The Coase Theorem

Today we're going to look at the Coase Theorem and market solutions to externality problems. Basically what Coase pointed out in a remarkable paper was that the problem with external benefits and external costs is not that they're external, but rather that property rights in these cases are vague and uncertain and that transactions costs are high. Let's get started with an example.

The Nobel prize-winning economist, James Meade, argued that the market would underprovide honey and pollination services. Bees, Meade argued, do two things. First, they create honey. That honey is bought and sold in markets and there's a price for the honey. Second, however, bees will also fly out and they'll pollinate the crops of nearby farmers. That's a very useful service, but Meade argued that the farmers wouldn't be paying for that service. The pollination services, Meade argued, were an external benefit. Because the beekeepers were not being paid for these useful pollination services, there would be too few bees, and as a result, too little honey, and also too little crops and too little pollination services.

However, another economist, Steven Cheung, proved that the Nobel Prize winner was wrong, and he did so by consulting the Yellow Pages. Cheung discovered that pollination in the United States, in fact, is a $15 billion industry. Beekeepers regularly truck their bee colonies around the country and they sell their pollination services to farmers. Because the farmers are paying the beekeepers for the services of the bees, the benefits in fact are not external, they're not on bystanders -- and the market works.

So why did Meade get it wrong? What about the bees, and what about the farmers, made it possible for this externality problem to be solved by markets when many other externality problems are not? The market for pollination works despite the fact that bees seem to create this external benefit because transactions costs are low. That is, all of the costs necessary for buyers and sellers to reach an agreement are low. In particular, bees simply don't fly very far.

So an agreement between one beekeeper and one farmer can internalize all the externality. That is, if the beekeeper puts his bees in the middle of the farm, basically the only crops which are going to be pollinated are the crops of that single farmer. So once an agreement is made between that beekeeper and that farmer, all of the externalities have been internalized. There are no bystanders once the beekeeper and the farmer make an agreement. Moreover, the property rights here are very clear. The beekeeper has the rights to the honey. The farmer owns the crops that the bees pollinate. There isn't going to be a lot of bargaining and disagreement about who owns what. The property rights are clear. In other cases of externalities, some of the ones we've looked at previously, neither of these things are true. Transactions costs are high and property rights are unclear.

Let's compare with pollution and flu shots. In both cases here, the transactions costs are high and property rights are unclear and uncertain. Consider pollution: there's an external cost -- the factory is putting lots of pollution up into the sky, but on who? It's not necessarily on the people who live right next door to the factory. The pollution could be causing acid rain, which is ruining lakes hundreds of miles away, or it could be causing global warming which is increasing sea levels and ruining people's lives thousands of miles away.

And exactly what are the costs? How much? How can we measure these costs? It's not obvious. Moreover, who has the rights here? Should the factory have to pay to pollute? Should it have to pay the people to whom it imposes an external cost? Or, should the bystanders have to pay the factory not to pollute? Does the factory have the right not to pollute, and do the bystanders have to pay the factory to stop?

If you think that's obvious, let's consider a flu shot. There are external benefits. If I get a flu shot, for example, I'm less likely to sneeze on people on the subway and give them the flu. But that could be hundreds, dozens of people, hundreds of people. I don't know exactly which people get the external benefit. And how much is this external benefit? It's hard to measure, once again. Moreover, should people have to pay me to get a flu shot or should I have to pay others if I don't get a shot?

Now, by the way, let's compare these two things -- the pollution and the flu shot. If you thought it was obvious that the factory should have to pay to pollute and not that the bystanders should have to pay the factory, well, consider the flu shot. Isn't sneezing, if you don't get a flu shot, isn't sneezing, isn't that like pollution? Isn't that polluting? Shouldn't the polluter, the sneezer have to pay? So in that case you might want to argue that if you don't get a flu shot, you should have to pay others. You're polluting on them, right? So the rights here are not as obvious as we might think at first glance.

Moreover, the main point is that the transactions costs of coming to an agreement between these hundreds or thousands or perhaps millions of people, figuring out what the external costs are, making that bargain, that's going to be very costly. And, we can't even agree on who has the rights here, or it's very difficult to come to an agreement. Should the factory have to pay? Should the factory be the one to be paid? Should the person getting the flu shot be paid, or should the person not getting the flu shot have to pay? The rights here are uncertain, and unclear, and again, that's also going to make coming to a market agreement difficult to do, and therefore the market isn't going to solve these types of externality problems very easily.

So the conclusion here is that the market can be efficient even when there are externalities -- when transactions costs are low and when property rights are clearly defined. And in fact that's the Coase Theorem. If transactions costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even if there are externalities. The conditions for the Coase Theorem to be met -- low transactions costs and clear property rights -- are in practice often not met. Even so, however, the theorem does suggest an alternative approach to externalities.

We've already looked at Pigouvian taxes and subsidies, and command and control. The Coase Theorem suggests another solution, namely the creation of new markets. If the government can define property rights and reduce transactions costs, then markets can be used to control externality problems. So the Coase Theorem plus a little bit of command and control in terms of defining property rights and reducing transactions costs, can create a new form of solution to externality problems. And in fact tradable permits is what we're going to be looking at in the next talk.