location and the marginal cost of meat production will be the same as before thus having no long-run effect on the allocation of resources IV. THE PRICING SYSTEM WITH NO LIABILITY FOR DAMAGE i now turn to the case in which, although the pricing system is assumed to work smoothly (that is, costlessly), the damaging business is not liable for any of the damage which it causes. This business does not have to make a payment to those damaged by its actions. i propose to show that the alloca- tion of resources will be the same in this case as it was when the damaging business was liable for damage caused. As I showed in the previous case that the allocation of resources was optimal, it will not be necessary to repeat this part of the argument. I return to the case of the farmer and the cattle-raiser. The farmer would suffer increased damage to his crop as the size of the herd increased. Suppose that the size of the cattle-raisers herd is 3 steers (and that this is the size of he herd that would be maintained if crop damage was not taken int account). Then the farmer would be willing to pay up to $3 if the cattle
6 THE JOURNAL OF LAW AND ECONOMICS cases in which the damage that the cattle would cause, and for which the cattlfe-raiser would be willing to pay, exceeds the amount which the farmer would pay for use of the land. In conditions of, perfect competition, the amount which the farmer would pay for the use of the land is equal to the difference between the value of the total production when the factors are employed on this land and the value of the additional product yielded in their next best use (which would be what the farmer would have to pay for the factors). If damage exceeds the amount the farmer would pay for the use of the land, the value of the additional product of the factors employed elsewhere would exceed the value of the total product in this use after damage is taken into account. It follows that it would be desirable to abandon cultivation of the land and to release the factors employed for production elsewhere. A procedure which merely provided for payment for damage to the crop caused by the cattle but which did not allow for the possibility of cultivation being discontinued would result in too small an employment of factors of production in cattle-raising and too large an employment of factors in cultivation of the crop. But given the possibility of market transactions, a situation in which damage to crops exceeded the rent of the land would not endure. Whether the cattle-raiser pays the farmer to leave the land uncultivated or himself rents the land by paying the land-owner an amount slightly greater than the farmer would pay (if the farmer was himself renting the land), the final result would be the same and would maximise the value of production. Even when the farmer is induced to plant crops which it would not be profitable to cultivate for sale on the market, this will be a purely short-term phenomenon and may be expected to lead to an agreement under which the planting will cease. The cattle-raiser will remain in that location and the marginal cost of meat production will be the same as before, thus having no long-run effect on the allocation of resources. IV. THE PRICING SYSTEM WITH No LIABILITY FOR DAMAGE I now turn to the case in which, although the pricing system is assumed to work smoothly (that is, costlessly), the damaging business is not liable for any of the damage which it causes. This business does not have to make a payment to those damaged by its actions. I propose to show that the allocation of resources will be the same in this case as it was when the damaging business was liable for damage caused. As I showed in the previous case that the allocation of resources was optimal, it will not be necessary to repeat this part of the argument. I return to the case of the farmer and the cattle-raiser. The farmer would suffer increased damage to his crop as the size of the herd increased. Suppose that the size of the cattle-raiser's herd is 3 steers (and that this is the size of the herd that would be maintained if crop damage was not taken into account). Then the farmer would be willing to pay up to $3 if the cattle-
THE PROBLEM OF SOCIAL COST raiser would reduce his herd to 2 steers, up to $s if the herd were reduced to I steer and would pay up to $6 if cattle-raising was abandoned. The cattle- raiser would therefore receive $3 from the farmer if he kept 2 steers instead of 3. This $3 foregone is therefore part of the cost incurred in keeping the third steer. Whether the $3 is a payment which the cattle- raiser has to make if he dds the third steer to his herd (which it would be if the cattle- raiser was liable to the farmer for damage caused to the crop) or whether it is a sum of money which he would have received if he did not keep a third steer(which it would be if the cattle- raiser was not liable to the farmer for damage caused to the crop)does not affect the final result. In both cases $3 is part of the cost of adding a third steer, to be included along with the other costs. If the increase in the value of production in cattle-raising through increasing the size of the herd from 2 to 3 is greater than the additional costs that have to be incurred(including the $3 damage to crops), the size of the herd will be in- the cattle-raiser is liable for damage caused to the crop or no same wh creased. Otherwise it will not The size of the herd will be the same whether It may be argued that the assumed starting point-a herd of 3 steers-was bitrary. And this is true. But the farmer would not wish to pay to avo crop damage which the cattle-raiser would not be able to cause For example, the maximum annual payment which the farmer could be induced to pay ould not exceed $9, the annual cost of fencing. and the farmer would only be willing to pay this sum if it did not reduce his earnings to a level that would cause him to abandon cultivation of this particular tract of land. Furthermore the farmer would only be willing to pay this amount if he believed that, in the absence of any payment by him, the size of the herd maintained by the cattle raiser would be 4 or more steers. Let us assume that this is the case. Then the farmer would be willing to pay up to $3 if the cattle raiser would reduce his herd to 3 steers, up to $6 if the herd were reduced to 2 steers, up to $8 if one steer only were kept and up to $9 if cattle-raising were abandoned It will be noticed that the change in the starting point has not altered the amount which would accrue to the cattle-raiser if he reduced the size of his herd by any given amount. It is still true that the cattle-raiser could receive an additional $3 from the farmer if he agreed to reduce his herd from 3 steers to 2 and that the $3 represents the value of the crop that would be destroyed by adding the third steer to the herd. Although a different belief on the part of the farmer (whether justified or not)about the size of the herd that the cattle-raiser would maintain in the absence of payments from him may affect the total payment he can be induced to pay, it is not true that this different belief would have any effect on the size of the herd that the cattle-raiser will actually keep. This will be the same as it would be if the cattle-raiser had to pay for damage caused by his cattle, since a receipt foregone of a given amount is the equivalent of a payment of the same amount It might be thought that it would pay the cattle-raiser to increase his herd
THE PROBLEM OF SOCIAL COST 7 raiser would reduce his herd to 2 steers, up to $5 if the herd were reduced to 1 steer and would pay up to $6 if cattle-raising was abandoned. The cattleraiser would therefore receive $3 from the farmer if he kept 2 steers instead of 3. This $3 foregone is therefore part of the cost incurred in keeping the third steer. Whether the $3 is a payment which the cattle-raiser has to make if he adds the third steer to his herd (which it would be if the cattle-raiser was liable to the farmer for damage caused to the crop) or whether it is a sum of money which he would have received if he did not keep a third steer (which it would be if the cattle-raiser was not liable to the farmer for damage caused to the crop) does not affect the final result. In both cases $3 is part of the cost of adding a third steer, to be included along with the other costs. If the increase in the value of production in cattle-raising through increasing the size of the herd from 2 to 3 is greater than-the additional costs that have to be incurred (including the $3 damage to crops), the size of the herd will be increased. Otherwise, it will not. The size of the herd will be the same whether the cattle-raiser is liable for damage caused to the crop or not. It may be argued that the assumed starting point-a herd of 3 steers-was arbitrary. And this is true. But the farmer would not wish to pay to avoid crop damage which the cattle-raiser would not be able to cause. For example, the maximum annual payment which the farmer could be induced to pay could not exceed $9, the annual cost of fencing. And the farmer would only be willing to pay this sum if it did not reduce his earnings to a level that would cause him to abandon cultivation of this particular tract of land. Furthermore, the farmer would only be willing to pay this amount if he believed that, in the absence of any payment by him, the size of the herd maintained by the cattle raiser would be 4 or more steers. Let us assume that this is the case. Then the farmer would be willing to pay up to $3 if the cattle raiser would reduce his herd to 3 steers, up to $6 if the herd were reduced to 2 steers, up to $8 if one steer only were kept and up to $9 if cattle-raising were abandoned. It will be noticed that the change in the starting point has not altered the amount which would accrue to the cattle-raiser if he reduced the size of his herd by any given amount. It is still true that the cattle-raiser could receive an additional $3 from the farmer if he agreed to reduce his herd from 3 steers to 2 and that the $3 represents the value of the crop that would be destroyed by adding the third steer to the herd. Although a different belief on the part of the farmer (whether justified or not) about the size of the herd that the cattle-raiser would maintain in the absence of payments from him may affect the total payment he can be induced to pay, it is not true that this different belief would have any effect on the size of the herd that the cattle-raiser will actually keep. This will be the same as it would be if the cattle-raiser had to pay for damage caused by his cattle, since a receipt foregone of a given amount is the equivalent of a payment of the same amount. It might be thought that it would pay the cattle-raiser to increase his herd
THE JOURNAL OF LAW AND ECONOMICS above the size that he would wish to maintain once a bargain had been made, in order to induce the farmer to make a larger total payment. and this ma be true. It is similar in nature to the action of the farmer (when the cattle- raiser was liable for damage) in cultivating land on which, as a result of an agreement with the cattle-raiser, planting would subsequently be abandoned (including land which would not be cultivated at all in the absence of cattle raising). But such manoeuvres are preliminaries to an agreement and do not affect the long-run equilibrium position, which is the same whether or not the attle-raiser is held responsible for the crop damage brought about by his cattle It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them But the ultimate result (which maximises the value of production) is pendent of the legal position if the pricing system is assumed to work wit cost V. THE PROBLEM ILLUSTRATED ANEW The harmful effects of the activities of a business can assume a wide variety of forms. An early English case concerned a building which, by obstructing currents of air, hindered the operation of a windmill. A recent case in Florida concerned a building which cast a shadow on the cabana, swimming pool and sunbathing areas of a neighbouring hotel. The problem of straying cattle the two preceding sections, although it may have appeared to be rathe.3 and the damaging of crops which was the subject of detailed examination ne example of a problem which arises in many different guises. To clarify the nature of my argument and to demonstrate its general applicability, i propose to illustrate it anew by reference to four actual cases Let us first reconsider the case of Sturges v. Bridgman' which I used as an illustration of the general problem in my article on"The Federal Communi cations Commission. In this case a confectioner (in Wigmore Street)used two mortars and pestles in connection with his business (one had been in operation in the same position for more than 60 years and the other for more han 26 years). a doctor then came to occupy neighbouring premises (in Wimpole Street). The confectioner's machinery caused the doctor no harm until, eight years after he had first occupied the premises, he built a consulting room at the end of his garden right against the confectioner's kitchen It was hen found that the noise and vibration caused by the confectioner's machin- 5 See Gale on Easements 237-39(13th ed M. Bowles 1959) See Fontainebleu Hotel Corp. v. Forty-Five Twenty-Five, Inc ., 114 So, 2d 357(1959) 11Ch.D.852(1879)
8 THE JOURNAL OF LAW AND ECONOMICS above the size that he would wish to maintain once a bargain had been made, in order to induce the farmer to make a larger total payment. And this may be true. It is similar in nature to the action of the farmer (when the cattleraiser was liable for damage) in cultivating land on which, as a result of an agreement with the cattle-raiser, planti~ng would subsequently be abandoned (including land which would not be cultivated at all in the absence of cattleraising). But such manoeuvres are preliminaries to an agreement and do not affect the long-run equilibrium position, which is the same whether or not the cattle-raiser is held responsible for the crop damage brought about by his cattle. It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost. V. THE PROBLEM ILLUSTRATED ANEW The harmful effects of the activities of a business can assume a wide variety of forms. An early English case concerned a building which, by obstructing currents of air, hindered the operation of a windmill.5 A recent case in Florida concerned a building which cast a shadow on the cabana, swimming pool and sunbathing areas of a neighbouring hotel.6 The problem of straying cattle and the damaging of crops which was the subject of detailed examination in the two preceding sections, although it may have appeared to be rather a special case, is in fact but one example of a problem which arises in many different guises. To clarify the nature of my argument and to demonstrate its general applicability, I propose to illustrate it anew by reference to four actual cases. Let us first reconsider the case of Sturges v. Bridgman7 which I used as an illustration of the general problem in my article on "The Federal Communications Commission." In this case, a confectioner (in Wigmore Street) used two mortars and pestles in connection with his business (one had been in operation in the same position for more than 60 years and the other for more than 26 years). A doctor then came to occupy neighbouring premises (in Wimpole Street). The confectioner's machinery caused the doctor no harm until, eight years after he had first occupied the premises, he built a consulting room at the end of his garden right against the confectioner's kitchen. It was then found that the noise and vibration caused by the confectioner's machins See Gale on Easements 237-39 (13th ed. M. Bowles 1959). 6 See Fontainebleu Hotel Corp. v. Forty-Five Twenty-Five, Inc., 114 So. 2d 357 (1959). 711 Ch. D. 852 (1879)
THE PROBLEM OF SOCIAL COST ery made it difficult for the doctor to use his new consulting room. "In partic ular... the noise prevented him from examining his patients by auscultation for diseases of the chest. He also found it impossible to engage with effect in any occupation which required thought and attention "The doctor therefore brought a legal action to force the confectioner to stop using his machinery The courts had little difficulty in granting the doctor the injunction he sought. "Individual cases of hardship may occur in the strict carrying out of the principle upon which we found our judgment, but the negation of the principle would lead even more to individual hardship, and would at the same time produce a prejudicial effect upon the development of land for residential The court's decision established that the doctor had the right to prevent the confectioner from using his machinery. But, of course, it would have been possible to modify the arrangements envisaged in the legal ruling by means of bargain between the parties. The doctor would have been willing to waive his right and allow the machinery to continue in operation if the confectioner would have paid him a sum of money which was greater than the loss of in- come which he would suffer from having to move to a more costly or less con- venient location or from having to curtail his activities at this location or, as was suggested as a possibility, from having to build a separate wall which would deaden the noise and vibration. The confectioner would have been will ing to do this if the amount he would have to pay the doctor was less than the fall in income he would suffer if he had to change his mode of operation at his location, abandon his operation or move his confectionery business to some other location. The solution of the problem depends essentially on whether the continued use of the machinery adds more to the confectioner's income than it subtracts from the doctor, s. But now consider the situation if the confectioner had won the case. The confectioner would then have had the right to continue operating his noise and vibration-generating machinery without having to pay anything to the doctor. The boot would have been the other foot: the doctor would have had to pay the confectioner to induce him to stop using the machinery. If the doctors income would have fallen more through continuance of the use of this machinery than it added to the income of the confectioner, there would clearly be room for a bargain whereby the doctor paid the confectioner to stop using the machinery. That is to say, the circumstances in which it would not pay the confectioner to continue to use the machinery and to compensate the doctor for the losses that this would bring(if the doctor had the right to prevent the confectioner's using his s Auscultation is the act of listening by ear or stethoscope in order to judge by sound the condition of the body. 9 Note that what is taken into account is the change in income after allowing for altera tions in methods of production, location, character of product, etc
THE PROBLEM OF SOCIAL COST 9 ery made it difficult for the doctor to use his new consulting room. "In particular . . . the noise prevented him from examining his patients by auscultations for diseases of the chest. He also found it impossible to engage with effect in any occupation which required thought and attention." The doctor therefore brought a legal action to force the confectioner to stop using his machinery. The courts had little difficulty in granting the doctor the injunction he sought. "Individual cases of hardship may occur in the strict carrying out of the principle upon which we found our judgment, but the negation of the principle would lead even more to individual hardship, and would at the same time produce a prejudicial effect upon the development of land for residential purposes." The court's decision established that the doctor had the right to prevent the confectioner from using his machinery. But, of course, it would have been possible to modify the arrangements envisaged in the legal ruling by means of a bargain between the parties. The doctor would have been willing to waive his right and allow the machinery to continue in operation if the confectioner would have paid him a sum of money which was greater than the loss of income which he would suffer from having to move to a more costly or less convenient location or from having to curtail his activities at this location or, as was suggested as a possibility, from having to build a separate wall which would deaden the noise and vibration. The confectioner would have been willing to do this if the amount he would have to pay the doctor was less than the fall in income he would suffer if he had to change his mode of operation at this location, abandon his operation or move his confectionery business to some other location. The solution of the problem depends essentially on whether the continued use of the machinery adds more to the confectioner's income than it subtracts from the doctor's.9 But now consider the situation if the confectioner had won the case. The confectioner would then have had the right to continue operating his noise and vibration-generating machinery without having to pay anything to the doctor. The boot would have been on the other foot: the doctor would have had to pay the confectioner to induce him to stop using the machinery. If the doctor's income would have fallen more through continuance of the use of this machinery than it added to the income of the confectioner, there would clearly be room for a bargain whereby the doctor paid the confectioner to stop using the machinery. That is to say, the circumstances in which it would not pay the confectioner to continue to use the machinery and to compensate the doctor for the losses that this would bring (if the doctor had the right to prevent the confectioner's using his 8 Auscultation is the act of listening by ear or stethoscope in order to judge by sound the condition of the body. 9 Note that what is taken into account is the change in income after allowing for alterations in methods of production, location, character of product, etc