The Answer Is Transaction Costs

Bees, Oranges, and Externalities: The Answer is Transaction Costs

• Michael Munger

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Bees and Valencia oranges from my family's farm in rural central Florida provide a snapshot of externalities and transaction costs. A local beekeeper wasn't just a boon for our crops but also an illustration of Arthur Pigou's theories on the divergence between supply price and marginal supply price. 

 Real-world practices, such as apple orchard owners paying for pollination services while beekeepers pay for the privilege of orange blossom honey, reveal how market dynamics naturally balance costs and benefits. 



If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !


You can follow Mike Munger on Twitter at @mungowitz


Speaker 1:

This is Mike Munger, the knower of important things from Duke University. Today we're going to talk about bees, the problem of externalities, a new twedge this week's letter and more Straight out of Creedmoor. This is Tidy C. I thought they'd talk about a system where there were no transaction costs, but it's an imaginary system. There always are transaction costs. When it is costly to transact, institutions matter and it is costly to transact. Let me say at the outset that I'm operating this week under remote conditions. Say at the outset that I'm operating this week under remote conditions. I'd intended to bring a microphone with me to Santiago de Chile where I'm attending the History of Economic Society meetings, but apparently I didn't. So I'm recording just from my laptop's recording device. I figured it was better to go ahead and record rather than just skip a week. I will let you, the listener, judge whether that's true. So I'm going to tell a story that I've told before about keeping bees, because it's an interesting illustration of the problem of transaction costs. So when I was growing up in rural central Florida, we kept bees. I never thought much about why. We lived on a big Valencia orange farm in the middle of thousands of acres of other people's orange groves. So the bees just seemed like part of the landscape. Twice a year, december and June, for about a month each time the air is just perfumed with orange blossoms, the trees are covered, and unless those blossoms are pollinated each one separately pollinated there's no orange. So every orange that you see is the result of pollination, and oranges are not really self-pollinating. They can't just use airborne pollination. They need some kind of bird or insect to do the pollination, to go from the male flowers to the female flowers. So you could walk in the grove without getting stung at that time of year. But you kind of had to pay attention because there were a lot of bees buzzing around. The orange blossoms were really full of nectar and that's what the bees wanted. The bees were also covered in thick pollen, carrying it from flower to flower. Now they also wanted that because there's protein in the pollen. So the bees consume pollen and they consume nectar from which they get sugar. But when the bees move from flower to flower and they have these thick yellow gaucho pants on their back legs so they look like the thick part of a horseman's pants they move from flower to flower. Some of that pollen gets rubbed off on the new flower, and so you get the fertilization of the female plants, and, as a result, oranges are able to grow. So the number of bees seemed just limitless, and they were on every tree.

Speaker 1:

So I remember my father talking to the bee man. The bee man we didn't know, I don't remember his name. The bee man, though, would bring in his hives on a flatbed truck, and he'd offload them with a helper using two 2x4s. So they put the 2x4s under the pallet, lift up the heavy hive, which would have 20,000 or more bees in each hive, and the bee man paid us in honey for the right to place his hive so close to the grove. He also would get quite a bit of other honey, which he would then sell. So his job was to harvest honey, and I actually found that if I stood around and looked sad, he'd give me a piece of the comb. Sometimes it was dripping honey and bee droppings, but it was great to gnaw on because it was delicious.

Speaker 1:

So, thinking back on it, I was in the middle of a really interesting and complex economic situation, but I missed the fact that there was something complicated going on, and you may already have figured it out. Notice that I've talked about two values. One was the value to the orange grove owner that was, us of having bees. We can't have oranges unless bees pollinate the orange blossoms. The other is the provision of honey. The question is, who should pay who? It's not obvious who should pay who. Well, markets work to produce prices. It could have been that the beekeeper would be paid by us because it was a really valuable service. But since beekeeping services are competitive and it's not that difficult to get a hive of bees, the price went the other way. The beekeeper paid us by giving us an enormous amount of value from pollinating the oranges. So the price in that case meant that the orange growers were getting much more valuable services than the beekeepers were receiving in the form of the amount of honey that they were able to sell, although he got several hundred dollars worth of honey just from our grove, I'm sure, because there's really a ton of nectar in orange blossoms. Orange blossoms are evolutionarily really trying to attract bees because they have been bred to do that by human genetic management. So let me take a step back.

Speaker 1:

An externality is an uncompensated consequence of my actions on your costs or on your utility, if I do something that affects you positively or negatively, without your consent or without my ability to withhold a benefit unless you pay, then that is an externality. Now, arthur Begoo in his 1920 book the Economics of Welfare, expressed externalities as the divergence between the supply price what a buyer pays and the marginal supply price, the actual opportunity cost of the resource used to produce the item. So the price paid might be less than the true cost, which is a negative externality, or more than the true cost, a positive externality. So in other words, if I pay to use a lake to dump waste into, the fact that the waste causes more damage to the lake than I'm actually paying for would mean that the price paid is less than the true cost, causes more damage to the lake than I'm actually paying for would mean that the price paid is less than the true cost of the damage to the lake, and that would be a negative externality. Pollution is always a negative externality. Beekeeping is a positive externality. The beekeeper comes there to get honey but then produces a positive externality, which is the value to the orange grower, which means that the beekeeper doesn't have to pay very much money, rather honey to the orange grower, but still the net benefits run in that direction. So the use of the concept of externality is much older than Pigou.

Speaker 1:

It was clearest in the analysis of lighthouse services in the mid-19th century. John Stuart Mill in his 1848 Principles of Political Economy said, I'm quoting no one would build lighthouses for motives of personal interest because and then he said, they could not collect the fees necessary to cover the cost. So his conclusion was, and again quoting it is a proper office of government to build and maintain lighthouses, since it is impossible that the ships at sea which are benefited should be made to pay a toll. And later Henry Sidgwick generalizes from lighthouse to the existence of a larger set of problems, in 1883 in his Principles of Political Economy. So he claimed that, and I'm quoting now, there is a large and varied class of cases end quote where voluntary private exchange would under-provide goods that produce positive externality. In particular, sidgwick claimed and again quoting 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, enjoyed by ships on which no toll could be conveniently placed. Well, that all makes sense. So that means, if that's right, that lighthouses are going to have to be produced by the state.

Speaker 1:

But then along comes one of the heroes of this podcast, because he believed that the answer to every question is transaction cost, and that is Ronald Harry Coase. So the problem with externalities from the perspective of society as a whole is that they cause the underproduction of useful things, like lighthouses, and they allow the overproduction of bad things, such as pollution. So in some analytic sense that's probably true. But Coase pointed out, the fundamental conception of externality may be wrong or at best incomplete. Understanding of transactions costs may be incomplete If a positive externality persists. That has to mean that some market participants who would benefit from increased or decreased production fail to receive the benefit that would result from that negotiation. So that creates a big incentive for somebody to figure out a solution to the problem. So Coase's first steps toward understanding the general solution was the problem of social cost in 1960, and he later took on in 1974,.

Speaker 1:

The problem of the title of the article is the lighthouse in economics. So that's far beyond what we can discuss. What I'm most interested in is just the problem of externalities rather than lighthouses. But let me note that Coase points out that in 1820, more than three quarters of all lighthouses had been built and were being operated by private individuals. Mill and Sedgwick sat down and they were in their study looking out the window and they said you know, I can't think of a way that private individuals could operate lighthouses, and I'm really smart. Therefore, there are no private lighthouses.

Speaker 1:

Coase, because he never thought he was that smart, went out and looked at the way the world actually was and found out that three quarters of all lighthouses were being privately operated. So the costs were paid by user fees that were levied in nearby ports. The whole system operated in the total absence of government activity except the enforcement of contracts. So the way that it worked was, if you have a bunch of people who were selling things in a port and it is difficult for ships to enter the port at night, you think you know it'd be great if we had a lighthouse. And so what they did was they paid a private person to operate, to build and operate a lighthouse, and then they continued to pay that person with user fees that were collected from ships that used the port. And ships were willing to use the port because the lighthouse made the whole thing more valuable. Now it is true that the state enforced the contract, but the state did not finance and the state did not actually build and operate lighthouses.

Speaker 1:

So sitting in your study and thinking I can't imagine the way that entrepreneurs would do that should tell you that maybe you should go ask entrepreneurs instead of just assuming you're smarter than everybody else. This is a common problem in economics. At the beginning I talked about bees as being a particular kind of externality. This point, theoretically, was made by the British economist JE Mead, and Mead is basically playing, I'm afraid, the same role as Mill and Sidgwick here. Instead of going and asking what actually happened, he looked at his window and said I can't think of a way that beekeepers would be compensated. This probably should be provided by the state. Beekeeping should be done by the state. He thought he had discovered a truly new phenomenon, a production relation so intricate and interconnected that markets couldn't handle it. So he thought the result he, mead, thought the result would always be inefficiency. Only the state could be efficient. Well, actually no, when you go, look at what actually happened. But thanks for playing, professor Mead, thanks for playing the economist game where you just try to imagine things rather than trying to see how things actually are. So it is like the lighthouse example in one important sense. If a smart person sits down and tries to think about economics rather than going out and investigating markets, you're going to embarrass yourself. So let's see how it actually worked.

Speaker 1:

Well, as Coase argued, all externalities are reciprocal. That means it requires the presence of both of the entities in order for the externality to apply. The case of bees is actually more than reciprocal. There's a recursive, independent production of apples or oranges or honey. So, on a side note, something Professor Mead might have known if he'd asked somebody is that, unlike oranges, apple blossoms don't produce enough nectar to make apple blossom honey viable. You can buy something called apple blossom honey, but it's made mostly from wildflowers that grow in the orchards, but they call it apple blossom honey, so it's possible to buy it somewhere. So notice the cool thing that is, the difference between apple orchards and orange orchards.

Speaker 1:

It happened that I grew up in an orange orchard and I noticed that the beekeeper paid us the orange grove owner, but in an apple blossom the direction of payment goes the other way, because there's not enough valuable honey produced as a result. A result, so apple orchard owners paid beekeepers to bring their hives and let them live in the orchard for a while so that they could fertilize the apples For oranges, the value of the honey was enough and there were enough beekeepers at the time I was growing up in the 1960s and 1970s that the direction of payment went the other way. Who could have known? Well, the answer is that nobody needed to know. Markets figured that out by looking at the relative costs and benefits and through negotiation.

Speaker 1:

It turns out apple orchard owners paid beekeepers and beekeepers paid orange orchard owners. The reason was that the value of orange honey is so much larger and the amount of orange blossom honey is so much larger that the beekeeper was. It is more profitable. Even paying the orange orchard owner. It was more profitable for the beekeeper to be in an orange grove than in an apple orchard.

Speaker 1:

Now there is a potential externality. If you have relatively small groves or a small apple orchard and I get a beehive in the middle of it, then the others around me are going to benefit from that, because the bees will move across. They don't recognize property boundaries, even if there's a fence, they don't care, they're bees, they'll fly, and so it does seem like there's going to be a positive externality. If one grove owner rents bee services, then all of the groves around him or her are also going to benefit. How could we solve that problem? Well, a famous economist, stephen NS Chung, actually investigated that problem in apple orchards in Washington state and he because he was a Coasean, that is, instead of trying to imagine what people might do, he went out and asked them. You can save a lot of time. I guess this is kind of a research hint for young people working in economics. You can sit around and try to imagine what people do, or you can go ask them and the whole go ask them thing. We don't admire it very much because it's not scientific. In fact, of course, economists who are real scientists would always go and ask what people actually do. So bees that are kept in one orchard, unless it's very large, are going to cross the boundaries into the neighboring orchard. The pollination services that the bees provide are thus external to the decision of any one landowner and that means there's going to be too few bees. We need to bring in the federal bureau of apiation. We need subsidies, we need them now.

Speaker 1:

So Chung found that apple growers, recognizing the highly reciprocal nature of that positive externality, had done two things. First, there was a big developed market in hive rentals, with beekeepers that shipped hives around on trucks. Many orchard owners would buy their own hives rather than rent, and then they could rent them out themselves. So it was easy and cheap to augment stocks of bees with booster packs. But the more important thing was what was called the custom of the orchard. The custom of the orchard was that it was understood that you needed something like one beehive for every two or three acres of orchard, and it was understood that everyone would rent those and the owners would go around and actually check. There were social pressures. Your neighbor expected you to keep this deal. So if all of us will rent beehives, then that means there's going to be plenty of bees. Everyone's apples are going to be fertilized, and maybe some of your apples are going to be fertilized by bees that I rented. Some of my apples are going to be fertilized by bees that you rented. But it's okay because all of us are paying on average for the correct amount. And so that custom, which had emerged spontaneously it wasn't government enforced, it was something that people recognized as being necessary to ensure that everyone's apples were always fertilized and that no one free rode was a way of solving this problem that I think worked astonishingly well.

Speaker 1:

Now, footnote much of this fell apart after the hive collapse problems of the 2000s. So there had been a problem with mites during the 1980s, mites that apparently had come over in some beehives that were transported, and those mites had killed most of the naturally occurring hives of bees. And so the price of bee services had gone up to the point where even in orange blossoms the orange owners had to pay for bee services, although not very much because the honey was still valuable, but the business was not as competitive as it was because you really did need to hire and pay a little bit higher price for the bees. Second thing is that hive collapse during the 2000s had reduced the number of bees to such a point where the price of bee services had gone up quite a bit. So the two-way difference between almonds or apples, where the orchard owner had to pay the beekeeper, or oranges, where the orange orchard owner was paid by the beekeepers. We no longer see that bifurcation now and probably for, unless the number of bees increases substantially, all orchard owners, as far as I know some listener may know better, but as far as I know, all orchard owners pay for bee pollination services. Whoa, that sound means it's time for the twedge. This week's economics joke. I have two.

Speaker 1:

First news announcement japanese banks. Following problems in the subprime lending market in america, uncertainty has now hit japan. In the last seven days, origami Bank has folded. Sumo Bank has gone belly up. Banzai Bank announced plan to trim many of its branches. It was announced that Karaoke Bank is going to be sold for a song, while shares in Kamikaze Bank today nosedived. Samurai Bank is soldiering on following sharp cutbacks. Ninja Bank is reported to have taken a hit, but they remain in the black. 500 staff at Karate Bank got the chop. Finally, analysts reported there's something fishy going on at the sushi bank. It's feared that staff may get a raw deal.

Speaker 1:

Tweed number two, a man who loved money more than just about anything, said just before he died wife now listen, when I die, I want you to take all my money and put it in the casket with me. I want to take my money to the afterlife with me. Well, when he died, she did what she had promised. She came over with the money box. She put it in casket. The undertakers locked the casket down and rolled it away. So her friend said girl, I know you weren't fool enough to put all that money in there with your husband. The wife said listen, I'm a Christian, I can't go back on my word. I promised him I was going to put all that money in the casket with him. You mean to tell me you really put all that money in the casket with him? You mean to tell me you really put all that money in the casket? I sure did, said the wife. I wrote him a check and I left it with his driver's license so he could cash it anytime he wants. I got a letter from RL about bearer bonds and I don't know much about this. Perhaps a listener does and we'll find out more.

Speaker 1:

Rl writes In my head. My understanding is that bearer bonds are used as a way of solving the problem of transaction costs. Let's say a US importer wants to buy bananas or actually more likely marijuana from a Guatemalan exporter, on credit that is, he wants the bananas now, but he doesn't want to have to pay until after the bananas have arrived in port and he gets a chance to sell them Now. If the Guatemalan trusted the American, he could just send the bananas without payment and collect later. You could build interest into the price, but of course there's no guarantee the American's going to pay, and this is an international transaction. You can't rely on the courts to force the American to pay, certainly not quickly. So the American could get a loan from a bank and could pay the Guatemalan the money now and then repay the bank later, but then the Americans would have to involve the bank in the details of the deal. So, like when you want to buy a house, the bank wants to appraise the value of the house, the bank wants to know if they're going to get paid back, and so there's a bunch of hassle in order to get the loan. You might not get it.

Speaker 1:

So RL says what I understand happens is that the American importer arranges for bearer bonds, and bearer bonds are financial instruments that, instead of having a name saying that when it matures this person will be paid, it's just pay to the bearer the amount and you can either wait for it to mature or you can sell it now at some discounted value compared to its face price. So it's basically like cash. If I have cash, it's a kind of bearer bond with a zero coupon. Bearer bonds that have some coupon rate will transact just like cash. They have a value and there's no name on it so it can be used by anybody. Now the American importer arranges for these bearer bonds to be issued and held by a trusted third party like a bank or a similar entity, or it could be a trusted mafia boss. In the case of marijuana, this amounts to an unsecured loan from the bank to the American and then Guatemalan can collect the bearer bonds when the bananas arrive in Miami. So basically, the American owes the bank money and the bank owes the Guatemalan money.

Speaker 1:

So the bearer bonds are used for shady operations a lot because of their anonymity. They're like cash in this way and that really can't be ignored. Bearer bonds are the cash equivalent for debt instruments and have all the advantages for shady deals and disadvantages theft of cash but just like cash, is a great way to encourage trade between two parties who don't trust each other. Bearer bonds are a great way to establish credit between two parties that don't trust each other. You do need a trusted third party or financial intermediary, like the bank, to issue the bearer bonds to pull this off. But this approach gives the bank plausible deniability about the true nature of the deal because they weren't involved in the giving of the loan. So it's convoluted and complicated, that is, there are high transactions costs and certainly other methods exist, but this is what I've always understood was the basic use value of bearer bonds. End of letter. Well, thanks, rl. And yes, there are transactions cost in some ways because there's a lot of friction of doing this, but it solves the trust problem. So the transfer part is more complicated, but the trust part is reliable and in a situation where trust is the primary problem, it does sound like bearer bonds might really solve it, but I don't know much about this. If listeners have experience with bearer bonds, please do share.

Speaker 1:

Well, it's time for Book of the Week. This week I want to recommend a book by Bruce Frohnen and Ted McAllister. Character in the American Experience An Unruly People. What's nice about it is that it is an evaluation of the nature of the perspectives on the Constitution. One of the funny things about Americans Europeans always comment on this to me a lot of very patriotic Americans, people that fly the flag and love the Constitution, absolutely hate the government and that distinction between the state, that is, the entity created by the Constitution of the United States, and the government, which is the elected officials. That distinction doesn't make sense most places. But because, as Cronin and McAllister point out, americans are an unruly people. That distinction is really important in the US. Well, the next episode will be released on Tuesday, july 23rd. I'll be back home with the regular microphone and recording equipment, so it'll sound better. We'll have a new topic, some letters and, of course, a new hilarious twedge. All that and more next week on Tidy C.