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

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

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

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External, but rather that property rights[br]in these cases are vague and uncertain

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

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The Nobel prize winning[br]economist, James Meade,

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argued that the market would underprovide[br]honey and pollination services. Bees, Meade

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argued, do two things. First, they create[br]honey. That honey is bought and sold in

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

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

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

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services, Meade argued, were an external[br]benefit. Because the beekeepers were not

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being paid for these useful pollination[br]services, there would be too few bees, and

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as a result, too little honey, and[br]also too little crops and too

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little pollination services.

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However, another economist, Steven Cheung,[br]proved that the Nobel Prize winner was

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wrong, and he did so by consulting the[br]Yellow Pages. Cheung discovered that

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pollination in the United States, in fact,[br]is a $15 billion industry. Beekeepers

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regularly truck their bee colonies around[br]the country and they sell their

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pollination services to farmers. Because[br]the farmers are paying the beekeepers for

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the services of the bees, the benefits in[br]fact are not external - they're not on

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

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the bees, and what about the farmers, made[br]it possible for this externality problem

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

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

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external benefit because transactions[br]costs are low. That is, all of the costs

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

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

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internalize all the externality. That is, if[br]the beekeeper puts his bees in the middle

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of the farm, basically the only crops[br]which are going to be pollinated are the

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

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and that farmer, all of the externalities[br]have been internalized. There are no

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

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

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

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of bargaining and disagreement about who[br]owns what. The property rights are clear.

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

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neither of these things are true.[br]Transactions costs are high and property

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

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

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Consider pollution: there's an external[br]cost - the factory is putting lots of

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pollution up into the sky, but on who?[br]It's not necessarily on the people who

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

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which is ruining lakes hundreds of miles[br]away, or it could be causing global

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

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away. And exactly what are the costs? How[br]much? How can we measure these costs? It's

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

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pollute? Should it have to pay the people[br]to whom it imposes an external cost? Or,

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should the bystanders have to pay the[br]factory not to pollute? Does the factory

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have the right not to pollute, and do the[br]bystanders have to pay the factory to

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stop? If you think[br]that's obvious,

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

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a flu shot. For example, I'm less likely[br]to sneeze on people on the subway and give

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

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don't know exactly which people get the[br]external benefit. And how much is this

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

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to pay me to get a flu shot or should I[br]have to pay others if I don't get a shot?

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

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

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not that the bystanders should have to pay[br]the factory, well, consider the flu shot.

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Isn't sneezing, if you don't get a flu[br]shot, isn't sneezing, isn't that like

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

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

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

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

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transactions costs of coming to an[br]agreement between these hundreds or

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thousands or perhaps millions of people,[br]figuring out what the external costs are,

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making that bargain, that's going [br]to be very costly. And, we

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

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

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

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

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also going to make coming to a market[br]agreement difficult to do, and therefore

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

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

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externalities - when transactions costs are[br]low and when property rights are clearly

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

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property rights are clearly defined,[br]private bargains will ensure that the

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market equilibrium is efficient even if[br]there are externalities.

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The conditions for the Coase Theorem to be[br]met, low transactions costs and clear

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

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

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Pigouvian taxes and subsidies, and command[br]and control. The Coase Theorem suggests

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another solution, namely the creation of[br]new markets. If the government can define

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property rights and reduce transactions[br]costs, then markets can be used to control

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

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in terms of defining property rights and[br]reducing transactions costs, can create a

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new form of solution to externality[br]problems. And in fact tradable, permits is

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

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- [Announcer] If you want to test[br]yourself, click "Practice Questions." Or,

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