Forging a New Environmental and Resource Economics Paradigm: The Contractual Bases for Exchange

August 15, 2005

by
Terry L. Anderson

Executive Director, Property and Environment Research Center

and Senior Fellow, Hoover Institution

2048 Analysis Dr Ste A

Bozeman MT 59718

(406)587-9591

Professor of Economics and Law

University of Arizona

and Research Associate, NBER

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Tucson AZ 85721

(520)621-4821
DRAFT. NOT TO BE CITED WITHOUT PERMISSION.

Forging a New Environmental and Resource Economics Paradigm:

The Contractual Bases for Exchange

August 15, 2005

by Terry L. Anderson and Gary D. Libecap¹
A survey of environmental and natural resource economics literature finds few references to property rights and transaction costs. The Journal of Economic Literature, for example, has no recent articles on natural resources or the environment containing the phrase “transaction costs,” “property rights,” or “Coase” in the title or abstract. When the search of the journal was expanded to these words appearing anywhere in the article, only one paper was found and it was about resource management without markets.¹

The environmental and natural resource literature instead focuses on problems of market failure in the tradition of A. C. Pigou. Accordingly, natural resources and environmental goods are either overexploited as a result of the tragedy of the commons—for example, fisheries—or under produced as a result of the free rider problem—for example, species habitat. In either case market failure is the issue and governmental intervention is warranted.

A key insight of the property rights theory and research described below is that when rights are well defined, private, voluntary negotiations result in efficient outcomes. That is, resources are allocated to their most valuable use at any point in time; long-term investment occurs; current access, production, and use are at optimal levels; information is continually generated about new resource values and options; and correspondingly, market exchange reallocates the resource as superior values or uses arise. These results are well known and not surprising to most economists as they are applied to standard market and production conditions. Yet, once attention is turned to natural resources such as fisheries or water or to environmental resources such as air quality or natural amenities, the lessons are forgotten. Property rights are assumed either not to exist or impossible to define and enforce, or judged to be irrelevant or inappropriate as a solution to the open-access problems that plague many natural and environmental resources. The resolution, instead, requires government intervention through cap and control regulation, outright ownership, subsidy, and/or tax policies.

Throughout our discussion we refer to both environmental and natural resource problems as ones of open access. In natural resources where there is unrestricted entry, the results are rapid depletion, no investment or conservation, and limited trade. In the environment, the inability to exclude leads to overuse (excessive pollution) or under provision (habitat). In either case, property rights and the potential for exchange are absent because of the physical characteristics of the resource or legal or cultural restrictions. Our approach to environmental and natural resource problems is to examine why this condition exists—not by assuming market failure, but by examining the nature of the transaction costs that inhibit the definition of property rights and trade to resolve the open-access problem. We are interested in the opportunities for greater definition of property rights and reliance on voluntary contractual solutions to environmental and natural resource issues.

The advantages of this contractual approach are flexibility, timeliness, accuracy, higher resource values, and not the least, social cohesion. State regulation, ownership, tax, or subsidy policies are political processes. As such they are inherently contentious, often dominated by established interest groups (regulatory capture) and implemented by bureaucratic officials who are not residual claimants to the social costs or benefits of their decisions. Their decisions may or may not increase the economic value or social contribution of the resource. Regulatory policies are slow and often inflexible in responding to new resource values. Because these policies are made in the absence of trade, they do not take into account information on the value of alternative uses. And, perhaps more importantly, many government environmental and resource policies have not been effective at achieving purported objectives. In contrast, where relatively competitive markets exist, decision makers can more quickly respond to new costs and benefits and bear the costs and benefits of their actions. In the aggregate, market exchange results in the maximization of the economic values of the resources involved.

Accordingly, we examine the potential for voluntary, private contractual approaches to the open-access problem. This requires attention to the more complete assignment of property rights, to the transaction costs that have limited them, and to how the state might assist in the definition of property rights and in lowering the transaction costs of measurement, enforcement, and exchange.

We are not arguing that all environmental or natural resource problems can be addressed by a contractual approach. There will be some cases either when governmental intervention into the marketplace is second-best optimal or when open-access inefficiency is not worth correcting given the costs of doing so. Rather our objective is to turn attention from market failure to market opportunity. We begin with an overview of how the existing environmental and natural resource literature has covered property rights and transaction cost issues.
The Old Resource Economics

The legacy of A. C. Pigou in The Economics of Welfare (1920) focuses on the divergence between social and private benefits and costs. If the conclusion is that an individual’s actions create costs that are not taken into account, then private costs are less than the costs to society, and social inefficiency results as too much of the good is produced. Similarly, if an individual’s actions, which create opportunity costs, result in benefits to others for which the individual is not compensated, private benefits are less than social benefits, and social inefficiency results as too little of the good is produced. Here we shall focus on the cost divergence though it is a simple exercise to consider the problem of benefit divergence.

Dubbed as “market failure,” the question becomes how can the failure be corrected? According to Pigou, there are three solutions. The state can tax production of the good equal to the divergence between private and social costs; calls for a carbon tax are an example. Alternatively, the state can regulate production to the efficient level. Historically, some air pollution in the United States has been regulated through specified, uniform emission levels. A variant of this regulation is to regulate the production process, for example, by requiring specific production technologies in the form of emission control devices, as called for in the Clean Air Act. Finally, the state can assume ownership and production of the good in question. Public landownership and management is a case in point.

It is beyond the scope of this review to consider the agency costs involved in political and bureaucratic decision making. There is a large “public choice” literature on these issues, and they are not trivial ones. Nevertheless, environmental and resource economists have abstracted from the details of the political process and ignored incentives and problems inherent in it. For example, Daniel Bromley claims that government agencies are

Perhaps the best-known example of the social agency problem related to environmental issues is Bruce A. Ackerman and W. T. Hassler’s analysis of Clean Coal/Dirty Air, or How the Clean-Air Act Became a Multibillion-Dollar Bail-Out for High Sulfur Coal Producers and What Should Be Done About It (1981).³ Ackerman and Hassler show that an unlikely coalition of environmentalists and eastern coal producers formed to amend the Clean Air Act to require a technological solution to sulphur emissions when burning low-sulphur western coal would have done more to lower emissions at less expense. Environmentalists favored the technological fix because they believed it would appropriately penalize electricity producers for the sulphur they emitted, and eastern coal producers favored it because they wanted to reduce competition from western coal. The result was dirtier air at a higher cost of control.

In another study of the 1977 amendments, Peter Pashigian (1985) questioned whether the regulatory approach required stricter controls on emissions in dirtier regions of the United States than in cleaner regions. He found just the opposite, namely that controls were stricter in the cleaner regions. He explained the paradox using variables to identify special interest demands implying that rather than responding to demands for environmental quality, politicians were responding to special interests who did not want to face higher cleanup costs in the dirtier regions.

The nexus between paradoxical special interests and environmental regulations can also be found in endangered species regulation.⁴ When environmentalists succeeded in listing the northern spotted owl as an endangered species, Weyerhaeuser, one of the Northwest’s largest timber companies hired biologists to search for spotted owl habitat. Because the endangered species designation required less logging in areas of spotted owl habitat, Weyerhaeuser’s actions seemed strange. The Wall Street Journal (Richards 1992, 1-A), however, provided an explanation for Weyerhaeuser’s apparently environmentally responsible behavior by noting that the scientists were not only searching on Weyerhaeuser’s private lands, but the national forests too. As a result, The Wall Street Journal reported that Weyerhaeuser “restricted logging on 320,000 acres to comply with federal and state rules protecting the birds. On the other hand, logging restrictions to protect the owl have put more than five million acres of federal timberland in the Pacific Northwest out of loggers’ reach—and driven lumber prices through the roof.” At a “timber summit” in Portland, Oregon, in 1993, President Clinton announced that his administration would significantly reduce timber harvests on federal lands in the Pacific Northwest, and headlines in USA Today (Kanamine 1993, A1) read “President Clinton dealt a blow to the Northwest timber industry Thursday, ordering a severe cut in tree harvest to protect the northern spotted owl.” The financial news in the same edition of the paper reported that “Paper stocks were higher. President Clinton announced plans to drastically reduce logging in the Northwest forests the next 10 years to protect the spotted owl. The logging cuts will likely mean higher paper prices, which helps paper companies’ profits.”

While policy analysts and researchers have been willing to grant the benefit of the doubt to the state, they have been much less willing to do so to the market, despite abundant evidence that political regulations often promote special interests rather than environmental improvements. Consider the call for extension of the “public trust” doctrine which calls upon the state to safeguard water and other environmental natural resources. The doctrine is used to justify government seizure of private water rights without compensation in order to maintain stream flows for aquatic habitat or other amenities. Private rights and market solutions are deemed both insufficient for providing public goods and unable to respond to new environmental values. As Blumm and Schwartz (1995, 703) state, for example: “Because prior appropriation allocates superior rights to the oldest uses, it promotes dead hand control of this generation’s most valuable resource . . . . The Mono Lake decision refused to allow decisions made by past generations to shackle allocations of water resources by this generation.” Blumm and Schwartz’s assessment is typical of public trust discussions and it is based on two notions. One is that private owners will under provide or under invest in public goods because of the inability to exclude and appropriate the returns on production and investment. The second is that private rights and markets are not responsive to changing resource values because there are no opportunities to capture them.

Putting aside whether or not the state will sufficiently supply public goods or effectively reallocate resources as values change over time, the questions to be addressed here are why property rights so under defined and why market transactions are so limited. If rights were completely assigned for all dimensions of water use, then there should be no problem of under provision or investment. Accordingly, public trust interventions would not be necessary. We are not claiming that property rights can always be completely defined to address open access and public goods problems. Rather, we are asking what impedes the formation of property rights and the operation of markets?

To be sure, there are problems of market imperfection. But where traditional approaches have assumed political responses to be optimal, they have also assumed that market responses will not be. In neither case has much attention been directed to the underlying bases for these conclusions. The task at hand then is to spell out the circumstances when the state can address environmental and resource problems more efficiently and when private contracting can do so. It is our contention that the range for the former is smaller than has been assumed and that for the latter is larger than has been appreciated. Valuable improvements in environmental and resource outcomes are possible.

In the existing literature, information questions have traditionally fallen under the rubric of benefit-cost analysis. Here questions range from what values to place on alternative resource uses based on market prices for similar goods; how to measure values when market prices are not available as with contingent valuation; and what discount rate to apply when costs and benefits span time. In contrast, focusing on the transaction costs associated with property rights definition, enforcement, and exchange forces the policy analyst to ask why values are not reflected in market transactions and whether information can be better produced by lowering the cost of exchange or by producing information that is under produced because it is a public good.

Though Ronald Coase’s focus on “The Problem of Social Cost” (1960) is the most cited article in economics, its impact on natural resource and environmental economics has not been profound. Where the “Coase theorem” has entered into environmental economics debates, it has been to focus attention on the impact of positive transaction costs on efficient resource allocation and on the wealth effects of alternative initial distributions of property rights.

Textbooks devote an obligatory two or three page discussion of Coase with slight variations in their interpretation of the Coase theorem. Interpreting Coase to say that resource allocation through voluntary exchange will be efficient if property rights are well defined and enforced and if transaction costs are zero, many conclude that voluntary exchange will lead to inefficient allocation because transaction costs are positive. Interpreting him to say that resource allocation will be invariant to the initial allocation of property rights if transaction costs are zero, they conclude that there are as many efficient allocations as there are initial distributions of the rights.⁵ A leading textbook, Environmental and Natural Resource Economics by Tom Tietenberg (1992), for example, devotes XX pages to Coase with a critique including a discussion of transaction costs and wealth effects. His conclusion is that “get quote” Hence the general conclusion from Coase’s insight is that his theorem either explains why markets fail or is trivial. [We must update the survey of texts.]

By contrast, Bruce Yandle (1998) has applied Coase’s approach to “the problem of social cost” to environmental and natural resource issues. Yandle emphasizes that all environmental problems emanate from competition for the use of resources for which property rights are not clear. If one party uses air as a disposal medium for waste and another demands clean air, there are competing uses. If one party uses the air to transmit sound waves and demands that the air be free of those waves, there are competing uses. If one party produces lumber for the market and another demands a view of live trees, there are competing uses.

Because one use precludes the other, the costs are reciprocal as Coase emphasized. For example, if air is used to transmit sound waves to music lovers, there is a cost to those who want quiet, and if the air is used to produce quiet, there is a cost to those who want music. Either way there is an opportunity cost created by the competing uses. Accordingly, there is a prospect for exchange if property rights were assigned. That is, if one of the parties “owned” the air and the other had a higher valued use for it, both could be made better off from trade and reallocation.

The question is why this does not occur. Of course the answer is that property rights do not exist. The question then is, why not? The answer to this question comes from Coase. Transaction costs arising from various sources impede the assignment of property rights and their trade. As Steven Cheung (1970) pointed out, there is no contractual basis for exchange. Identifying the sources of those transaction costs and determining how (if at all) they might be reduced is more complicated. But this is our call to the profession.

The central message is that attention should be focused on the potential transaction, the parties involved, and the size of the open-access problem. The emphasis on “externalities” as occurs in the literature is neither warranted nor useful. Indeed, as Dahlman (1979) has pointed out, if externalities exist because of transaction costs, then it is incorrect to conclude that their presence is evidence of inefficiency. Transaction costs are resource costs and any observed losses of open access occur because of them.⁶ Otherwise, rational agents would take actions to lower those losses and capture the resulting gains. There may be remedial norms to move toward as Williamson (1998) has argued, but this can take place only by examining how to reduce transaction costs which are the source of the problem, and not externalities which are only symptoms. Accordingly, the term externality could either be expunged from the analysis or relegated to a description of the open-access problem.

Uses of environmental and natural resources involve reciprocal costs, and in much traditional discussion of externalities, there is an implicit assumption of property rights to those resources. Otherwise, there is no way to state who is imposing costs on whom. There is noise pollution only if the demander of quiet has that right or quiet pollution if the music demander has that right. One might claim that social norms determine the direction of the externality, but this is the equivalent of saying there is a property right. Saying that this is an externality diverts attention from the important issues of how property rights are determined and how they allocate reciprocal costs, which was precisely Coase’s point. Indeed, Randall (1993, 145) concluded that “Externality is . . . a vacuous and unhelpful term.”

The lack of precision in property rights assumptions in discussions of externalities can have consequences beyond confusing the analysis. Transaction costs may be increased because the implied rights appear to be un-enforced. This could justify state intervention to do so. There are of course, distributional implications from any rights assignment, and these too can have important transaction cost implications. Property rights are political institutions, and costly lobbying by the parties who expect to benefit from a particular allocation is a form of rent seeking (Tullock, 1967). Further, an assignment of rights that is skewed with respect to wealth or otherwise viewed as socially inappropriate will be more costly to enforce over the long term. For these reasons, economists (for example, see Demsetz 1972) have argued that property rights should be allocated to those parties who can enforce and exchange them at lowest cost. This argument, however, begs the question of who will assign the rights and what incentives will the assigning entity face.

From Coase we learn that economists have not been careful in their analyses of environmental and natural resourced issues, claiming externalities without considering the structure of property rights and how they do or do not evolve depending on the nature of transaction costs. Fortunately, because of Coase’s insights, economists are equipped to consider how different ownership regimes and transaction cost constraints evolve and how they can resolve competing uses.

A contractual approach to environmental and natural resource problems relies on the definition of property rights as the basis for exchange. Demsetz (1967) started economists on a path “Toward a Theory of Property Rights,” pointing out that the evolution of property rights, like the production of other goods and services is a function of the benefits and costs of defining and enforcing those rights. His evidence included an application of his theory to Native American property rights to beaver trapping territories. Anthropological evidence shows that these property rights were better defined and enforced as the value of beaver pelts rose with the trade in them. A nonowner passing through a beaver trapping territory belonging to another could take a beaver for food, but was required to leave the valuable pelt where it could be collected by the owner. Violation of these rights could be punishable by death.

Anderson and Hill (1975, 2004) followed Demsetz’s lead, extending his theory and applying it to the evolution of property rights on the American frontier. On the western frontier of the United States, Europeans sought ways to contract with American Indians when the property rights were clear and fought with them when they were not (Anderson and McChesney 1994). They then developed their own property rights once the rights of Indians were effectively extinguished. The case first illustrates how recognition of existing rights can lead to reallocation of resources in the face of new demands; the second illustrates how high transactions costs and low costs of taking can yield the worst type of rent seeking—war; and the third shows how parties with conflicting demands can contract to establish new property rights where they are absent.⁷

Similarly, Libecap (1976) examined the evolution of private mineral rights along the Comstock Lode in nineteenth-century Nevada. His data show that as mine values increased, mineral rights were made more explicit and definite in a manner predicted by Demsetz. Definition and enforcement evolved from local property rules within the mining camps to more formal territorial and state statutes and judicial opinions as the extent and value of the silver deposits in the region became more apparent. With increased competition for control of valuable mineral lands, informal rules were insufficient to reduce uncertainty and support the investment necessary to develop the mines. The territorial and state institutions that replaced them provided greater definition and enforcement and reduced uncertainty. A mining stock exchange emerged on this institutional support. Production and investment followed.

Mining camps and private mineral rights have been examined also by Umbeck (1977a, 1977b), Zerbe and Anderson (2001), and others. The emergence of mineral rights provides a laboratory for testing Demsetz’s intuition because there were few other constituencies to compete for western lands besides miners and the legal and social structure of the mining frontier was supportive of private property and exchange.

Property rights, however, do not always evolve so efficiently as they seemed to in mining camps.⁸ In the case of western timberlands, there were no procedures under the law to secure private rights to federal land that was not suitable for farming. But it was rich in timber resources. To gain access to land and to have the security of ownership necessary to support capital intensive logging and lumber milling, entrepreneurs hired “entry men” who would claim land as farms of sub-optimal size and turn the title over to their employers once it was obtained from the government. The plots could be then consolidated into holdings of sufficient size to support viable lumbering operations. But this raised the cost of securing ownership and delayed the assignment of property rights to land. Libecap and Johnson (1979) estimate that in some cases the added transaction costs were more than the government price of the land. In the meantime, open access in the form of “timber depredations” continued.

Similarly, Hansen and Libecap (2004) find that the constraints of the Homestead Act led to dense settlement of the semi-arid Great Plains and farms that were too small to be economically viable over the long term in the region. To squeeze out a living on their homestead plots of 160 acres, farmers placed all of their lands in cultivation, increasing exposure to prevailing winds and wind erosion. Erosion control required use of strips of fallowed land with last year’s wheat shafts left standing to slow the flow of wind. But because farmers could not afford to leave much land in fallow and because of the large number of farms, effective collective action to combat erosion was impossible. The Dust Bowl of the 1930s was the result. As farms failed and were consolidated into larger units, more suitable farming practices became possible.

Although, these historical applications are more in the genre of economic history, they point out the importance of understanding how property rights emerge and the constraints that can impede their development. A more contemporary example of legal constraints on the establishment or maintenance of property rights lies in the growing extension of the “public trust” doctrine in western states. The doctrine is being expanded to restrict “excessive” diversions from non-navigable streams to protect aquatic environments. Because the doctrine is so elastic and potentially expansive, it supports broad government intrusion in water rights (Epstein 1987). Public trust extensions emphasize that private water rights are merely usufructs that are non-vested, and revocable without compensation. As such it is a regulatory vehicle that can importantly undermine existing rights arrangements that have been longstanding and their ability to address open-access conditions. Greater ownership uncertainty can be expected to result in more water waste and less conservation. Moreover, since compensation is not required nor considerations of the private opportunities foregone, public trust interventions will not generate needed information on the economic values of the private and social tradeoffs faced. Hence, whether or not the policies increase or decrease the economic value of water is unknown.

Another example from water shows how transaction costs of property rights assignment and exchange can impede solutions to resource problems. There is growing conflict over the use of instream flows. Past ownership largely has gone to farmers for irrigation. They maintain their water rights under the “use-it-or-lose-it” requirement to document beneficial use. Increasingly, fishers and others seek less water diversion for irrigation, leaving more in the stream for recreational habitat and amenities (Anderson and Johnson 1986).

There would seem to be an opportunity for beneficial trade between farmers and recreational demanders, but it is thwarted by a number of problems. First, some western states do not recognize instream flows as a beneficial use. Hence, they are treated like an abandoned water right and available to downstream diverters. In this case, neither the farmer nor the instream flow purchasers would retain control of the water. Second and related, most western states require diversion to establish a water right. This requirement is due to the relative ease of measuring diversion as compared to actual consumption and to the high cost of enforcing claims to mobile, undiverted water.⁹ If fishers or other instream flow demanders purchased diversion rights and left them instream, their water rights might not be legally recognized, and even if they were, the costs of preventing subsequent diversion by others are very high. Third, free riding by those who enjoy recreational or amenity values but who cannot be excluded from that enjoyment if they do not pay, can result in under provision of instream flows in the marketplace. Fourth, “public trust doctrine” actions by the state to arbitrarily reallocate water from irrigation to instream flows without compensation encourages rent seeking as the preferred means of obtaining instream flows. This occurred, for example, in the Klamath River Basin in Oregon (see Meiners and Kosnik 2003).

The problem of insufficient instream flows, then, is not one of externality. It is due to the lack of the ability of the parties to contract. Some of the restrictions on trade are due to the physical character of water, and some are due to constraints of the law. The focus of attention then should be on the sources of high transaction costs and how they might be reduced to better define property rights and support exchange.

In this context the common law becomes a fertile venue in which property rights evolve to resolve conflicting resource uses. Cooter and Rubinfeld (1989) summarize how parties approach dispute resolution in a general context. They summarize the framework by considering four stages of a legal dispute: harm, assertion of a legal claim, bargaining (and perhaps settlement), and litigation. These four stages easily translate into the theory of the evolution of property rights and encompass transaction costs inherent in environmental issues. For this reason, Yandle (1997, XX) concludes that “common law, which is based on and supports property rights held by ordinary people, is part of the process approach for dealing with the commons problem.” When cast in terms of Pigou versus Coase, the common law is clearly part of the Coase solution.”

A critical contribution to property rights clarification by common law courts is the bargaining process that it promotes. A Pigovian solution starting with the presumption of an externality, on the other hand, has no room for bargaining. To correct the problem, a tax, subsidy, or regulated output is imposed by a governmental authority with the “presumption” that it will move production more in the direction of efficiency. Not only do these examples illustrate the way property rights apply to the problem of social cost, they also illustrate the evolutionary nature of property rights when applied to modern environmental issues. By focusing on the economics of property rights evolution, negative externalities become uncaptured benefits to those entrepreneurs who can capture the returns through defining and enforcing rights and trading them. If and how they are able to do so depend on the nature of transaction costs.
Property Rights, Transaction Costs, and Negotiated Solutions to Environmental/Resource Problems
The work of Coase (1960), Williamson (1975, 1985), Cheung (1970), Dahlman (1979), and others directs attention to the transaction costs of exchange. Market failure implies a loss in value of the resource. Rational parties have incentive to prevent that loss—to close the so-called externality through production, investment and exchange and to capture the gains from doing so. The persistence of an open-access problem indicates that something is blocking the exchange.

The task then is to see if it is possible to lower transaction costs to achieve a different production and allocation mix. For natural and environmental resources, a positive response by the state to open access would be to determine why the problem exists, why maximizing parties have not addressed it, and how state intervention might facilitate private exchange as mitigation. Transaction cost considerations also mean that not all environmental or resource problems will be completely solved. Indeed, it may be efficient to leave some open-access situations unaddressed. As Coase (1960, 39) pointed out, “But the reason why some activities are not the subject of contracts is exactly the same as the reason why some contracts are commonly unsatisfactory—it would cost too much to put the matter right.”

Those who reject efficiency as an objective for environmental and natural resource policy in calling for government ownership, regulation, or taxes must be explicit about the political model they have in mind. That is, they must demonstrate how political and bureaucratic decisions made within existing political institutions to achieve a different objective is more welfare enhancing than market exchange.

It is our position that government should focus on lowering the transaction costs of defining property rights and facilitating exchange to address environmental and resource problems. The advantages of contractual/market solutions are that they are more flexible than state regulation in adapting to new benefits and costs. They are incentive compatible and reduce compliance costs. The parties directly involved with the resource are part of the solution, not the problem. They are more accurate and effective because they generate information about resource values which does not take place under government allocation by fiat. What is a corrective tax or regulatory policy if we do not know the competitive optimal outcome?

Transaction costs include the costs of search, negotiation, measurement, and enforcement. They may be high due to the physical nature of the resource or due to social or legal conditions. The following is a summary of the factors that raise transaction costs.

1. The nature and distribution of information about the environmental/resource problem: This is an information measurement problem (Barzel 1982). If there is limited or asymmetric information about the size of the problem or of the costs of addressing it, the gains from trade may be uncertain. An appropriate state response here is to provide credible, scientific information about the open-access loss such as the size of declining fish stocks, air pollution costs, or amenity value of a resource. Additionally, uncertainty as to the distribution of the benefits and costs of resolving the problem will reduce contracting because the parties will have no clear sense of how they will fare under the new arrangement. This is a property rights and enforcement problem. Will those who invest in solutions be able to appropriate the returns? An appropriate state response here is to guarantee property rights and trade.

2. The physical characteristics and value of the resource: These are measurement, bargaining, and enforcement problems. Larger, more mobile, unobservable environmental/natural resources such as groundwater, air, and fish and wildlife stocks have higher measurement and enforcement costs than do stationary resources such as land. The state may assist contracting by providing information about the boundaries of the resource and enforcing those boundaries and by private partitioning of the resource. More valuable resources are associated both with more enforcement costs because there are more claimants and entry, and with greater returns to a bargaining solution because the open-access losses are larger. Capturing a portion of these is the motivation for negotiations among private agents to address the resource problem. As outlined by Demsetz (1967) and illustrated in the case examples above, more valuable resources tend to have more precise property rights because the larger benefits from definition and enforcement offset the higher costs of doing so. Here again, the state can assist in the contractual solution by supporting property rights and their exchange.

3. The number and heterogeneity of the bargaining parties: These are bargaining and enforcement problems. An extensive body of research on collective action regarding natural resources as well as within cartels, reveals that larger, more heterogeneous groups have higher costs of reaching agreement and enforcing compliance. There is potential for free riding, holdup, and defection. The state can mitigate these problems by defining property rights to limit entry and by punishing those who violate contracts and trespass. Alternatively, as Ostrom (1990) and others have shown, small homogeneous groups with frequent interaction can effectively and efficiently reach agreement on resource allocation and use. These groups often use community property to mitigate open-access problems and enforce it through norms and customs. The state should recognize those institutional solutions and not undermine them as it has done, for example, by dismantling the arrangements set up by inshore fishermen unions in the United States to regulate entry and harvest (Johnson and Libecap, 1982; Adler (in Leal volume *).

4. Equity and precedent of resource ownership, access, and use. These are bargaining and enforcement problems. The law or long-standing precedent may limit trading to reduce the environmental or natural resource problem and reduce the range of options. For instance, standard “polluter pays” notions in air and water pollution cases fail to recognize the inherent reciprocal nature of pollution. Automatic compensation of “victims” reduces incentive to take defensive action and encourages behavior that raises the cost of the problem. Hence polluters may over invest in pollution abatement, whereas victims under invest in behavioral adjustment. The common law principle of “coming to the nuisance” is an example of how the evolution of property rights can optimize the investment by both parties in preventing and avoiding harm. Compensation demands are politically contentious because they require answers to who will pay, how much will be paid, and who will receive. Another complexity introduced by such legal concepts is their inherent ambiguity. The public trust concept described above is used to revoke private property rights in the name of the public interest, but the notion is vague, elastic, and uncertain. It invites opportunism and strategic holdup. As such property rights are weakened and open-access conditions potentially exacerbated.

5. The rule of law: The rule of law provides legal certainty to contracts and property rights and thereby lowers transaction costs. With these transaction cost factors in mind, the state can act to lower them and to promote private contractual solutions to environmental and natural resource problems. Because current environmental/resource policies neglect transaction costs and Coase’s basic insights about the reciprocal nature of the problems and the corresponding bases for trade, they have been costly and often ineffective. They rely too much on centralized regulation, taxes and subsidies, and too little on the assignment of property rights, lowering of transaction costs, and trade. We now turn to more discussion of Coase’s insights.

Through not writing specifically about traditional environmental and natural resource issues, Stephen Cheung’s pioneering work on property rights sheds light on how the Coasean lens can help us better understand the essence of natural resource and environmental problems. Cheung, like Coase, admonished economists for being “so willing to accept theorems or so reluctant to test the alternative implications of their hypotheses. . . . Using imaginary ‘facts’ to support imaginary policies seems habitual in the Pigovian tradition” (1978, 55). Following his own admonition, Cheung’s careful analysis of agricultural contracting, beekeeping and pollination services, and fisheries suggest fruitful avenues for applying property rights and transaction cost economics to natural resource questions. Like Coase, Cheung understood that the “devil is in the details” making the careful study of the details necessary lest we perpetuate fables.

Following Coase’s logic and subsequent extensions to property rights and transaction costs, some economists have begun to change the way we approach environmental economics. Their property rights/transaction cost approach lessens the emphasis on market failure. Instead, it examines what the property institutions are, what the transaction costs are, and what efficiency implications follow from these two constraints. Consider some examples of the opportunities possible using this approach.