Private actors will sometimes effectively address externalities and reach efficient outcomes without government intervention. Private players will sometimes arrive at their own solutions. The Coase Theorem, developed by Ronald Coase, states that parties will be able to bargain with each other to reach an efficient agreement that addresses externalities.
The Coase theorem states that if property rights are well-defined, and negotiations among the actors are costless, the result will be a socially efficient level of the economic activity in question. It is one of the most important and influential theorems in economics.
The common feature of all externalities is that there are costs and/or benefits to economic activity that are not accounted for in the price of the activity. Suppose, a factory is causing a lot of air pollution in a neighbourhood that is making people sick and raising their medical expenses. The way Coase saw the problem was that property rights—the rights to control the use of a good or resource– are not well defined in the case of an air-polluting factory. That is, if neighbors do not have the well-defined right to clean air there is no incentive for the factory to pay for or take into account the neighbors’ medical bills, and diminished quality of life due to the odor from the factory.
The Coase theorem states that if property rights are well-defined, and negotiations among the actors are costless, the result will be a socially efficient level of the economic activity in question. It is one of the most important and influential theorems in economics. However, the theorem assumes certain conditions for such a solution to occur, including low transaction costs and well-defined property rights. If the conditions are met, the bargaining parties are expected to reach an amicable agreement. In practice, however, transaction costs do exist in most processes of agreement and as a result, private individuals often fail to resolve problems.
Application of the Coase theorem
Suppose that the neighbours’ combined medical and other costs, per unit of output, is $10. Also, the marginal private cost incurred by the factory is constant at $100 per unit. The marginal social cost is then the $100 private cost plus the $10 external cost, or $110 per unit of output.
Defining clean air as a property right and allowing for free negotiation enables the neighbours to quantify at $10 their willingness to pay for clean air or, conversely, their willingness to accept the dirty air. So, for each unit of output, neighbours will demand to be compensated exactly the amount of their true loss: $10. Since they have the right to clean air, the factory owners are obliged to pay them, and thus the new cost to the factory owners takes into account the social cost or S-social. We know now that this will result in a socially efficient outcome.
Now suppose that the factory owners instead had the right to pollute the air as much as they like. Neighbours would be willing to pay the factory owners $10 a unit (the external cost of the pollution) to reduce emissions from the current level. So again the socially efficient level of output will result. The transfer of wealth is quite different here, so assigning property rights has big implications in terms of the relative welfare of the groups. But in terms of the socially efficient level of output, the assignment of property rights has no impact.
You may think that implementing the Coase theorem is an ideal policy solution for externalities, but a few words of caution are in order. The assumption of costless negotiation is quite improbable in practice. In order for it to be true in the example of the polluting factory, the neighbours all have to be able to identify themselves and band together, correctly assess the values of the damage done to them per unit of output, and be able to demand the money from the factory owners. Costless negotiation is unlikely to be the case in any similar real word situation.
An interesting real-world application of the Coase theorem has happened in sparsely populated areas of eastern Oregon where residents have been paid $5000 by a wind-energy company to put up with the noise of wind turbines (residents must sign a waiver promising not to complain about the noise). Oregon law gives the right to peace and quiet to the residents, so for the turbines to exist, the residents must agree to live with the noise. In this case, because the area is sparsely populated and it is pretty easy to determine who is affected (just use a decibel meter), negotiation is relatively easy.
“Chapter 20 Externalities” in Intermediate Microeconomics by Patrick M. Emerson is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.