This new paper by Harold Demsetz  is – like so many of Demsetz’s papers – truly profound. I hope it gets the attention it deserves, which is lots. I’ll say more about it in the weeks and months ahead.
In the meantime, here’s a – although not the only – key part (pp. 4-5; emphasis added):
[A.C.] Pigou’s other examples are of the same sort. They depict conditions that seem quite removed from how we would describe a decentralized, private-ownership economic system (populated by rational persons). A private person (or the Dept. of Recreation) constructs a park but does not control its use by others; the park is over-crowded as a result. But it must be that the owner of the property takes pleasure from the overcrowding or that he neglects his own interest. In the first case there is no inefficiency, since the pleasure he derives from large crowds must be taken into account; in the second case, this person cannot be a resident of the model being examined by Smith or neoclassical economists. A third type of example involves what we now call an agency problem. An owner of land rents the land to an occupant. Pigou asserts that the occupant will not take proper care of the land because he cannot be monitored closely by the owner of the land. Hence, Pigou calls for legislation to reduce the severity of misuse of property. But there is no reason to suppose the State can monitor the renter more effectively than can the land’s owner. It must be then, if the owner is rational, that the cost of monitoring the tenant’s behavior exceeds the added value that doing so would bring to the owner’s property. Hence, there is no inefficiency. All Pigou’s examples that I have examined suffer from this type of failure: they assume faulty behavior or a non-private organizational arrangement (State ownership or the complete absence of ownership) that is precluded by the neoclassical model. Special attention should be given to the last example discussed above, the land-owner/land-renter example, for the assumed positive cost of monitoring comes very close to costs that Coase would classify as transaction costs or as being necessary to a price system.
In response to the inefficiencies that he sees, Pigou turns to the State to levy taxes or confer subsidies that result in equality between private and social cost. His manner of doing this idealizes the State, which somehow knows the facts and is able to employ them at less cost than could private parties. He writes of idealized State-directed solutions to the problems that, as illustrated above, are likely to have been caused by the State itself. A Nirvana State is a dangerous tool, for it diverts attention from the real underlying problem. Why is ownership lacking or why is an owner not tending to his self-interest? In The Economics of Welfare and the doctrine that it spawned, the State is but a magic wand that Pigou waves with no effort to make private and social cost equal – the same State that, through its mismanagement, has caused many of the inequalities between private and social cost that Pigou discusses.
Notwithstanding the weaknesses in Pigou’s demonstration, his view commanded attention from economists and succeeded in replacing or becoming an appendage to the neoclassical model. Then, in 1960, came Coase’s ‘ The Problem of Social Cost.’ Coase noted, as had Knight, that Pigou’s examples were offered without rationalizing their emergence from or within a private ownership, decentralized, competitive economy. Coase then goes on to modify the conditions that describe the decentralized, private-ownership economic system. Since perfect decentralization assumes that all persons know all prices that are relevant to their decisions, the model implicitly assumes that the cost of acquiring knowledge about various opportunities for employing resources is zero. Coase identifies this implicit assumption as a presumption that the price system is free to all to use, and he argues effectively for rejecting this assumption and replacing it with one that recognizes that resources are needed to create and maintain a price system. (Following contemporary discussion, I henceforth denote the cost of creating and maintaining the price system as the cost of transacting.) I concur with Coase in his claim that the perfect decentralization model treats the price system as if it were free. Where Pigou simply conjures unowned resources and failures of contracts, Coase essentially proposes a modified model of a decentralized, private-ownership economic system in which positive transaction cost is embedded. However, had Coase remembered Knight’s work, he might have found an equally good or, in my judgment, a better way to enrich the neoclassical model. The model assumes that private ownership attaches to all resources and that rights of ownership are fully respected. In effect, in addition to a free price system, it assumes a free private ownership system. And we know this cannot be the case. Rather than rely on positive transaction cost, Coase could have insisted on positive cost of ownership, or on both.