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- Today we're going to look at the Coase Theorem and market solutions to
externality problems. Basically what Coase pointed out in a remarkable paper was that
the problem with external benefits and external cost is not that they're
external but rather that property rights in these cases are vague and uncertain
and that transactions costs are high. Let's get started with an example.
- The Nobel prize winning economist James Meade
argued that the market would under provide honey and pollination services. Bees Meade
argued do two things first they create honey. That honey is bought and sold in
markets and there's a price for the honey. Second however, bees will also fly out and
they'll pollinate the crops of nearby farmers. That's a very useful service but
Meade argued that the farmers wouldn't be paying for that service. The pollination
services Meade argued were an external benefit because the beekeepers were not
being paid for this useful pollination services there would be too few bees and
as a result too little honey, and also too little crops and too
little pollination services.
However, another economist Steven Cheung proved that the Nobel prize winner was
wrong and he did so by consulting the yellow pages. Cheung discovered that
pollination in the United States in fact is a $15 billion industry. Beekeepers
regularly truck their bee colonies around the country and they sell their
pollination services to farmers because the farmers are paying the beekeepers for
the services of the bees the benefits in fact are not external. They're not on
bystanders and the market works. So why did Meade get it wrong? What about
the bees and what about the farmers made it possible for this externality problem
to be solved by markets when many other externality problems are not?
The market for pollination works despite the fact that bees seem to create this
external benefit because transactions costs are low that is all of the costs
necessary for buyers and sellers to reach an agreement are low. In particular, bees
simply don't fly very far. So an agreement between one beekeeper and one farmer can
internalize all the externality that is if the beekeeper puts his bees in the middle
of the farm basically the only crops which are going to be pollinated are the
crops of that single farmer. So once an agreement is made between that beekeeper
and that farmer all of the externalities have been internalized. There are no
bystanders once the beekeeper and the farmer make an agreement. Moreover, the
property rights here are very clear. The beekeeper has the rights to the honey. The
farmer owns the crops that the bees pollinate. There isn't going to be a lot
of bargaining and disagreement but who owns what? The property rights are clear.
In other cases of externalities, some of the ones we've looked at previously
neither of these things are true. Transactions cost are high and property
rights are unclear. Let's compare with pollution and flu shots. In both cases
here, the transactions costs are high and property rights are unclear and uncertain.
Consider pollution there's an external cost the factory is putting lots of
pollution up into the sky but on who? It's not necessarily on the people who
live right next door to the factory. The pollution could be causing acid rain,
which is ruining lakes hundreds of miles away or it could be causing global
warming which is increasing sea levels and ruining people's lives thousands of miles
away and exactly what are the costs? How much? How can we measure these costs? It's
not obvious. Moreover, who has the rights here? Should the factory have to pay to
pollute? Should it have to pay the people to whom it imposes an external cost or
should the bystanders have to pay the factory not to pollute? Does the factory
have the right not to pollute and do the bystanders have to pay the factory to
stop? If you think that's obvious,
let's consider a flu shot. There are external benefits if I get
a flu shot for example I'm less likely to sneeze on people on the subway and give
them the flu but that could be hundreds, dozens of people, hundreds of people. I
don't know exactly which people get the external benefit and how much is this
external benefit? It's hard to measure once again. Moreover, should people have
to pay me to get a flu shot or should I have to pay others if I don't get a shot.
Now by the way let's compare these two things, the pollution and the flu shot. If
you thought it was obvious that the factory should have to pay to pollute and
not that the bystanders should have to pay the factory. Well consider the flu shot,
isn't sneezing, if you don't get a flu shot isn't sneezing, isn't that like
pollution? Isn't that polluting? Shouldn't the polluter, the sneezer have to pay? So
in that case you might want to argue that if you don't get a flu shot, you should
have to pay others. You're polluting on them. Right? So the rights here are not as
obvious as we might think at first glance. Moreover the main point is, is that the
transactions costs of coming to an agreement between these hundreds or
thousands or perhaps millions of people figuring out what the external costs are
making that bargain. That's going to be very costly and we
can't even agree on who has the rights here or it's very difficult to come to an
agreement. Should the factory have to pay? Should the factory be the one to be paid?
Should the person getting the flu shot be paid, or should the person not getting the
flu shot have to pay? The rights here are uncertain, and unclear and again that's
also going to make coming to a market agreement difficult to do and therefore
the market isn't going to solve these types of externality problems very easily.
So the conclusion here is that the market can be efficient even when there are
externalities when transactions costs are low and when property rights are clearly
defined and in fact that's the Coase Theorem. If transactions costs are low and
property rights are clearly defined private bargains will insure that the
market equilibrium is efficient even if there are externalities.
The conditions for the Coase Theorem to be met low transactions costs and clear
property rights are in practice often not met. Even so, however the theorem does
suggest an alternative approach to externalities. We've already looked at the
Pigovian taxes and subsidies, and command and control. The Coase Theorem suggests
another solution namely the creation of new markets. If the government can define
property rights and reduce transactions costs then markets can be used to control
externality problems. So the Coase Theorem plus a little bit of command and control
in terms of defining property rights and reducing transactions costs can create a
new form of solution to externality problems and in fact tradable permits is
what we're going to be looking at in the next talk.
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