Negative Externalities & the Coase Theorem


Standard economic theory states that any voluntary exchange must be beneficial to both parties in the trade because no one would ever knowingly and voluntarily enter into a trade that somehow left them worse off. However, economic activities can cause additional effects on third parties not directly involved in the exchange. These effects are called externalities, because they are not borne by the people making the decision about the activity. They are also known as spill-over effects, and they can be negative (e.g., health problems caused by pollution from a factory), or positive (honey bees kept for honey that also pollinate crops).

When externalities are present, market prices fail to correctly signal the complete cost of goods or services, resulting in a misallocation of resources. In particular, negative externalities are a concern because they result in the market producing costs that subtract from social welfare. The following video explains the concept of negative externalities in micro-economic terms.

In Khan’s view, which corresponds to the standard neoclassical understanding of externalities, the solution to problems of external cost is to internalize the costs. In Khan’s example, simply raising the price of plastic bags by charging the bag producers (or consumers, it doesn’t matter) for social costs such as cleaning up litter will decrease plastic bag production and free up resources (capital, energy, material, labor) to produce other goods that people ultimately find more satisfying.

If plastic bags kill animals (or people), the economist asks “What are consumers willing to trade (in money) for these lost lives?”

Simply find that number, and adjust the price of bags accordingly until the enjoyment from the last bag produced (the marginal bag) is equivalent to the distress (i.e., cost) of the last (marginal) life loss.

This simplistic view of internalization is not particularly concerned with problems of distribution — i.e., who is killed, or who benefits (e.g., from plastic bags). The primary concern in the Khan video is allocation (how much to produce of which goods).  Internalization of external costs solves the allocation problem, but could still result in problems of distributional injustices.

“Solutions” to Negative Externalities

The following video reveals three theoretical ways to address the allocation problem of externalities, including: 1) taxation, 2) regulation, and 3) property rights. Taxation places the financial burden of external costs on the producer. Regulation can be in the form of requiring a technological fix or limiting the quantity of goods and/or pollution produced. The property rights solution is also known as the Coase Theorem, developed by Nobel Prize winner Ronald Coase. The theory states that optimal allocation of resources is achievable without any government intervention, provided that transaction costs are low and property rights are pre-determined. In this case, Coase claims that the polluting and damaged parties will negotiate a transfer of payments between them to either accept damage or reduce pollution — whichever is more profitable.

The Coase Theorem does not consider whether the Farmer or the Fishermen drive the harder bargain. That is, so long as profits (or enjoyment) as a whole are optimized, then the Coase Theorem is satisfied. But what if property rights are assigned to the Farmer? Suppose the Farmer would profit 10 (dollars, or whatever) from fertilization of the corn field. The fisherman enjoy fishing so much that they’d be willing to pay 15 to fish. According to Coase, the Fishermen complain to the Farmer that the fertilizer is killing fish, but the Farmer says that without the fertilizer, his profits would be reduced to 10. So the Fisherman offer to pay 6 to the Farmer to persuade him to stop using the fertilizer.

The Farmer’s profits are now 11 (5 from unfertilized corn farming and 6 from payments received from Fishermen) and the Fisherman pay only 6 for something that they enjoy as much as 15. Everyone is better off.

But what if the Farmer drives a hard bargain? Maybe he thinks, “If these crazy, rich Fishermen will pay 6, then they’ll probably pay 7, or 8.” Even in the case of ideal conditions for Coasian bargaining, there is nothing to guarantee that the moral implications of the externality will be resolved, partly because Coase is concerned only with the optimal allocation of resources and not the optimal distribution of benefits (or profits) resulting from the economic activity.

When the Farmer controls the property rights, and is under no obligation to sell them, the Farmer-Fishermen interactions can be modeled as The Dictator Game, wherein the Farmer can capture all the benefits of fishing for himself!

Aside from this distributional issue, and the moral problems that it creates, other obstacles often prevent Coasian bargaining. Coase himself admits that in reality, transaction costs are rarely low enough to allow for efficient bargaining. Moreover, direct causality is often difficult to prove.

Imagine the Farmer claiming, “My fertilizer doesn’t kill fish. The fish love my fertilizer.”

If the Fishermen don’t realize what is killing fish, then how would they know to approach the Farmer with an offer?

Or, what if the Fishermen value the fish highly, but simply have no money to pay? Perhaps instead of the recreational fishermen represented in the video, they are subsistence fishermen who use the lake to feed themselves. To the Fishermen, the fish are priceless. But a willingness to pay does not equate to an ability to pay!

The External Costs of Climate Change

Richard Tol wrote in his 2009 paper entitled, The Economic Impact of Climate Change, that “Climate change is the mother of all externalities: larger, more complex, and more uncertain than any other environmental problem”. The reason for this complexity is that emissions of green-house gases from any geographical location on the Earth’s surface travel to the upper atmosphere and play a role in affecting climate globally. Hence, the impact of any particular emission of greenhouse gases (GHGs) is not realized solely at its source, either individual or geographical; impacts are dispersed to other actors and regions of the Earth. Furthermore, GHG emissions are responsible for a myriad of impacts including changes to Earth’s climate system, manifested in events such as drought, floods, sea-level rise, temperature changes, extinction of species, and spread of disease.

This video draws attention to the fact that climate change will adversely impact people that are unable to protect themselves and did little or nothing to create the problem.

The moral complexities surrounding global climate change beg the ethical questions, “What are the developed world’s obligations to the developing countries? And should the developed countries risk their own sense of well-being to meet these obligations?”

Lastly, economists might ask “If property rights were well-defined, could Coaseian bargaining resolve the problem of global climate change?”

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4 thoughts on “Negative Externalities & the Coase Theorem

  1. jonathanedgington

    Climate change response: If it happens or when it happens everyone will still be pointing fingers about who is to blame, how to deny it, how to accept it, and how to profit from it.
    Pandora’s box did it have to be opened, is there necessary evil ?

  2. jonathanedgington

    It seems hard to judge with much precision and accuracy which is the best fit. Currently there are many loopholes in the provided regulations, property rights, and taxation. The rules do not seem to apply to everyone equally and even at the same time for the same reason.
    This is not a complaint for justice for all but instead more of a statement suggesting there is no real clear panacea. Society advocates accomplish what seems most appropriate at the time of inception but it is always with a way in and a way out of every commitment, statement, and action.

    There might someday be a good resolution to promote highly efficient sustainable methodology but only when all stakeholders can agree on what must be sacrificed and what must be saved.

  3. Trevor W

    I can’t agree with taxation. However, regulation and property rights seem like logical steps to stop negative externalities.


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