In a classic paper on externalities, the Nobel Prize-winning economist James Meade wrote that the market for honey was inefficient. As they make honey, bees pollinate fruits and vegetables, which is an important benefit to farmers. Since pollination is an external benefit of honey production, Meade argued there was too little honey being made.

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Meade was right about the bees, but wrong about the market for honey. Bee pollination is a thriving business for which beekeepers are paid. In fact, in the United States, beekeepers manage around half a billion bees that they truck around the country to rent out to farmers. Since farmers pay beekeepers to pollinate their crops, the “external benefit” becomes internalized—the beekeepers earn money from the pollination of fruits and vegetables and so expand production toward the efficient quantity, the quantity that takes into account the benefits of bees for honey production and for fruit and vegetable production.2

The lesson of the bees is that our earlier story was a bit too pessimistic. The market equilibrium can be efficient even when there are externalities, if there is systematic trading in those externalities. To see which externalities the market can handle, let’s take a closer look at why the market for pollination works reasonably well.

The market for pollination works because transaction costs are low and property rights are clearly defined. Transaction costs are all the costs necessary to reach an agreement. The costs of identifying and bringing buyers and sellers together, bargaining, and drawing up a contract are all transaction costs. Transaction costs are low for beekeepers and farmers because farms are large and bees don’t fly that far. So when a beekeeper places bees in the center of a large farm, the beekeeper and the farmer know that the bees will pollinate the crops owned by the farmer who is paying and not pollinate some other farmer’s crops. As a result, the externality from bees is limited to one farmer at a time and can be internalized with one transaction.

Property rights over farms and bees are also clearly defined. Everyone knows that the beekeeper has the right to the benefits created by bee pollination, so if the farmer wants bees to pollinate his crops, he must pay the beekeeper. This works for beekeepers and farmers, but as you will see, property rights in other externalities are not as clearly defined and this makes transactions more difficult; you might say that unclear property rights are a type of transaction cost, since they make it harder to trade.

It’s not so difficult for beekeepers to trade with farmers, but how many transactions would it take to internalize the external benefit created when someone has a flu shot? When one person is vaccinated, thousands of other people benefit by a small amount, especially if the vaccinated person spends a lot of time in airports. When Alex has the flu and coughs while boarding a plane, he could spread the flu virus to dozens of other people, each of whom could in turn pass it on to many others. If Alex receives a flu shot, all these people are better off. In theory, if each of these people paid Alex a small amount for getting a flu shot, Alex would be more likely to get a flu shot. But the transaction costs of arranging a deal like this are enormous—simply to identify the beneficiaries is difficult and getting thousands of them to send a check to Alex is next to impossible (trust us, we have tried!).

What about property rights? We assumed that other people might be willing to pay Alex to get a flu shot because the flu shot creates an external benefit. But when Alex spreads the flu, he imposes an external cost on other people. Maybe Alex should have to pay other people when he doesn’t get a flu shot! Even when other transaction costs are low, if property rights are not well-defined—who should have to pay whom—it will be difficult to solve externality problems with bargaining.

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Ronald Coase, another Nobel Prize winner, summarized the situations in which markets alone can solve the externality problems in what has come to be called the Coase theorem. The Coase theorem says that if transaction costs are low and property rights are clearly defined, then private bargains will ensure that the market equilibrium is efficient even when there are externalities. In other words, in these cases trading makes sure that just the right amount of the externality is produced. If there were either too little or too much of the externality, trading would push the quantity to the optimum level.

Recall that in a free market, the quantity of goods sold maximizes the sum of consumer and producer surplus. If the conditions of the Coase theorem are met, we can replace this with the even stronger conclusion that in a free market, the quantity of goods sold will maximize social surplus, the sum of consumer, producer, and everyone else’s surplus.

But the conditions of the Coase theorem are often unlikely to be met. Transaction costs for many externalities are high and property rights are often not clearly defined. Thus, markets alone will not solve all externality problems.

The importance of the Coase theorem lies not in suggesting that markets alone might solve externality problems, but in suggesting a solution—the creation of new markets. If property rights can be clearly defined and transaction costs reduced, then a market for externalities might develop. If such a market does develop, we know from the Coase theorem that it will have all the efficiency properties of ordinary markets.

Government can play a role in defining property rights and reducing transaction costs. In fact, in recent years governments have helped to create working markets in many externalities, verifying the insights of the Coase theorem. Next, we discuss one of these new markets, a market in the right to emit pollution.