FREC 424 -- Resource Economics
Lecture #3: Property Rights, Externalities, Pigovian Taxes and Coasian Bargaining
Property Rights
A system of private property rights is the fundamental precondition for any economic exchange. Primitive
property rights actually exist among many species, and stem from the weaker individual’s acknowledgement
that it won’t be able to wrest control of the disputed food or mate or habitat from the stronger individual.
Most resource management inefficiencies can be interpreted as failures of property rights. An ideal property
rights system would have four characteristics.
1. Universality: Everything is owned; everyone knows with certainty who owns what property and rights to it.
2. Exclusivity: The owner can exclude non-owners; the benefits and costs of the resource accrue only to its
owner; there are no incidental spillover effects on any non-owners.
3. Transferability: All property and rights to it are freely transferable by voluntary gift or exchange; this is the
primary function of markets.
4. Enforceability: All property and rights to it are fully protected from seizure or encroachment by nonowners; this is the primary function of government.
Real-world property rights systems obviously fall short of these ideals. The over-harvesting of marine fisheries
illustrates some practical failures of property rights. No one owns the ocean or the fish in it until they are
caught. The ocean is open-access and non-exclusive, so anyone who wants to fish can do so. There are
significant “spillover” effects, since each vessel’s harvests affect stock reproduction and future harvests for all
vessels. If governments could allocate private fishing rights to various parts of the ocean, those rights could be
bought or sold, but this has only happened in a few regulated fisheries. Policing large areas of the ocean against
poaching would be costly, and fish don’t necessarily stay in specific zones anyway. The consequence of these
failures is that economically valuable marine fish stocks are typically over-harvested to the point where net
reproduction is impaired, and people end up spending more time and money to catch fewer fish.
It is possible to imagine a property rights solution to just about any resource inefficiency problem. Property
rights are closely linked to incentives: people can be expected to manage their own property efficiently, but
won’t necessarily exercise the same care for things they don’t own. Farm tenants have less incentive to invest
in soil erosion controls than farmland owners. Occasionally the easiest solution to a resource allocation
problem is to establish some new property rights that will create the right incentives.
Market failures
Mainstream microeconomic theory assumes perfect markets (many buyers and sellers, full information
precluding price discrimination, etc.) that achieve Pareto-optimal outcomes. However economists have
identified various categories of market failure, where violations of one or more key assumptions of the perfect
market model prevent markets from achieving a Pareto-optimal outcome. Market failures arise in cases of...
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externalities
open-access (usually common-property) resources
public goods
imperfect markets
diverging social and private rates of discount
government failure
Externalities
An externality occurs when one party generates an incidental economic cost or benefit for a second party, but is
not accountable for that cost or benefit.
A positive externality generates an incidental benefit for someone else. For example, in the process of making
honey for herself, a bee-keeper's bees pollinate the neighboring farmer’s crops, improving his crop yields, but
the farmer doesn't pay the bee-keeper for providing this economic benefit. A negative externality generates an
incidental cost for someone else. For example, a paper mill pollutes the river upstream from a trout hatchery
and reduces the hatchery's productivity and profits, but doesn't factor the economic harm to the hatchery into its
own profit accounting.
(A pollution externality may be interpreted as a property rights problem that violates the universality,
exclusivity and/or enforceability principles. Nobody actually owns the environment. Because of the spillover
effects, the interests of the polluter and victim are commingled rather than exclusive, and the rights of the
polluter to dispose of his pollution are not clearly delineated from the rights of the victim to a clean
environment. Or these rights might be well-delineated but impractical to enforce.)
We need to distinguish the total social costs of production, including pollution externality costs, from the
polluting firm’s private costs of production. In the graph below, a firm generates a market product with a
pollution by-product, and uses the environment for free pollution disposal; the environmental costs are borne by
society. Without controls, this firm operates at its private optimum, the point where marginal private cost equal
marginal revenue (Demand). But the social optimum is where the marginal social cost (marginal private cost
plus marginal pollution damage cost) equals marginal revenue (Demand). The social optimum level of the
firm's output Q* is less than the private optimum level Q'. The social optimum price per unit P* is higher than
the private optimum price P'.
The default outcome is that the polluting firm produces too much output, sells its output too cheaply, and
generates too much pollution. Society is basically subsidizing the firm with free waste disposal services. In
producing too much, the unrestrained firm bids other resources away from more efficient uses. It can afford to
sell its output more cheaply because it gets free pollution disposal. And free disposal gives the firm no
incentive to reduce its waste flow at all--no investment in waste management, recycling or re-use. Thus
pollution externalities can generate market distortions that ripple throughout the economy.
Economists are careful to distinguish true externalities from "pecuniary externalities." Unlike a true externality,
a pecuniary externality only affects prices; it doesn't affect consumers' utilities or firms' productivities directly.
For example, a large firm moves into an area and bids up local wages, increasing labor costs for the other firms
in the area. The other firms may complain, but this is how efficient labor markets are supposed to work.
Pecuniary externalities do not imply market failure, and are not true externalities.
A Corrective Tax or Subsidy
The Cambridge economist A.C. Pigou proposed correcting this market failure by imposing a tax on the
polluter's output corresponding to the marginal external damage cost. This presumes that the victims of the
externality are entitled to a clean environment, so the polluter should pay compensation for the damage he
causes.
The pollution tax thus "internalizes" the externality, making the firm's marginal cost schedule coincide with the
marginal social cost of production. Facing marginal tax $T per unit of output, the profit-maximizing firm
reduces its output to the socially optimal level Q*, charges P* and earns an after-tax marginal revenue (P*-T)
which just covers marginal private cost. For simplicity, the tax of $T per unit could be applied to the firm's total
output, generating a tax revenue of $TQ* (as shown in the graph below), or the pollution tax schedule could
follow the marginal damage cost schedule; the firm's corrected incentives are the same in either case.
The equivalent outcome could be achieved by subsidizing the firm's pollution abatement in line with the
marginal damage schedule. This implies that the polluter is entitled to pollute, and should be compensated
(bribed) by the victims to forego that right. In this case, the subsidy for pollution abatement creates an
opportunity cost of pollution for the polluter: each unit of pollution he emits is a subsidy payment forgone, so he
will again reduce output to the socially optimal level Q*, charge P* and earn total revenue (P*+S)Q*. The
subsidy per unit could be paid on all of the firms output, or paid in accordance with the marginal damage cost
schedule; again, the firm's corrected incentives are the same in either case.
There is no difference in theoretical efficiency between a “polluter pays” tax solution and a “victim pays”
subsidy solution; the decision is mostly normative. But if there are few polluters and many victims, the
“polluter pays” solution may be more practical to implement.
Each solution may generate its own incentive problems. A pollution tax paid by the firm might be distributed to
the victims, but this weakens the victims' incentive to move away from the pollution or find other ways to
reduce their exposures to the pollution. Furthermore, the provision of compensation might conceivably attract
additional pollution-tolerant "victims" to the area, who could then extort additional compensation from the
polluting firm. In fact, Ronald Coase proposed that the victims of the externality should be taxed to prevent
exactly this kind of behavior. In most cases this should not be necessary: the harm suffered by the victim
should provide sufficient incentive to avoid it; the victim should not be compensated or taxed.
There is one special case where taxing the victim is appropriate: suppose the victim has the ability to shift the
harm from the externality to a third party. In such cases, the victim becomes a secondary generator of an
externality, and should pay a Pigovian tax reflecting the externality he imposes on the third party.
A pollution abatement subsidy paid to the polluting firm may create adverse incentives as well; if the subsidy is
based on the environmental threat from the firm, the firm has an incentive to maximize that threat, perhaps
targeting its pollution to the most vulnerable victims. The subsidies may also attract additional polluting firms
to the area.
The Coase Theorem and Transactions Costs
Suppose a paper mill discharges waste into a river rather than paying $100 to dispose of it in some
environmentally benign way. Suppose that a fish hatchery downstream loses $60 in fish because of the paper
mill's emissions. What will happen?
A Pigovian tax on the paper mill makes the paper mill bear the full social cost of its activities, but the mill keeps
on polluting, since it's cheaper to pay the $60 tax rather than pay the $100 treatment cost. The government
collects the tax revenue, but doesn't compensate the hatchery. The hatchery still has an incentive to relocate to a
less polluted river if this is more profitable.
Ronald Coase's famous 1960 article "The Problem of Social Cost" (Journal of Law and Economics 3:1-44)
takes a different view of this problem and points out some important limitations of the Pigovian solution. If the
hatchery sues the paper mill for damages, the court will merely clarify the parties' property rights to the river:
either the paper mill has the right to dump waste into the river, or the hatchery has the right to a clean river. But
the court's decision will not determine whether or not the paper mill will continue dumping its waste into the
river! This is for the hatchery and paper mill to negotiate between them.
If the court finds for the paper mill, the mill continues dumping and the hatchery continues suffering damages
of $60. The hatchery would be willing to offer the mill up to $60 not to pollute, but since the alternative
treatment costs $100, the paper mill would decline. But if the court finds for the hatchery, the paper mill would
be willing to offer the hatchery compensation up to $100 for putting up with its waste, and since this exceeds
the hatchery's damage costs, the hatchery would accept any compensation over $60 and the paper mill would
continue polluting as before. So the amount of pollution the mill dumps in the river is determined by the
relative costs of the parties, not by the court's decision. The court's decision merely determines who pays who.
Coase's "theorem" is summarized as "In the absence of transactions costs, the generator of an externality and
the victim will negotiate to the same externality level regardless of how the property rights are assigned."
The stipulation regarding transactions costs is important. This implies a small number of victims who can
collectively negotiate with the firm reasonably efficiently. In contrast, a large number of victims is unlikely to
negotiate efficiently, since no individual victim is likely to have sufficient personal incentive to shoulder the
burden of mobilizing the entire group. (That kind of collective action is a type of “public good” which is
typically undersupplied; we will discuss public goods next.)
In effect, there is a $40 economic surplus available for distribution between the polluter and the victims, so
negotiations between the parties will proceed as long as the transactions costs are less than $40. More
specifically, negotiations will proceed as long as each party's share of the transactions costs is less that his or
her expected share of the $40 total gain from the negotiation. Coase argues that a Pigovian tax should be
unnecessary! Here's why:
Suppose the polluter and victim have marginal benefit and damage functions as shown here. In the absence of
negotiation, the polluter's output is A, where his own marginal benefit goes to zero. If the parties engage in
efficient Coasian bargaining, they will negotiate a socially optimal level of output B, where the marginal
damage to the victim equals the marginal benefit to the polluter. An environmental regulator, perceiving that
the victim is still suffering some pollution damage, might now impose a Pigovian tax of $T on the polluter,
equivalent to the remaining marginal damage suffered by the victim. This effectively shifts the polluter's
marginal benefit schedule downward to MB-T, so the final level of output is C, less than the social optimum.
The sequence of bargaining and tax imposition could be reversed, but the outcome is the same. In this case
Pareto efficiency is achieved by either the Pigovian tax or the Coasian bargain, not by both. The conclusion
here is that the Pigovian tax is only appropriate where Coasian bargaining fails to reduce the externality to the
socially optimal level on its own.
As noted above, Coasian bargaining typically fails in cases where there are large numbers of victims.
Conversely, Pigovian tax/subsidy schemes may fail in small-numbers cases where parties may have incentives
to engage in strategic behaviors, such as polluters threatening more harm to increase the abatement subsidy
payment, or victims threatening to expose themselves to additional harm to increase the polluter's tax burden or
their own compensation.
We can immediately see some general corollaries from Coase's theory. Since transactions costs prevent Paretoimproving bargaining, any technology, institution or market mechanism that reduces transactions costs must be
Pareto-improving. The Coase theorem ought to apply to politics as well: rational political bargaining between
interest groups should result in socially efficient policies. If transactions costs remain high, it may be
appropriate to inquire why: is there some third party that benefits from keeping the two parties apart?