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Coase Theorem

Describes the economic efficiency of an economic allocation or outcome in the presence of externalities Main Point- If trade is possible in externalities and there are no transactional costs bargaining will lead to an efficient outcome regardless of the initial allocation of property rights Or simply speaking when Private Markets run into trouble there is a secondary market where externalities can be traded without external conditions

Beginning of the theorem

He developed the theory based on the radio frequencies problem Property rights ought to be well defined The allocation of property rights was immaterial The one with highest revenue generation would pay other party for not interfering The parties could mutually strike a deal Transaction costs however could not be ignored Should property rights be initially assigned to the actors gaining the most utility from them?

Some issues
First problem in real life is that nobody knows ex ante the most valued use of a resource Also, that there exist costs involving the reallocation of resources by government. Another, more refined normative conclusion is that government should create institutions that minimize transaction costs, so as to allow misallocations of resources to be corrected as cheaply as possible.

For example, two property owners own land on a mountainside. Owner #1's land is upstream from Owner #2 and there is significant, damaging runoff from Owner #1's land to Owner #2's land. Four scenarios are considered: The damage caused to the property is $100 and the cost of construction of wall is $50

1.If a cause of action exists (i.e. #2 could sue #1 for damages and win) & the property damage equals $100 while the cost of building a wall to stop the runoff equals $50, the wall will probably exist. Owner #1 will build the wall, or pay Owner #2 between $1 & $50 for nuisance. 2.If a cause of action exists and the damage equals $50 while the cost of a wall is $100, the wall will not exist. Owner #2 may sue, win the case and the court will order Owner #1 to pay #2 $50. This is cheaper than actually building the wall. Courts rarely order persons to do or not to do actions, they prefer monetary awards

3. If a cause of action does not exist, and the damage equals $100 while the cost of the wall equals $50, the wall will exist. Even though #2 cannot win the lawsuit, he or she will still pay #1 some amount between $51 and $99 to build the wall.
4. If a cause of action does not exist, and the damage equals $50 while the wall will cost $100, the wall will not exist. #2 cannot win the lawsuit and the economic realities of trying to get the wall built are prohibitive.

The Externality of Planting Pear Trees: Let's assume the following:

Cost of Planting a tree is $25: how many trees will be planted

An externality is a benefit or cost that is not experienced by the agent making the production or consumption decision.
Pecuniary externalities

Non-pecuniary externalities
Air pollution

Bilateral and multilateral externalities Public goods

Examples of Externalities
Negative externalities
Irritating behavior Grading on a curve Global warming

Positive externalities
Lawn care Scientific discoveries Vaccinations

Externalities and Market Failure

Market Failure
Strictly speaking, a market failure occurs whenever there is deadweight loss, which represents unrealized gains from trade. An externality creates a market failure by causing the market to consume an inefficient quantity of a good.

Optimality condition: under perfect competition, MB=MC implies Pareto optimality. For any externality, the social benefit (or social cost) deviates from the private benefit (or private cost).

Pareto Optimality
Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made. If one person has 100% resources and another 0% then change in distribution will make one person worse off !!

Example: a Paper Producer

Implication: the optimal amount of pollution is not zero!

The firm maximizes profit with respect to private cost but not social cost.

To reach the social optimum, the firm must account for the social cost, which is the sum of the private cost and the cost to others (cg).

If this cost is positive, it forces the firm to optimize at a higher price/lower quantity. How is a positive externality different?

Perloff Appendix 18A

An industry has inverse demand P=a-bQ.

Marginal private cost is linear: MCp=c+dQ. Marginal social cost includes an additional term: MCs=c+(d+e)Q.

At the competitive equilibrium, P=MCp.


At the social optimum, P=MCs

Qo=(a-c)/(b+d+e), Po=a-b(a-c)/(b+d+e)

Internalizing the Externality

Option 1: Tax the quantity (A Pigouvian Tax)
Specific tax: a fixed amount per quantity. Alternatively, set the tax equal to the marginal social cost, which varies with quantity In principle, either of these taxes can be set to reach the efficient quantity.

When possible, it is better to tax the externality directly rather than an input in the externalitys production function.
Example: a tax on cars, or a tax on gasoline?

Option 2: Regulate the quantity Either of these options is great if the government observes all of the relevant information.

A Pigouvian Tax

If the government knows the optimal quantity, it can impose that quantity through regulation. Complications arise if the government does not know the optimal quantity, or if the impact of the externality is heterogeneous. Example: two farmers produce pollution through their use of pesticides, but the farmers have different marginal benefit curves.
Efficiency dictates that MB=MSC for each farmer. This implies that one farmer must reduce his use of pesticides more than the other farmer because he receives less benefit from their use.


Market Structure with an Externality

Less competition may be good for a market with a negative externality.
Under perfect competition, the market consumes too much of the good. A monopoly restricts quantity.

Welfare implications
If the monopoly and competitive quantities both exceed the social optimum, then the monopoly improves welfare. If the monopoly quantity is less than the social optimum, then the implication is ambiguous.

Monopoly with an Externality

Example with Monopoly

A monopoly has inverse demand P=a-bQ. The monopolist reduces quantity
Marginal private cost is MCp=c+dQ Marginal social cost is MCs=c+(d+e)Q Setting MR=MC, a-2bQ=c+dQ Q*=(a-c)/(2b+d), P*=a-b(a-c)/(2b+d) Q*=Qo only if b=e (no reason why this would necessarily be true).

A tax on the monopolist

Taxing at a rate of eQ leads to a quantity of Q**=(a-c)/(2b+d+e), which is too little quantity. Exercise: solve for the optimal tax rate for a monopolist.

Bargaining and the Coase Theorem

To achieve the socially optimal outcome through taxes or regulation, the government must know a lot about the demand curve, the supply curve, and the social cost of the externality. Poorly-defined property rights are the root cause of externalities. One way to internalize an externality is to assign a clear property right. Coase Theorem: if bargaining is costless, assigning a property right eliminates the externality and leads to an efficient allocation of resources.

Example: a Smoker and a Non-Smoker

Two goods: smoke and money. Person A enjoys money (M) and smoke (S). Person B enjoys money and the absence of smoke. The indifference curves of these two people will be tangent at any efficient allocation. Assigning a property right amounts to picking an initial endowment of M and S.

A Smoker and a Non-Smoker

Limitations of Bargaining
For the Coase Theorem to apply, bargaining must be costless. In many situations, bargaining is costly.
The cost of bargaining is relative to the gain. If the matter is not consequential, it will not be in either sides interest to bargain. The cost of bargaining rises with the number of agents. Imagine a polluter negotiating with multiple factions within a community. Strategic dynamics may also become important. It may be costly to quantify the externality. Agents may have asymmetric information about the costs and benefits of bargaining.

A Coasian Bargaining Game

No Property rights allocated Fs pollution reduces BRs profit. Bs production does not affect Fs profits.

The factory (F) imposes a negative externality on the boat rental company (BR).

The social optimum is 1 ton of pollution and 1 rental (highest total payoff) If pollution is allowed, the NE is 2 tons of pollution and 1 rental. If pollution is not allowed, the NE is 0 tons of pollution and 2 rentals.

Boat Rental (number of boats) 0 Factory (tons of pollution) 0 1 2 0,0 10,0 15,0 1 0,14 10,10 15,2 2 0,15 10,5 15,-3

A Coasian Bargaining Game

Suppose BR has the right to a lake without pollution, but F can pay $7 per ton to pollute. The new payoffs are given below:
Now the NE is 1 ton of pollution, 1 rental. The aggregate payoff is maximized. Reaching this solution did not require taxes or regulation.

Boat Rental (number of boats) 0 Factory (tons of pollution) 0 1 2 0,0 3,7 1,14 1 0,14 3,17 1,16 2 0,15 3,12 1,11

A Coasian Bargaining Game

Suppose instead that F has the right to pollute, but BR may pay (bribe) it $6 per ton not to pollute.
The NE is 1 ton of pollution and 1 boat. The outcome is the same but the distribution of payoffs differs from the previous case.

Boat Rental (number of boats) 0 1 2

Factory (tons of pollution)

1 2

16,-6 15,0

16,4 15,2

16,-1 15,-3

Incentives for Pollution Abatement

If firms have heterogeneous marginal costs of abatement, mandating the same reduction from both is inefficient
Suppose both firms reduce emissions by 50, the MC of abatement is lower on the left, meaning we could achieve the same abatement at lower cost by cutting on the right and adding on the left.

Emissions Fees
This approach is frequently contrasted with an emissions tax.
The tax on output (discussed above) does not incentivize the polluter to search for other ways (besides output reduction) to reduce pollution. Example: a gas tax incentivizes fewer carbon emissions through gas conservation, but does not incentivize fewer carbon emissions through technologies that would make gas emit less carbon per unit. Instead, the government could tax the emissions directly.

An Emissions Fee