Coase Theorem

Ronald Coase, Nobel Prize winning economist, born 1910, still living!

1937: “The Nature of the Firm” 1960: “The Problem of Social Cost” Theorem: No problems of social cost would

arise in a world where: There is perfect competition There is complete information Transactions are costless

Rancher vs. farmer

Rancher’s cattle stray onto farmer’s land and damage the crops. What to do?

Six possible solutions Put up a fence

paid for by rancher paid for by farmer

Allow cattle to stray and do damage rancher reimburses farmer for damage farmer absorbs cost of damage

Rancher stops raising cattle Farmer stops growing crops

Assumptions

Numbers (chosen by Coase) Damage done by cattle: $90 Fence costs $110 Farmer loses $100 if he doesn’t raise crops Rancher loses $200 if he doesn’t raise cattle

Two entitlement scenarios Farmer is entitled to raise his crops without

damage Rancher is entitled to raise his cattle irrespective

of damage

Case 1: Farmer is entitled to raise his crops without damage Rancher has to decide what to do Possible strategies for rancher:

(1) Allow cattle to roam, pay $90 damages to farmer

(2) Put up fence, pay $110 (3) Pay farmer $100 not to raise crops (4) Stop raising cattle, absorb $200 loss

Case 2: rancher is entitled to let his cattle roam free

Farmer must decide what to do Possible strategies for farmer

(1) Allow cattle to roam, absorb damage: $90 (2) Put up fence: $110 (3) Don’t plant crops, forgo $100 income (4) Pay rancher not to raise cattle: $200

Conclusion

Same outcome irrespective of who holds the legal entitlement

No need of government involvement (prosecutors, courts) under stated assumptions: There is perfect competition There is complete information Transactions are costless

Is justice served? Perhaps not, but total costs (“social costs”) are minimized

Implications of assumption of zero transaction costs

Courts costs are a form of transaction costs and would not exist. Courts might not even exist.

Police would not exist

Implications of assumption of perfect information

No disputes about entitlements could arise All contracts would perfectly anticipate all

contingencies Torts could not happen

What good is the Coase Theorem with such drastic assumptions?

It is a counterfactual situation invented just to clarify the real, factual world

Real world: transacting is always costly, but reducing transaction costs gets us closer to efficient outcomes. Law is needed.

Transaction costs can be introduced into the analysis (Table 4.2)

Coase vs. Pigou

Example (Friedman) Steel mill does $200,000 annual damage to

neighboring property Steel mill could stop pollution at a cost of

$100,000 Neighbor could shift land use from summer

resort to growing timber at a cost of $50,000 Coase solution

First possibility: steel mill owner has the right to pollute.

Continues to pollute Neighbor shifts to timber Cost: $50,000

Coase vs. Pigou

Coase solution, continued Second possibility: neighbor has the right to be

free of pollution. Steel owner continues to pollute Pays neighbor to shift from resort to timber Cost: $50,000

Pigou solution: Government collects a fine equal to the damage

done, $200,000 Steel mill stops polluting, $100,000 damage

eliminated Net cost $100,000

Coase theorem conclusions

In the imaginary world of zero transaction costs Negative externality problems are jointly caused Parties will find the least-cost solution by

negotiation No formal law is needed, nor any government

action The final result is the same irrespective of the

initial distribution of property rights In the real world of positive transaction costs

Law does matter We can move toward least-cost solutions

Pollution mitigation

Suppose three factories emit pollutants in various quantities and they have varying mitigation costs Factory A emits 15,000 units per month, cleanup

cost $1 per unit Factory B emits 30,000 units per month, cleanup

cost $2 per unit Factory C emits 45,000 units per month, cleanup

cost $3 per unit First approach: EPA prohibits emissions

exceeding 15,000 units per month Factory A does nothing Factory B spends (30,000-15,000)x2 = $30,000 Factory C spends (45,000-15,000)x3 = $90,000 Total cost $120,000, total benefit 45,000 units

Pollution mitigation

Second solution: EPA requires each factory to cut its emissions in half Factory A: 7,500 units x $1 = $7,500 Factory B: 15,000 units x $2 = $30,000 Factory C: 22,500 units x $3 = $67,500 Total cost $105,000, total benefit 45,000 units

Third solution: EPA requires each factory to cut its emissions by 15,000 units Factory A: 15,000 units x $1 = $15,000 Factory B: 15,000 units x $2 = $30,000 Factory C: 15,000 units x $3 = $45,000 Total cost $90,000, total benefit 45,000 units

Pollution mitigation

Fourth solution: EPA requires each factory to cut its emissions in half Factory A: 7,500 units x $1 = $7,500 Factory B: 15,000 units x $2 = $30,000 Factory C: 22,500 units x $3 = $67,500 Total cost $105,000, total benefit 45,000 units

Fifth solution: Pigovian tax Impose $2.01 unit tax on all factories Factory A will eliminate all its pollution, cost

$15,000, benefit 15,000 units Factory B will eliminate all its pollution, cost

$60,000, benefit 30,000 units Factory C will continue polluting Total cost $75,000, total benefit 45,000 units Total benefit to EPA: $90,450

Pollution mitigation

Sixth solution (Coase): EPA mandates total pollution reduction, allows factories to trade pollution rights EPA orders factory C to reduce total emissions

by 45,000 units or pay $2.01 fine for each unit by which they fall short

Factory C is the high-cost avoider of pollution Factory C will offer factory A $15,000 (plus $100

for their trouble) to eliminate its emissions Factory C will then offer factory B $60,000 (plus

$100 for their trouble) to eliminate its 30,000 units

Factory C continues polluting Total cost $75,200 vs. $135,000 to cleanup