Coase Theorem
&
Review of Regulation
ECON 100
Mar 9, 2009
Negative Externalities
& Property Rights
• “Common” Property Problem
– No one “owns” the air/water; therefore no one
benefits from managing (pricing) its usage
• One solution is to assign the property right
to one party and allow them to trade its
use in the marketplace
– Coase Theorem
Problem of the Commons
• An example from Fisheries
– No one “owns” the fishery; therefore no one benefits
from “economically” optimally managing its usage
– Rivalry in consumption; but non-excludable resource
• Solution is to assign/auction the property rights
to catch “x” fish to one or more party (parities)
and allow them to trade the permit in the
marketplace
– Coase Theorem solution
Coase’s Theorem
• If property rights exist and transaction
(bargaining) and information costs are low
– Then parties will be able to bargain among
themselves (without government intervention)
to obtain an efficient outcome
An Example of the Coase Theorem
• Marketplace
– Firm upstream from a farmer
• Firm produce a good valued by consumer but
dumps pollutants into the river as a byproduct
• Cost of using the river to the firm is $0
– Farmer
• Downstream from the firm
• Uses water to irrigate his agricultural products
• Pollution affects/degrades his product
Assigning the Property Rights
• If assigned to the firm
– Farmer is willing to “bribe” the firm to reduce
pollution
• Willing to pay firm to reduce gallons discharged up
to marginal value of crop damage due to pollution
• Firm: willing to accept payments that are >= marg
costs of treatment/reduction
Assigning Property Rights
• Assigned to the Farmer
– Firm is willing to pay farmer up to the marginal
value of “avoided” treatment costs
– Farmer is willing to accept payments >=
marginal cost of crop damage
• Either way: socially efficient (marginal
value = marginal cost) solution
– However, there are different income effect
• Concluding which is best => normative statement
Criticism of Coase’s Theorem
• If more than 1 farmer
– Transaction costs of getting all affected parties
together may be too great to get to optimal solution if
rights assigned to firm
• Demsetz (1964): “when transaction costs are too high; status
quo may be optimal”
– Leffler: “if it exists, it’s optimal. But, why?”
– Use of the government to lower transaction costs
• Strategic behavior
– Last individual may “hold” out (lower bribe/higher
payment) as key to agreement
– Fire protection example
Tradable permits proposed to
slow deforestation
•
Environmental groups are pushing for the use of market mechanisms to address one
of the world's largest sources of greenhouse gas emissions: deforestation.
•
Similar to carbon trading, the CR plan would award tradable "credits" to countries that
voluntarily reduce their deforestation rates below historical baseline levels
–
countries could then sell the credits to other nations that are unable to meet their emissions
reduction goals.
•
To ensure the validity of countries' claims, compensation would be given only after a
specific period of time and after sufficient satellite and on-the-ground observation.
•
According to Environmental Defense and its partner groups, the clearing and burning
of tropical forests is responsible for as much as 25 percent of human-created GHG
emissions.
–
South America's Amazon Forest alone holds some 60 gigatons of carbon
•
–
•
more carbon than all countries release from cars, power plants, and other human-related activities in a
decade.
current rates of destruction, forest losses in Brazil and Indonesia alone will negate nearly 80
percent of the emissions reductions achieved under the Kyoto Protocol by 2012.
Slowing deforestation has the additional benefit of preserving biodiversity in
threatened tropical forests, the groups note.
Application to Fisheries
• Fishing Industry
– ITQs: Individual Transferable Quotas
• Boats bid for the right/license to catch predetermined amount of fish
– Then can either use the license to catch fish;
– or resell license to another boat
– Boat owners will be willing to sell license if the
price offered > profits from catch
• Licenses will go to highest valued/most efficient
use
Fisheries
• Other approaches
– Quotas
• Total catch for the fishery
• Quota for each boat
– Maximum Sustainable Yield (Biologists)
Regulatory Effectiveness
• What are the goals?
– Allocative Efficiency
• Marginal Value (benefits) to consumers = Marginal costs
(including opportunity costs) of the resources used to
produce the goods
– Productive Efficiency
• Firms produce at minimum costs
– Technological Innovation
• Other considerations
– Administrative Costs
– Dynamics
Regulatory Effectiveness
• Regulatory prohibitions
– Prohibiting Anti-competitive behavior
• Sherman Anti-trust Act, Clayton Act
• Designed to prevent “monopoly-like” behavior
– Should improve all 3 goals
• But:
– Lag behind what’s actually occurring in the marketplace
– Depends on getting caught and convicted
– Long judicial process
Regulatory Effectiveness
• Standards
– Prohibit emissions/pollution beyond a “threshold”
• Can be designed to get to “optimal” level of pollution
– But:
•
•
•
•
•
Don’t change prices/costs in the marketplace
Don’t provide incentives for tech innovation
Don’t allocate quotas in a least cost manner
Not dynamic
High administrative costs (2x taxes admin costs)
Regulatory Effectiveness
• Incentive Mechanisms
– Price caps, taxes and tradable permits
– Taxes
• Correct market signal -> raises costs -> raises
price
– Productive/allocative efficient; provides incentive for tech
innovation (adopt least cost technology)
• Administratively less costly than standards
• Easier to adjust for dynamic/market changes than
standards
Regulatory Effectiveness
• Price Caps
– Provide “correct” price signal
• Adjust for inflation and incentive to innovate from
use of average industry productivity
• Allocative/productive efficient
– Administrative costs less than rate-of-return
regulation
• No incentive to “goldplate” costs (AJ Effect)
• Fewer rate reviews/hearings
Final Comments
• Remember the goals
– Economic efficiency
– Low Administrative Costs
– Flexibility to adjust
• Competitively neutral
• Simplicity
– Sappington’s myths of deregulation
Regulatory Effectiveness
• Tradable Permits
– Fisheries, pollution
• License to catch “x” fish or emit “x” pollutants
– Can be designed to attain “optimal” level of
pollution/fish catch
– Market Value of permit (resalable) ensures marginal
benefit (keeping permit) = opportunity cost
• Allocative/productive efficiency
• Incentive to adopt cost-savings technology
– May be better at adjusting to changes in the
marketplace than taxes > standards