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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 underprovide
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 these 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 about 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 costs 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 ensure 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
Pigouvian 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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