1. Coase paper
“The Problem of Social Cost” Ronald Coase Coase, Ronald H. Journal of Law & Economics, 3: 1 – 44, 1960.

2. The Problem Some actions of firms harm others
Factory emits smoke which harms neighbors
Cattle trample crops of adjacent farmers
Standard Economic Analysis (Pigou)
Make factory / rancher liable for damage
Tax activity which causes damage
Restrictive zoning of harmful activities

3. Reciprocal Nature of Problem
The presence of both parties is required for damage to occur.
The presence of the rancher and farmers are a pre-requisite to cattle damaging crops
Either party can prevent the damage.
The rancher can fence his property or reduce the size of his herd.
The farmer can fence his property or leave adjacent land uncultivated.

4. Economic Optimum
The objective should be to maximize the value of the joint output of beef and grain.
Consider the behavior of a single firm that owns ranch and farm land – it will increase the size of the herd if the value of the additional beef exceeds the crop damage.

5. Allocation of Property Rights
The rancher is liable for any damage his cattle cause.
The rancher can reduce the size of his herd, limiting his liability
The rancher can fence his property
The rancher can pay the farmer to leave land uncultivated, thus mitigating his damages.

6. Coase Theorems
I. If two parties negotiate freely, and if transactions costs are negligible, then they
will arrive at the economic optimum
The resources devoted to ranching and farming will depend on the value (market price * yield) of meat and grain.
II. The optimum solution is not dependent upon
the initial allocation of property rights.

7. Transactions Costs
In the presence of transactions costs, an optimal negotiated solution may not be achieved.
The market has created mechanisms to minimize transactions costs.
Single ownership of large tracts of land, commercial or industrial projects
Restrictive covenants
Although market transactions are be costly, the costs of government regulation may be greater.

8. Restatement of Pigou
Divergence between private and social cost arises when party A, in the course of rendering a service to B, damages C.
Government regulation can be used to “internalize” external costs.
Tax on External Costs
Establishment of liability for external damages

9. Critique of Pigou
If we tax the polluter, and compensate the victim, this will encourage people to move into the neighborhood to receive compensation.
In the absence of a Pigovian tax we have too much smoke and too few neighbors
In the presence of a tax we have too little smoke and too many neighbors.