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

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and market solutions
to externality problems.

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Basically what Coase
pointed out in a remarkable paper

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was that the problem
with external benefits

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and external cost is not
that they're external,

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but rather that property rights
in these cases

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are vague and uncertain

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and that transactions costs
are high.

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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 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
and sold in markets

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and there's a price for the honey.

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Second, however,
bees will also fly out

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and they'll pollinate the crops
of nearby farmers.

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That's a very useful service,
but Meade argued

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that the farmers wouldn't
be paying for that service.

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The pollination services,
Meade argued,

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were an external benefit.

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Because the beekeepers
were not being paid

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for these useful
pollination services,

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

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and also too little crops
and too little pollination services.

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However, another economist,
Steven Cheung,

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proved that the Nobel Prize winner
was wrong,

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and he did so
by consulting the Yellow Pages.

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Cheung discovered that pollination
in the United States, in fact,

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is a $15 billion industry.

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Beekeepers regularly truck
their bee colonies

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around the country and they sell

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their pollination services
to farmers.

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Because the farmers
are paying the beekeepers

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for the services of the bees,

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the benefits in fact
are not external --

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

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So why did Meade get it wrong?

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What about the bees,
and what about the farmers,

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made it possible
for this externality problem

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to be solved by markets

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when many other
externality problems are not?

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The market for pollination works

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despite the fact that bees seem
to create this external benefit

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because transactions costs are low.

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

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to reach an agreement are low.

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

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So an agreement between
one beekeeper and one farmer

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can internalize all the externality.

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That is, if the beekeeper
puts his bees

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in the middle of the farm,

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basically the only crops
which are going to be pollinated

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are the crops
of that single farmer.

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So once an agreement is made

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between that beekeeper
and that farmer,

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all of the externalities
have been internalized.

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There are no bystanders

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once the beekeeper and the farmer
make an agreement.

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Moreover, the property rights here
are very clear.

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The beekeeper has
the rights to the honey.

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The farmer owns the crops
that the bees pollinate.

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There isn't going to be a lot
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
we've looked at previously,

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neither of these things are true.

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Transactions costs are high
and property rights are unclear.

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Let's compare with pollution
and flu shots.

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In both cases here,
the transactions costs are high

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and property rights
are unclear and uncertain.

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Consider pollution:
there's an external cost --

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the factory is putting
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
to the factory.

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The pollution
could be causing acid rain,

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which is ruining lakes
hundreds of miles away,

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or it could be causing
global warming

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which is increasing sea levels

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and ruining people's lives
thousands of miles away.

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And exactly what are the costs?
How much?

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

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Moreover, who has the rights here?

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Should the factory
have to pay to pollute?

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Should it have to pay the people

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to whom it imposes
an external cost?

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

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Does the factory
have the right not to pollute,

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and do the bystanders
have to pay the factory to stop?

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

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There are external benefits
if I get a flu shot.

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

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and give them the flu
but that could be hundreds,

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dozens of people,
hundreds of people.

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

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And how much
is this external benefit?

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It's hard to measure, once again.

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

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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 --

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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
to pay to pollute

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and not that the bystanders
should have to pay the factory,

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well, consider the flu shot.

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

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isn't sneezing,
isn't that like pollution?

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Isn't that polluting?

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Shouldn't the polluter,
the sneezer have to pay?

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So in that case
you might want to argue

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

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You're polluting on them. Right?

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So the rights here
are not as obvious

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as we might think at first glance.

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Moreover, the main point is,
is that the transactions costs

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of coming to an agreement

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between these hundreds
or thousands

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or perhaps millions of people,

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figuring out
what the external costs are,

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

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

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or it's very difficult
to come to an agreement.

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Should the factory have to pay?

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Should the factory
be the one to be paid?

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Should the person
getting the flu shot be paid,

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

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The rights here are uncertain,
and unclear, and again,

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that's also going to make
coming to a market agreement

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difficult to do,

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

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of externality problems
very easily.

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So the conclusion here is
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
are clearly defined.

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And in fact
that's the Coase Theorem.

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If transactions costs are low

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and property rights
are clearly defined,

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private bargains will ensure

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that the market equilibrium
is efficient

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even if there are externalities.

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The conditions
for the Coase Theorem to be met,

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low transactions costs
and clear property rights,

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are in practice often not met.

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Even so, however,
the theorem does suggest

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an alternative approach
to externalities.

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

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and command and control.

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The Coase Theorem
suggests another solution,

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namely the creation of new markets.

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If the government
can define property rights

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and reduce transactions costs,

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then markets can be used
to control externality problems.

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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,

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can create a new form of solution
to externality problems.

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

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in the next talk.

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- [Narrator] If you want
to test yourself,

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click "Practice Questions."

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

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♪ [music] ♪