Coase Theorem

1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Implications of assumption of perfect information • No disputes about entitlements could arise • All contracts would perfectly anticipate all contingencies • Torts could not happen

9. 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)‏

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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