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 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.

- [Narrator] If you want
to test yourself,

click "Practice Questions."

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

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