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Michael Munger

Orange Blossom Special: Externalities and the Coase Theorem

Michael Munger*

 
"'The custom of the orchard' is an understanding that a certain number of hives are required to pollinate some fixed area, on average."
I grew up on a Valencia farm, in orange country south of Orlando. Twice a year, December and June, air was perfumed with orange blossoms, advertising their sweet nectar. Bees filled the air, harvesting that nectar. But the bees looked as if they were wearing thick yellow gaucho pants, carrying pollen from flower to flower.

An old guy with skin like leather, whom we knew as "Bee Man," would bring his hives in, and arrange them in a row. I found that if I looked sad he'd give me a piece of comb, dripping honey (and bee droppings, to be honest) to gnaw on. The bees produced enough honey that Bee Man could pay us in honey and still make money.

Thinking back on it, I was in the middle of one of the most interesting and complex economic situations around. But the sun-warmed, honey-soaked wax comb tasted so good that I missed what some economists call "externalities," bees fertilizing fruit and flowers giving bees nectar for honey.

Externalities

If I do something that affects you, positively or negatively, without your consent or without my own ability to withhold a benefit unless you pay, then that is an externality.

Economist A.C. Pigou expressed the problem as a divergence between supply price (what a buyer pays) and the "marginal supply price" (the total amount something costs). Price paid might be less than true cost (a negative externality) or more than true cost (a positive externality). A commonly alleged example is a lighthouse, a positive externality. As Henry Sidgwick put it, nearly 150 years ago, "it may easily happen that the benefits of a well-placed lighthouse must be largely enjoyed by ships on which no toll could be conveniently placed."

This conclusion seems perverse, and it is. Folks who would benefit from increased production of a positive externality will try to come up with a solution. As another economist, Ronald Coase, pointed out, Pigou was ignoring an important fact: in real markets, externality problems are often solved privately, which means that the externality disappears. In fact, Coase did a little digging, and found something interesting: in 1820, in England (home of Sidgwick!), more than three quarters of all lighthouses were built and operated privately.

Coase gives a general analysis of externalities in his landmark 1960 paper, "The Problem of Social Cost." He makes three fundamental points. First, externalities are reciprocal. Second, externalities persist only if transactions costs are high. Finally, if transactions costs are low, market processes will lead to the same efficient outcomes, irrespective of the assignment of property rights.

Let's see what a Coasian analysis would tell us about the externality I was interested in. Let's think about bees.

A Coasian Analysis: Cheung's "Fable of the Bees"
 

From J.E. Meade, "External Economies and Diseconomies in a Competitive Situation." Economic Journal. 62 (245), pp. 56-7.

Suppose that in a given region there is a certain amount of apple-growing and a certain amount of bee-keeping and that the bees feed on the apple-blossom. If the apple-farmers apply 10% more labour, land and capital to apple-farming they will increase the output of apples by 10% ; but they will also provide more food for the bees. On the other hand, the bee-keepers will not increase the output of honey by 10% by increasing the amount of land, labour and capital applied to bee-keeping by 10% unless at the same time the apple-farmers also increase their output and so the food of the bees by 10%. Thus there are constant returns to scale for both industries taken together: if the amount of labour and of capital employed both in apple-farming and bee-keeping are doubled, the output of both apples and honey will be doubled. But if the amount of labour and capital are doubled in bee-keeping alone, the output of honey will be less than doubled; whereas, if the amounts of labour and capital in apple-farming are doubled, the output of apples will be doubled and, in addition, some contribution will be made to the output of honey.

We call this a case of an unpaid factor, because the situation is due simply and solely to the fact that the apple-farmer cannot charge the bee-keeper for the bees' food, which the former produces for the latter. If social-accounting institutions were such that this charge could be made, then every factor would, as in other competitive situations, earn the value of its marginal social net product. But as it is, the apple-farmer provides to the beekeeper some of his factors free of charge. The apple-farmer is paid less than the value of his marginal social net product, and the bee-keeper receives more than the value of his marginal social net product.

In 1952, an economist named J.E. Meade published a paper in the Economic Journal. Meade thought that he had discovered a truly new phenomenon, an externality relation so intricate that markets could not handle it. As you can see in the sidebar, Meade thought the result would always be inefficiency, because the orchard grower cannot capture all the benefits created by bee-keeping. Consequently, he argued, some kind of subsidy or government provision is required.

But Meade was wrong. The first reason is that, unlike oranges, apple blossoms don't produce enough nectar to make "apple blossom honey" viable. Yes, you can buy something called apple blossom honey. It is made mostly from wildflowers that grow in the orchards. But "apple blossom honey" sounds way better than "weed flower honey."

Further, all externalities are reciprocal. Economically, the bee and the flower are as interconnected as the chicken and the egg. And the gains to solving the problem are significant. Meade's claim about the "failure" of markets to capture the externality would have been news to apple growers, as later work by economist Steven Cheung demonstrates.

Remember, the general problem is supposed to be that positive externalities cause underproduction. And Meade argues that the specific problem of beekeeping is a perfect positive externality. Bees kept in one orchard, unless it is very large, will cross boundaries into the neighboring orchard. So pollination is "external" to the decision of any one landowner. And that means that there will be too few bees. Bring in the Federal Bee-reau of Apiation! We need subsidies, and we need them now.

Cheung ignored the economists, and looked at the economics. He found that apple growers had solved the problem. Bees fly far in their search for nectar, sometimes a mile, maybe three miles. Apple orchards can be big (the average size is a little over 50 acres), but bees might easily cross the property line and pollinate trees in the next orchard. So, suppose I have a moderate-sized orchard in the middle of several other orchards. Suppose further that I expect the growers around me to invest in bees. I can free ride, after all! Much, perhaps most, of my orchard will be pollinated by roving bees from the surrounding growers.

 

From Cheung, "The Fable of the Bees," p. 30. Emphasis added.

[I]f a number of similar orchards are located close to one another, one who hires bees to pollinate his own orchard will in some degree benefit his neighbors. Of course, the strategic placing of the hives will reduce the spillover of bees. But in the absence of any social constraint on behavior, each farmer will tend to take advantage of what spillover does occur and to employ fewer hives himself. Of course, contractual arrangements could be made among all farmers in an area to determine collectively the number of hives to be employed by each, but no such effort is observed.

Acknowledging the complication, beekeepers and farmers are quick to point out that a social rule, or custom of the orchards, takes the place of explicit contracting: during the pollination period the owner of an orchard either keeps bees himself or hires as many hives per area as are employed in neighboring orchards of the same type. One failing to comply would be rated as a "bad neighbor," it is said, and could expect a number of inconveniences imposed on him by other orchard owners. This customary matching of hive densities involves the exchange of gifts of the same kind, which apparently entails lower transaction costs than would be incurred under explicit contracting, where farmers would have to negotiate and make money payments to one another for the bee spillover.

But if some economist with a blackboard can figure this out then surely the apple growers can, too. There are real gains to solving this problem, which is local and involves only small numbers of orchardists. Stephen Cheung describes a powerful implicit contract, the "custom of the orchard," that gets farmers out of Meade's predicament.

"The custom of the orchard" is an understanding that a certain number of hives are required to pollinate some fixed area, on average. It is true that some bees from farm A will end up on neighboring farm B, and vice versa, in what look like random search patterns. But if both farmers purchase the correct average number of hives, and the bees randomly search for pollen and nectar, then the externality is entirely internalized. My bees pollinate some of your trees, and yours some of mine, but the average and marginal allocations of resources are fully optimal! If there is money to be made, and transactions costs are not too high, people will figure out something on their own.

Orange Blossom Special

Still, what is the market price of bee services? How can markets solve that problem? Cheung (p. 19) proposes a simple answer: since the possible externality is reciprocal, pollination might be worth more, or honey production might be worth more. So, the exchange will be some combination of money and honey, and it is not clear to an outsider who will pay whom. But the actual parties to the exchange can solve the problem among themselves.

Remember that in Washington, apple blossoms produce relatively little nectar. The result is that the beekeepers in Washington are producing more value in pollination than they are taking out in honey. So, apple orchardists pay beekeepers, over and above whatever honey the beekeepers produce, and keep. But the apple orchardists pay less for bee services than if no honey were produced at all.

Orange blossoms, by contrast, are an enormous source of valuable honey. And, the direction of payment is reversed:In Florida, until recently, beekeepers pay the grove owner. (The "until recently" caveat is necessary because bee populations have shrunk in the last few years, in many parts of the country, including Florida, so that now grove owners pay beekeepers.)

 

For a related podcast, see Munger on Subsidies and Externalities on EconTalk.

Thus, at its simplest level, we can see that a remarkably complex theoretical problem is solved in a simple and straightforward way by the price mechanism. Beekeepers will make offers, and so will farmers. Both parties to such transactions benefit. Who pays whom, and how? An outsider might have trouble guessing. The prices will signal the relative scarcities of the inputs (including the bees!), and the demand for the farm products. In apple orchards, the farmers pay the beekeepers. In orange orchards, the beekeepers pay the farmers.

And no one had to tell them what to do to make honey. Sweet.


Further Reading

James Buchanan and W. C. Stubblebine, "Externality," Economica, 1962, 29, 371-84.

Steven N. S. Cheung, "The Fable of the Bees: An Economic Investigation," Journal of Law and Economics, 1973, 16, 11-33

Ronald C. Coase, "The Problem of Social Cost." Journal of Law and Economics. 1960, 3, 1-44.

J.E. Meade, "External Economies and Diseconomies in a Competitive Situation." Economic Journal. 62, 51-69.

A.C. Pigou, The Economics of Welfare, (1920) 2001. Piscataway, NJ: Transaction Publishers.

Henry Sidgwick, The Principles of Political Economy, 1883. New York: MacMillan and Company.


* Michael Munger is Chair of Political Science at Duke University.

For more articles by Michael Munger, see the Archive.
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