Pincus, Jonathan J.

English

Research Papers in Economics

Environmental economics and the
Murray–Darling: Comment*
Jonathan J. Pincus

In an excellent and interesting article, John Quiggin surveys the environ-
mental issues of the Murray–Darling basin and, citing the relevant economic
literature, proposes an eclectic approach to their solution. Quiggin’s
preferred policy framework involves three elements: taxing the polluter;
creation of new forms of communal property rights (to encourage Coasian
bargaining or internalisation); and regulation (also to assist in achieving
sustainability).
I make three connected comments. Buchanan and Stubblebine (1962)
showed that the combination of Pigovian taxation and Coasian bargaining,
of the kind that Quiggin wishes to encourage, can be inconsistent in that
bargaining can move the economy away from the Pareto eﬃcient allocation
that would be achievable by taxation alone. My second comment revolves
around the dual meanings of the words ‘unilateral’ and ‘reciprocal’. Quiggin
concentrates on externalities that are unilateral in a physical sense. In
contrast, Coase (1960) assumes as a practical matter that externalities are
reciprocal in an economic sense. If so, it tells against many strong claims in
favour of speciﬁc forms of public intervention – Coase claimed regulating the
polluter, or awarding damages against the polluter, or taxing the polluter will
not necessarily improve the eﬃciency of the allocation of resources. My ﬁnal
remarks relate to the concept of eﬃciency used by Quiggin and Coase, and
how Quiggin’s economics leads him to what I take to be the central message
in Coase (1960). My comments relate only to eﬃciency and not directly to
equity considerations;
1 nor to Quiggin’s argument concerning the value of
notions of sustainability.
* The views expressed are not necessarily those of the University of Adelaide or of the
Productivity Commission (where the paper was written). Valuable comments were made by
Yew-Kwang Ng, Geoﬀ Edwards, Richard Damania and participants at a Monash seminar.
 J.J. Pincus is the George Gollin Professor of Economics, University of Adelaide; Principal
Adviser Research, Productivity Commission.
1 In his section on property rights, Quiggin’s emphasis shifts from eﬃciency to equity.
However, the bulk of his argument is about eﬃciency.
 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishers Ltd 2002
The Australian Journal of Agricultural and Resource Economics, 46:4, pp. 619–626Turn now to the ﬁrst issue: that Coase’s 1960 analysis of bargaining
solutions would ‘trump’ the Pigovian tax, even in cases when the Pigovian tax
is in fact optimal. The argument is illustrated in Figure 1, adapted from
Figure 2 of Buchanan and Stubblebine (1962). There is an activity in quantity
Q that person A can decide upon, which beneﬁts A and harms person B. The
beneﬁt and harm are shown as marginal evaluations, with MEA measured
conventionally, and MEB shown for convenience as its negative. Assume that
there is nothing that B can do to relieve or increase her hurt. Left to herself, A
will choose quantity Q1. With a Pigovian tax schedule in place, MEA –M E B
becomes A’s marginal evaluation schedule, post tax, and Q2 becomes A’s
independent adjustment equilibrium, post tax.
However, there is a Coasian twist that links tax remedies with Quiggin’s
advocacy of reforms in property rights. At Q2 the private marginal
evaluations of A and B diﬀer (zero for A; less than zero for B). Say that a
change in property rights so improves the climate for Coasian bargaining
that it becomes costless. The damaged party, B, pays the polluter, A, to
reduce Q until the quantity becomes Q3. Buchanan and Stubblebine call a
point like Q3 a ‘Pareto equilibrium’ (p. 380), meaning, I think, that there are
no more feasible ‘gains from trade’ to be made. Alternatively, it could be
called the Coasian equilibrium under the Pigovian tax regime.
2 (Note that,
because tax revenue falls, the movement from Q2 to Q3 is not a Pareto
improvement.)
This example simply assumed away the issue of the reciprocal nature of
externalities, to which we now turn. In his section entitled ‘Externality’,
Quiggin wrote that:
‘A second crucial distinction is that between unilateral and
reciprocal or congestion externalities. Unilateral externalities
arise when the actions of one party generate externalities
aﬀecting another, but not vice versa. To the extent that the
actions of upstream users degrade water quality for down-
stream users, the salinity problem may be viewed as a unilateral
non-point externality. The externality framework is most
valuable in the consideration of unilateral externalities.’ (p. 77)
2 There is a diﬀerent Coasian (or costless bargaining) equilibrium for each diﬀerent tax
regime, and a diﬀerent optimal Pigovian tax for each bargaining situation. In particular, the
Coasian equilibrium under the no-tax regime is Q2; and the optimal Pigovian tax with costless
bargaining is zero. As to the Pareto optimality of Q2 and Q3 in Figure 1: Q2 is P-O when
bargaining between A and B is costless and no pollution tax has been imposed; and Q2 is also
P-O when no bargaining can take place and the tax schedule MEB is imposed. However, Q3 is
P-O if bargaining is costless and the Pigovian tax schedule MEB is imposed; and Q3 is also P-O
if there is no bargaining between A and B, and if a tax schedule suitably heavier than MEB is
imposed. (The required tax schedule, not drawn, would impose a tax of MEA if output is Q3.)
J.J. Pincus 620
 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishers Ltd 2002Similarly, when discussing property rights, Quiggin asserted that ‘Coase
discussed unilateral externalities involving two parties.’ (pp. 77–78, emphasis
added).
A Coase-like example will suﬃce to illustrate the reciprocal nature of
externalities when considered from the viewpoint of the devising of policies to
improve allocative eﬃciency. A man increases the height of a chimney which
Figure 1
Environmental issues of the Murray–Darling 621
 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishers Ltd 2002has the eﬀect of polluting the air of another property owner. For eﬃciency
reasons, and without further economic inquiry, should the chimney owner be
forced to close his chimney or to modify its use, so as to restore the air quality
previously enjoyed by his neighbour? Or should a tax be levied, so that the
polluter pays?
Surely it is obvious that the actions of building and using the chimney are
what caused the externality. Well, no. If the polluted party were to close his
door or window, or to install an air ﬁlter, or to live somewhere else, then the
externality would be ameliorated and possibly completely removed. The
crucial economic fact is that the actions or inactions of both parties jointly
cause the externality problem. The reciprocality of ‘unilateral externalities’
consists in the fact that the damage caused to the injured party depends on
the actions and inactions of that party, as well as on the actions and inactions
of the polluter. Through this reasoning, applied in numerous examples,
Coase argued that various legal or property rights or regulatory ‘remedies’
would not necessarily improve matters.
Turn to Quiggin’s central example of upstream users whose activities
adversely aﬀect downstream users. According to Quiggin, the upstream users
are the generators of a unilateral externality. By this he means that the
downstream users – and this claim is crucial – are doing nothing to harm the
production of the upstream users.
However, a legislative, ﬁscal, regulatory or legal remedy, aﬀorded the
downstream producers, does harm upstream users. It would contribute to
economic eﬃciency only if such a remedy caused an increase in the
downstream net production or surplus greater than the induced fall in
upstream surplus.
3 In thinking about this cost-beneﬁt test, note that, once the
remedy is in place, the downstream producers, actual or potential, when
deciding on their level of activity, need not take into account the harm that
they do to the upstream producers (via the operation of the remedy). As in
the chimney example, such a remedy may do more harm than good.
Remember that I am focusing entirely on economic eﬃciency. Coase’s
index of economic eﬃciency is the value of net product; Quiggin’s is similar
(aggregate net surplus); both are practical versions of the cost-beneﬁt or
Hypothetical Compensation Principle. To achieve improvements in eﬃciency
on these criteria, we should choose the policy or legal remedy that generates
the largest social product (or surplus). For non-tax remedies, this requires
assessing the costs and beneﬁts of all possible actions of both parties;
choosing the set of actions that maximises aggregate net beneﬁt; and
specifying the feasible policy action that would implement the maximising
3 This is a simpliﬁcation which assumes, for example, that the Murray–Darling is an isolated
system.
J.J. Pincus 622
 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishers Ltd 2002allocation (the consequences of reciprocality for taxation are considered
later). As an example, Quiggin (2001) reports on work in Quiggin (1988),
which made a comparison between the allocation that maximises the sum
(S*) of upstream and downstream surpluses and the allocation that
maximises the upstream surplus ﬁrst (SU), and then the downstream surplus
(SD). The diﬀerence between S* and SU+SD Quiggin identiﬁes as the ‘social
loss associated with the upstream-downstream externality’; or as the
diﬀerence between a regime with ‘common property’ and a regime of ‘open
access’ Quiggin (2001, p. 80).
Running a cost-beneﬁt study of all feasible actions is a diﬃcult task; but
what are the alternatives? Rules of thumb or legal rules? Coase was sceptical
that judges or policy-makers can, in every instance, select the remedy that
achieves the most eﬃcient outcome. What has attracted the most attention in
Coase’s article is his discussion of situations in which a judge and a policy-
maker need do nothing. When the aﬀected parties will negotiate a Pareto-
improving change, it does not matter to whom property rights are awarded
(if that were the remedy under consideration). That is, when transaction costs
are low enough, a tax ‘on the externality’ would be otiose at best, as the
discussion of Figure 1 illustrates.
4
The fame of the ‘Coase theorem’ is despite the fact that the bulk of Coase’s
1960 article is about hard cases, when spontaneous solutions cannot be relied
upon. Concerning these, Coase set out to throw doubt on the belief in the
eﬃcacy of any single or simple rule (like the rule of ﬁrst settlement, as in the
case of the country estate troubled by an airﬁeld; or the rule that ‘the polluter
must pay’; or the rule of ‘do nothing’).
How then to reduce the social loss? Quiggin earlier (1988) discussed a
corrective policy very like a Pigovian tax on the upstream producers (namely,
to raise the price of water). At the end of his 1960 article, Coase included
Pigovian taxation in the class of remedy against which his strictures apply:
A tax system which was conﬁned to a tax on the producer for
damage caused would tend to lead to unduly high costs being
incurred for the prevention of damage. Of course this could be
avoided if it were possible to base the tax, not on the damage
caused, but on the fall in the value of production (in the widest
sense) resulting from the emission of smoke. But to do so would
require a detailed knowledge of individual preference and I am
unable to imagine how the data needed for such a taxation
system could be assembled (p. 41).
4 On taxation, see the previous note. Coase (1960) has a discussion of the externality caused
to a business, by a machine located adjacent in the same building. An eﬃcient solution may
involve modiﬁcations on the side of the injured party (and a side payment).
Environmental issues of the Murray–Darling 623
 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishers Ltd 2002As Ng (2002) has pointed out, Coase was wrong about taxation, in that
the introduction of an inﬁnitesimal tax on A’s activity must improve
eﬃciency, as Coase deﬁned eﬃciency improvements. To illustrate this, at
Q1 in Figure 1, which is A’s independent adjustment equilibrium before the
tax, A’s marginal valuation of her own activity is zero, while B’s valuation
must be negative. Therefore, a marginal fall in A’s activity harms A less
than it beneﬁts B (and some tax is collected, also). To go conﬁdently
beyond an inﬁnitesimal rate, detailed knowledge is required (e.g. through
policies, if such exist, that induce truthful revelation of all the required
information).
Conclusion
There is a theorem which says that, whatever the allocation of endow-
ments (including property rights), a decentralised process of decision-
making can achieve an eﬃcient outcome through markets. It is the ﬁrst
fundamental theorem of welfare economics, which becomes the ‘Coase
theorem’ when the words ‘through markets’ are replaced with ‘through
voluntary exchange’. The theorems do not say that the voluntary exchange
outcome is the best of all possible worlds; merely that policy – be it
regulatory, legislative, judicial, or any imposed solution – will hurt some
and possibly help others. That is, imposed solutions cannot generate
Pareto improvements (except by chance). In particular, starting from zero,
a marginal tax on the activity that generates the pollution will satisfy the
hypothetical compensation principle, but will not be a Pareto improve-
ment. Person A will lose and would have selﬁsh grounds to oppose the
change.
This is not to imply that all such impositions are necessarily bad or
unjustiﬁable, but that they are not justiﬁed on the Paretian criteria for
improvements in economic eﬃciency. The approach called Constitutional
Political Economy, pioneered by Buchanan and Tullock (1965), and
developed by Brennan and Buchanan (1985), explores in economic terms
the idea of exchange of agreements about rules of society (‘the social
contract’), applying the Paretian criterion at one remove from ordinary
policy-making. For example, if people are risk averse, as is assumed in
Quiggin’s expression (p. 81), behind the veil of uncertainty they would not
agree to market or policy rules designed to maximise the sum of surpluses
in all instances and would not agree to the unbridled operation of the
hypothetical compensation principle, especially if the incidental redistribu-
tions are random or regressive with respect to initial levels of individual
well-being, and large relative to the aggregate gains made. But they would
J.J. Pincus 624
 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishers Ltd 2002agree to some rules that forced them to do, in some circumstances, what
they would not otherwise do voluntarily.
5
There is in Quiggin (2001) an interesting discussion of possible ways to
reduce the social loss, other than taxes on polluters. Instanced is Dudley’s
1992 proposal to deﬁne water drawing-rights in terms of shares of the
capacity of the storage, rather than as rights to non-contingent amounts of
water for delivery on demand. As Quiggin correctly points out, instability of
property rights encourages ‘rent seeking’ aimed at securing a reassignment of
rights; ditto, for taxes and subsidies. Turning Hayek (1945) on his head,
Quiggin (2001, p. 88) makes the point that the economic information
required to assign property rights eﬃciently in the ﬁrst place, and once and
for all, is the very information required for detailed central planning; ditto,
for Pigovian tax schedules that take into account the costs of all possible
actions and inactions of all the players, actual and potential (as Coase
claimed in the quotation cited earlier). That is to say, the search for simple
but invariably eﬃciency-improving policy rules, as well as the search for
perfect assignments of unchangeable property rights, are quests for chimeras.
But this is exactly what I read into Coase (1960) and Quiggin.
6
References
Brennan, H.G. and Buchanan, J.M. 1985, The Reason of Rules: Constitutional democracy.
Cambridge University Press, New York.
Buchanan, J.M. and Stubblebine, W.C. 1962, ‘Externality.’ Economica, vol. 24, pp. 371–384.
Buchanan, J.M. and Tullock, G. 1965, The Calculus of Consent: Logical foundations of
constitutional democracy. University of Michigan Press, Michigan.
Coase, R.H. 1960, ‘The problem of social cost.’ The Journal of Law and Economics, vol. 3,
pp. 1–44.
Dudley, N.J. 1992, Water allocation by markets, common property and capacity sharing:
Companions or competitors? Natural Resources Journal, vol. 32, pp. 757–778.
5 For example, they might agree to the pragmatic policy regime, to which I am attracted,
under which environmental problems that are large, and singular, merit considerable detailed
research and investigation (for tailored solutions); that any class of middle-sized environ-
mental problems, with common characteristics and with large numbers of examples in the
class, warrants some search for rule-based or ‘generalised’ solutions (like zoning); and that
other problems are probably best left alone (or to the courts). This policy regime requires
methods for deciding into which class a problem falls.
6 ‘‘As the expansionary phase drew to a close and problems of the mature water economy
became evident, the need for appropriate economic institutions became apparent. Indeed,
there was some tendency to suggest that the resolution of the problems was a simple matter of
getting prices right (or, from a Coasian perspective, creating clearly deﬁned property rights).
The experience of the last decade has shown that appropriate economic institutions are
essential, but that the complexity of the problem is such that no simple policy solution is likely
to prove adequate’’ (Quiggin 2001, p. 90, emphasis added).
Environmental issues of the Murray–Darling 625
 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishers Ltd 2002Hayek, F.A. 1945, ‘The use of knowledge in society.’ American Economic Review, vol. 35,
pp. 519–530.
Ng, Y.K. 2002, Externality, Pigou and Coase. A case for bilateral taxation and amenity rights.
Monash University Department of Economics, Clayton.
Quiggin, J. 1988, ‘Murray River salinity – an illustrative model.’ American Journal of
Agricultural Economics, vol. 70, pp. 635–645.
Quiggin, J. 2001, ‘Environmental economics and the Murray-Darling river system.’ Australian
Journal of Agricultural and Resource Economics, vol. 45(1), pp. 67–94.
J.J. Pincus 626
 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishers Ltd 2002

626  Australian Agricultural and Resource Economics Society Inc.

Environmental economics and the Murray-Darling river system.’

Externality, Pigou and Coase. A case for bilateral taxation and amenity rights.

Murray River salinity – an illustrative model.’

The Calculus of Consent: Logical foundations of constitutional democracy.

The problem of social cost.’

The Reason of Rules: Constitutional democracy.

The use of knowledge in society.’

Water allocation by markets, common property and capacity sharing: Companions or competitors?

Environmental economics and the Murray–Darling: Comment

Environmental economics and the Murray–Darling: Comment

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