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

• Ranchers cattle stray onto farmers 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 doesnt raise crops
• Rancher loses 200 if he doesnt 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) Dont 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