Thursday, June 28, 2007

A Peculiar Market Failure?

I found Jared Diamond's book Collapse to be very disappointing compared to his previous book, Guns, Germs, and Steel. Nevertheless there was one intriguing problem he presented, which seems to me to be a kind of curious market failure, with no obvious solution short of direct government regulation.

Suppose a mining operation begins near your town. The mining company operates in a seemingly environmentally-friendly manner, keeping erosion under control, preventing leakage of tailings, and perhaps even covering up the site after mining is complete. This seems acceptable to nearby residents.

Near the end of the mine's life, the mining company goes bankrupt. Perhaps they set aside enough money in advance to cover up the site, so there is no big eyesore remaining. Perhaps not. In any case, the company goes out of business and disappears. Ten years later a problem appears. Perhaps leakage from the mining site pollutes groundwater, or kills the plants above the site, or dangerous fumes being to escape. Or maybe they just don't have the money to clean up the site after bankruptcy.

What can be done to prevent this? There's no one to sue to recover damages or of whom to demand cleanup. The company is gone. The former owners and operators are not liable for the corporation's actions. If the company truly existed forever there would be no problem; one could sue the company and recover damages, reducing the incentive for other companies to engage in such behavior. So long as a company can make profits and then shut down like this, however, they can escape future damage claims. One cannot file suit for damages that one does not know will exist in ten years, so action prior to the damage isn't possible. If neighbors could inspect the mine regularly themselves, that might also eliminate the problem, but the neighbors would have to hire an expert to look at the problem (which costs money, introducing free-rider problems). They would also have to gain permission from the mining company, which is unlikely to agree.

One potential solution is to end corporate personhood, i.e. eliminate the limited liability enjoyed by owners of corporation, i.e., if a company of which you owned 5% 20 years ago did something bad 20 years ago, you owe 5% of the current damages. The main problem with this is that it will significantly discourage investment in companies. One reason modern stock markets work so well, and are able to finance so many large operations, is that investors know that their liability is limited. Perhaps this tradeoff would be worthwhile. It has the advantage of being a non-regulatory solution--it lets the market continue to work; it simply changes the liability rules under which a market operates.

Another solution, of course, is to simply have the government inspect and carefully regulate every aspect of all mining operations. The problem here is that governments suffer from similar problems to that of the corporation. The people doing the inspection now might not be in those jobs in ten years when problems arise; they're not likely to exercise as much diligence as we would like. That's in addition to the usual problems with government action, such as lack of cost control and regulatory capture (the tendency of regulated businesses to get chummy with the regulators, resulting in decisions that help incumbent firms, rather than unbiased regulation).