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Coase Theorem. Ronald Coase, Nobel Prize winning economist, born 1910, still living! 1937: “The Nature of the Firm” 1960: “The Problem of Social Cost” Theorem: No problems of social cost would arise in a world where: There is perfect competition There is complete information - PowerPoint PPT Presentation
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Coase Theorem
Ronald Coase, Nobel Prize winning economist, born 1910, still living!
1937: “The Nature of the Firm” 1960: “The Problem of Social Cost” Theorem: No problems of social cost would
arise in a world where: There is perfect competition There is complete information Transactions are costless
Rancher vs. farmer
Rancher’s cattle stray onto farmer’s land and damage the crops. What to do?
Six possible solutions Put up a fence
paid for by rancher paid for by farmer
Allow cattle to stray and do damage rancher reimburses farmer for damage farmer absorbs cost of damage
Rancher stops raising cattle Farmer stops growing crops
Assumptions
Numbers (chosen by Coase) Damage done by cattle: $90 Fence costs $110 Farmer loses $100 if he doesn’t raise crops Rancher loses $200 if he doesn’t raise cattle
Two entitlement scenarios Farmer is entitled to raise his crops without
damage Rancher is entitled to raise his cattle irrespective
of damage
Case 1: Farmer is entitled to raise his crops without damage Rancher has to decide what to do Possible strategies for rancher:
(1) Allow cattle to roam, pay $90 damages to farmer
(2) Put up fence, pay $110 (3) Pay farmer $100 not to raise crops (4) Stop raising cattle, absorb $200 loss
Case 2: rancher is entitled to let his cattle roam free
Farmer must decide what to do Possible strategies for farmer
(1) Allow cattle to roam, absorb damage: $90 (2) Put up fence: $110 (3) Don’t plant crops, forgo $100 income (4) Pay rancher not to raise cattle: $200
Conclusion
Same outcome irrespective of who holds the legal entitlement
No need of government involvement (prosecutors, courts) under stated assumptions: There is perfect competition There is complete information Transactions are costless
Is justice served? Perhaps not, but total costs (“social costs”) are minimized
Implications of assumption of zero transaction costs
Courts costs are a form of transaction costs and would not exist. Courts might not even exist.
Police would not exist
Implications of assumption of perfect information
No disputes about entitlements could arise All contracts would perfectly anticipate all
contingencies Torts could not happen
What good is the Coase Theorem with such drastic assumptions?
It is a counterfactual situation invented just to clarify the real, factual world
Real world: transacting is always costly, but reducing transaction costs gets us closer to efficient outcomes. Law is needed.
Transaction costs can be introduced into the analysis (Table 4.2)
Coase vs. Pigou
Example (Friedman) Steel mill does $200,000 annual damage to
neighboring property Steel mill could stop pollution at a cost of
$100,000 Neighbor could shift land use from summer
resort to growing timber at a cost of $50,000 Coase solution
First possibility: steel mill owner has the right to pollute.
Continues to pollute Neighbor shifts to timber Cost: $50,000
Coase vs. Pigou
Coase solution, continued Second possibility: neighbor has the right to be
free of pollution. Steel owner continues to pollute Pays neighbor to shift from resort to timber Cost: $50,000
Pigou solution: Government collects a fine equal to the damage
done, $200,000 Steel mill stops polluting, $100,000 damage
eliminated Net cost $100,000
Coase theorem conclusions
In the imaginary world of zero transaction costs Negative externality problems are jointly caused Parties will find the least-cost solution by
negotiation No formal law is needed, nor any government
action The final result is the same irrespective of the
initial distribution of property rights In the real world of positive transaction costs
Law does matter We can move toward least-cost solutions
Pollution mitigation
Suppose three factories emit pollutants in various quantities and they have varying mitigation costs Factory A emits 15,000 units per month, cleanup
cost $1 per unit Factory B emits 30,000 units per month, cleanup
cost $2 per unit Factory C emits 45,000 units per month, cleanup
cost $3 per unit First approach: EPA prohibits emissions
exceeding 15,000 units per month Factory A does nothing Factory B spends (30,000-15,000)x2 = $30,000 Factory C spends (45,000-15,000)x3 = $90,000 Total cost $120,000, total benefit 45,000 units
Pollution mitigation
Second solution: EPA requires each factory to cut its emissions in half Factory A: 7,500 units x $1 = $7,500 Factory B: 15,000 units x $2 = $30,000 Factory C: 22,500 units x $3 = $67,500 Total cost $105,000, total benefit 45,000 units
Third solution: EPA requires each factory to cut its emissions by 15,000 units Factory A: 15,000 units x $1 = $15,000 Factory B: 15,000 units x $2 = $30,000 Factory C: 15,000 units x $3 = $45,000 Total cost $90,000, total benefit 45,000 units
Pollution mitigation
Fourth solution: EPA requires each factory to cut its emissions in half Factory A: 7,500 units x $1 = $7,500 Factory B: 15,000 units x $2 = $30,000 Factory C: 22,500 units x $3 = $67,500 Total cost $105,000, total benefit 45,000 units
Fifth solution: Pigovian tax Impose $2.01 unit tax on all factories Factory A will eliminate all its pollution, cost
$15,000, benefit 15,000 units Factory B will eliminate all its pollution, cost
$60,000, benefit 30,000 units Factory C will continue polluting Total cost $75,000, total benefit 45,000 units Total benefit to EPA: $90,450
Pollution mitigation
Sixth solution (Coase): EPA mandates total pollution reduction, allows factories to trade pollution rights EPA orders factory C to reduce total emissions
by 45,000 units or pay $2.01 fine for each unit by which they fall short
Factory C is the high-cost avoider of pollution Factory C will offer factory A $15,000 (plus $100
for their trouble) to eliminate its emissions Factory C will then offer factory B $60,000 (plus
$100 for their trouble) to eliminate its 30,000 units
Factory C continues polluting Total cost $75,200 vs. $135,000 to cleanup