Econ 201
Chpt. 10
Coase Theorem: Establishing Property Rights &
Tradable Permits
Tradable Permits
A Property Rights Approach
• “Common” Property Problem
• No one “owns” the air/water; therefore no one benefits
from managing (pricing) its usage
• Solution is to assign the property right to one party
and allow them to trade its use in the marketplace
• Coase Theorem
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 produces 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
An Example
• Emissions from a local factory damages strawberry
crops in the area. The damage to the strawberry crop
is $5 million per year, and the cost of abating the
emissions would be $3 million per year. Under which
of the following conditions could an efficient
bargaining solution be reached?
• A) Property rights are assigned to the firm
• B) Property rights are assigned to the farmer
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 effects
• 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
Comparison of Approaches
• Standards
• Can also produce optimal level of pollution
• But set same standard for all firms (and are not productively
efficient, e.g. min cost)
• To set individual quotas: requires knowledge of each firm’s costs
• But have higher administrative costs
• Not only have to monitor emissions
• Enforcement costs: legal proceedings (time delays and expense)
• Not very flexible: regulatory process for changing standards
• Provide no incentive for firms to reduce pollution below
current “authorized” levels
Comparison of Approaches
• Standards
• Are most useful when:
• Problem is short-lived (“burn” bans for high pollution days)
• Optimal level is zero
• Or pollutant is highly toxic even in small concentrations
• Arsenic, Mercury
Comparison of Approaches
• Taxes
• Can produce “optimal” amount of pollution at minimum
costs and lower administrative costs
• Kneese (1977): comparing taxes versus standards found that desired
quality costs half as much using taxes
• Automatically allocates pollution levels among firms based on
their costs
• Provides incentive for firms to reduce pollution levels through
technological innovation
• Easy to adjust/”tune”
• Tax revenues can be used finance admin costs
And They Are Endorsed
by the Sierra Club!
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Sierra Club Conservation Policies
Pollution Taxes
The Sierra Club advocates the establishment of pollution taxes which would make it less expensive for a
polluter to adopt alternative processes or invest in additional equipment to curtail releases to the
environment than it would be for him to continue as before. Such taxes would supplement, and not
replace, standards on maximum permissible emissions. These taxes should be imposed when the following
conditions are found to prevail generally:
for competitive or other reasons, cost-minimizing behavior tends to exist in the company or industry;
the cost of abatement is expected to be significant, both in relation to revenue from sales and in absolute
terms; and
the quantity of the pollutant released to the environment can be determined with reasonable accuracy,
either by direct monitoring of every source, statistical sampling of a small fraction of many similar sources
produced by a few manufactures, or by indirect means. The cost of monitoring should be small in relation
to the tax revenue expected in the absence of abatement.
As a first step, a tax equal to 15 cents per pound should be imposed on sulfur contained in fuels intended
for combustion (with a rebate given to those who demonstrate that the sulfur was not released to the
environment), and on sulfur emitted from smelters, refineries, and sulfuric acid plants. The tax on lead
contained in gasoline ... should be promptly enacted.
The feasibility of taxes on the emission of nitrogen oxides, particulate matter, carbon monoxide, and
hydrocarbons should be investigated ... for possible action on these air pollutants; studies should also be
conducted on the practicality of similar taxes for various of the water pollutants.
Adopted by the Board of Directors, February 13-14, 1997
Comparison of Approaches
• Tradable Permits
• Cost efficient
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Firms will purchase permits from more efficient firms if permit cost <
abatement (technology) costs
• Technological incentive to reduce pollution
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Marginal cost of abatement = permit cost
• Similar to taxes
• Administratively simpler
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Require less information about the firms’ cost
Better able to handle “spatial” variation in pollution
• Fewer permits auctioned in bad areas
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Adjust “automatically” for changes in inflation and growth
• If auctioned -> revenues for admin costs