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- Today we're going to look at the
Coase Theorem and market solutions to

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externality problems. Basically what Coase
pointed out in a remarkable paper was that

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the problem with external benefits and
external cost is not that they're

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external but rather that property rights
in these cases are vague and uncertain

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and that transactions costs are high.
Let's get started with an example.

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- The Nobel prize winning
economist James Meade

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argued that the market would under provide
honey and pollination services. Bees Meade

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argued do two things first they create
honey. That honey is bought and sold in

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markets and there's a price for the honey.
Second however, bees will also fly out and

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they'll pollinate the crops of nearby
farmers. That's a very useful service but

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Meade argued that the farmers wouldn't be
paying for that service. The pollination

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services Meade argued were an external
benefit because the beekeepers were not

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being paid for this useful pollination
services there would be too few bees and

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as a result too little honey, and
also too little crops and too

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little pollination services.

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However, another economist Steven Cheung
proved that the Nobel prize winner was

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wrong and he did so by consulting the
yellow pages. Cheung discovered that

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pollination in the United States in fact
is a $15 billion industry. Beekeepers

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regularly truck their bee colonies around
the country and they sell their

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pollination services to farmers because
the farmers are paying the beekeepers for

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the services of the bees the benefits in
fact are not external. They're not on

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bystanders and the market works.
So why did Meade get it wrong? What about

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the bees and what about the farmers made
it possible for this externality problem

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to be solved by markets when many other
externality problems are not?

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The market for pollination works despite
the fact that bees seem to create this

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external benefit because transactions
costs are low that is all of the costs

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necessary for buyers and sellers to reach
an agreement are low. In particular, bees

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simply don't fly very far. So an agreement
between one beekeeper and one farmer can

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internalize all the externality that is if
the beekeeper puts his bees in the middle

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of the farm basically the only crops
which are going to be pollinated are the

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crops of that single farmer. So once an
agreement is made between that beekeeper

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and that farmer all of the externalities
have been internalized. There are no

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bystanders once the beekeeper and the
farmer make an agreement. Moreover, the

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property rights here are very clear. The
beekeeper has the rights to the honey. The

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farmer owns the crops that the bees
pollinate. There isn't going to be a lot

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of bargaining and disagreement but who
owns what? The property rights are clear.

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In other cases of externalities, some of
the ones we've looked at previously

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neither of these things are true.
Transactions cost are high and property

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rights are unclear. Let's compare with
pollution and flu shots. In both cases

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here, the transactions costs are high and
property rights are unclear and uncertain.

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Consider pollution there's an external
cost the factory is putting lots of

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pollution up into the sky but on who?
It's not necessarily on the people who

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live right next door to the factory.
The pollution could be causing acid rain,

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which is ruining lakes hundreds of miles
away or it could be causing global

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warming which is increasing sea levels and
ruining people's lives thousands of miles

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away and exactly what are the costs? How
much? How can we measure these costs? It's

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not obvious. Moreover, who has the rights
here? Should the factory have to pay to

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pollute? Should it have to pay the people
to whom it imposes an external cost or

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should the bystanders have to pay the
factory not to pollute? Does the factory

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have the right not to pollute and do the
bystanders have to pay the factory to

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stop? If you think
that's obvious,

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let's consider a flu shot. There
are external benefits if I get

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a flu shot for example I'm less likely
to sneeze on people on the subway and give

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them the flu but that could be hundreds,
dozens of people, hundreds of people. I

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don't know exactly which people get the
external benefit and how much is this

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external benefit? It's hard to measure
once again. Moreover, should people have

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to pay me to get a flu shot or should I
have to pay others if I don't get a shot.

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Now by the way let's compare these two
things, the pollution and the flu shot. If

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you thought it was obvious that the
factory should have to pay to pollute and

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not that the bystanders should have to pay
the factory. Well consider the flu shot,

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isn't sneezing, if you don't get a flu
shot isn't sneezing, isn't that like

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pollution? Isn't that polluting? Shouldn't
the polluter, the sneezer have to pay? So

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in that case you might want to argue that
if you don't get a flu shot, you should

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have to pay others. You're polluting on
them. Right? So the rights here are not as

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obvious as we might think at first glance.
Moreover the main point is, is that the

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transactions costs of coming to an
agreement between these hundreds or

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thousands or perhaps millions of people
figuring out what the external costs are

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making that bargain.
That's going to be very costly and we

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can't even agree on who has the rights
here or it's very difficult to come to an

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agreement. Should the factory have to pay?
Should the factory be the one to be paid?

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Should the person getting the flu shot be
paid, or should the person not getting the

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flu shot have to pay? The rights here are
uncertain, and unclear and again that's

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also going to make coming to a market
agreement difficult to do and therefore

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the market isn't going to solve these
types of externality problems very easily.

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So the conclusion here is that the market
can be efficient even when there are

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externalities when transactions costs are
low and when property rights are clearly

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defined and in fact that's the Coase
Theorem. If transactions costs are low and

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property rights are clearly defined
private bargains will insure that the

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market equilibrium is efficient even if
there are externalities.

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The conditions for the Coase Theorem to be
met low transactions costs and clear

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property rights are in practice often not
met. Even so, however the theorem does

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suggest an alternative approach to
externalities. We've already looked at the

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Pigovian taxes and subsidies, and command
and control. The Coase Theorem suggests

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another solution namely the creation of
new markets. If the government can define

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property rights and reduce transactions
costs then markets can be used to control

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externality problems. So the Coase Theorem
plus a little bit of command and control

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in terms of defining property rights and
reducing transactions costs can create a

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new form of solution to externality
problems and in fact tradable permits is

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what we're going to be
looking at in the next talk.

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