1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Implications of assumption of perfect information No disputes about entitlements could arise All contracts would perfectly anticipate all contingencies Torts could not happen

9. 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)‏

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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