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

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and market solutions[br]to externality problems.

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Basically what Coase[br]pointed out in a remarkable paper

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was that the problem[br]with external benefits

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and external cost is not[br]that they're external,

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but rather that property rights[br]in these cases

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are vague and uncertain

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and that transactions costs[br]are high.

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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[br]would underprovide

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honey and pollination services.

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Bees, Meade argued, do two things.

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First, they create honey.

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That honey is bought[br]and sold in markets

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and there's a price for the honey.

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Second, however,[br]bees will also fly out

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and they'll pollinate the crops[br]of nearby farmers.

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That's a very useful service,[br]but Meade argued

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that the farmers wouldn't[br]be paying for that service.

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The pollination services,[br]Meade argued,

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were an external benefit.

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Because the beekeepers[br]were not being paid

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for these useful[br]pollination services,

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there would be too few bees,[br]and as a result, too little honey,

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and also too little crops[br]and too little pollination services.

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However, another economist,[br]Steven Cheung,

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proved that the Nobel Prize winner[br]was wrong,

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and he did so[br]by consulting the Yellow Pages.

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Cheung discovered that pollination[br]in the United States, in fact,

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is a $15 billion industry.

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Beekeepers regularly truck[br]their bee colonies

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around the country and they sell

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their pollination services[br]to farmers.

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Because the farmers[br]are paying the beekeepers

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for the services of the bees,

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the benefits in fact[br]are not external --

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they're not on bystanders --[br]and the market works.

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So why did Meade get it wrong?

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What about the bees,[br]and what about the farmers,

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made it possible[br]for this externality problem

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to be solved by markets

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when many other[br]externality problems are not?

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The market for pollination works

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despite the fact that bees seem[br]to create this external benefit

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because transactions costs are low.

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That is, all of the costs[br]necessary for buyers and sellers

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to reach an agreement are low.

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In particular,[br]bees simply don't fly very far.

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So an agreement between[br]one beekeeper and one farmer

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can internalize all the externality.

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That is, if the beekeeper[br]puts his bees

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in the middle of the farm,

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

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are the crops[br]of that single farmer.

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So once an agreement is made

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between that beekeeper[br]and that farmer,

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all of the externalities[br]have been internalized.

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There are no bystanders

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

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Moreover, the property rights here[br]are very clear.

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The beekeeper has[br]the rights to the honey.

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The farmer owns the crops[br]that the bees pollinate.

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There isn't going to be a lot[br]of bargaining and disagreement

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about who owns what.

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The property rights are clear.

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In other cases of externalities,

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some of the ones[br]we've looked at previously,

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neither of these things are true.

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Transactions costs are high[br]and property rights are unclear.

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Let's compare with pollution[br]and flu shots.

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In both cases here,[br]the transactions costs are high

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and property rights[br]are unclear and uncertain.

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Consider pollution:[br]there's an external cost --

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the factory is putting[br]lots of pollution up into the sky,

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but on who?

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It's not necessarily on the people

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who live right next door[br]to the factory.

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The pollution[br]could be causing acid rain,

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which is ruining lakes[br]hundreds of miles away,

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or it could be causing[br]global warming

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which is increasing sea levels

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and ruining people's lives[br]thousands of miles away.

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And exactly what are the costs?[br]How much?

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How can we measure these costs?[br]It's not obvious.

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Moreover, who has the rights here?

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Should the factory[br]have to pay to pollute?

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Should it have to pay the people

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to whom it imposes[br]an external cost?

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

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Does the factory[br]have the right not to pollute,

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and do the bystanders[br]have to pay the factory to stop?

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If you think that's obvious,[br]let's consider a flu shot.

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There are external benefits[br]if I get a flu shot.

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For example, I'm less likely[br]to sneeze on people on the subway

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and give them the flu[br]but that could be hundreds,

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dozens of people,[br]hundreds of people.

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I don't know exactly which people[br]get the external benefit.

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And how much[br]is this external benefit?

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It's hard to measure, once again.

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Moreover, should people[br]have to pay me to get a flu shot

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

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Now, by the way, let's compare[br]these two things --

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the pollution and the flu shot.

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If you thought it was obvious

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that the factory should have[br]to pay to pollute

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and not that the bystanders[br]should have to pay the factory,

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well, consider the flu shot.

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

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isn't sneezing,[br]isn't that like pollution?

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Isn't that polluting?

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Shouldn't the polluter,[br]the sneezer have to pay?

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So in that case[br]you might want to argue

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that if you don't get a flu shot,[br]you should have to pay others.

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You're polluting on them. Right?

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So the rights here[br]are not as obvious

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as we might think at first glance.

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Moreover, the main point is,[br]is that the transactions costs

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of coming to an agreement

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between these hundreds[br]or thousands

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or perhaps millions of people,

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figuring out[br]what the external costs are,

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

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And, we can't even agree[br]on who has the rights here,

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or it's very difficult[br]to come to an agreement.

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Should the factory have to pay?

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Should the factory[br]be the one to be paid?

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Should the person[br]getting the flu shot be paid,

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or should the person not getting[br]the flu shot have to pay?

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The rights here are uncertain,[br]and unclear, and again,

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that's also going to make[br]coming to a market agreement

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difficult to do,

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and therefore the market[br]isn't going to solve these types

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of externality problems[br]very easily.

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So the conclusion here is[br]that the market can be efficient

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even when there are externalities --

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when transactions costs are low

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and when property rights[br]are clearly defined.

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And in fact[br]that's the Coase Theorem.

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If transactions costs are low

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and property rights[br]are clearly defined,

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private bargains will ensure

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that the market equilibrium[br]is efficient

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even if there are externalities.

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The conditions[br]for the Coase Theorem to be met,

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low transactions costs[br]and clear property rights,

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are in practice often not met.

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Even so, however,[br]the theorem does suggest

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an alternative approach[br]to externalities.

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We've already looked at[br]the Pigouvian taxes and subsidies,

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and command and control.

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The Coase Theorem[br]suggests another solution,

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namely the creation of new markets.

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If the government[br]can define property rights

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and reduce transactions costs,

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then markets can be used[br]to control externality problems.

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

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

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can create a new form of solution[br]to externality problems.

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And in fact tradable, permits is[br]what we're going to be looking at

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in the next talk.

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- [Narrator] If you want[br]to test yourself,

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click "Practice Questions."

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Or, if you're ready to move on,[br]just click "Next Video."

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