The Coase Theorem

In this video, we show how bees and pollination demonstrate the Coase Theorem in action: when transaction costs are low and property rights are clearly defined, private arrangements ensure that the market works even when there are externalities. Under these conditions, the market properly manages externalities.

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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 under provide
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 this 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 but 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 cost 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 insure 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

Pigovian 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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