1 of 26

Economics 309

Public Finance

Mark Witte

Northwestern University

​

Coase & Property Rights

2 of 26

Market based ways of regulation pollution

  • Pigou 1920:  Tax brings efficiency, "Polluter pays"
  • Coase 1960:  Efficiency from property rights
  • Crocker & Dales 1968:  Cap & Trade applies Coase

Crocker & Dales

Coase

Pigou

3 of 26

Hayek’s “Knowledge Problem”

  • Friedrich Hayek offered another view in the 1930s. Any modern economy, capitalist or state-run, is a great soup of private “know-how” dispersed among the specialised participants. No one, he said, not even a state agency, could amass all the knowledge that each participant “on the spot” inevitably acquires. The state would have no idea where to invest. Only capitalism solves this “knowledge problem." 
    • Edmund Phelps, 2006 Nobel Prize winner
  • Private knowledge held by private agents that is unavailable to policy makers
  • Seriously, what are social marginal benefits and costs from externalities? 
  • If we don't know this...how can we do Pigouvian taxes?

4 of 26

Think of it like this….

"If a tree falls in the woods and there's no one there to hear it, does it make a sound?"

​

​

​

​

"Marge, it takes two to lie. One to lie, and one to listen." 

5 of 26

Coase wrote a lot, but w/o much math

  • "Federal Communications Commission” (1959) introduced the idea of spectrum auctions
  • "Durability & Monopoly" (1972) with the Coase Conjecture that a monopoly that produced a durable good would have little market power since it would quickly be competing with itself (Windows 95 still works great!)
  •  "The Lighthouse in Economics" (1974) about market systems producing public goods
  • "The Nature of the Firm" (1937!!!) about how firms exist to minimize TRANSACTIONS COSTS!

​

6 of 26

Coase: If no one is offended….

  • Pigou: Who is to blame for pollution? Tax that polluter!  
  • Coase: "The Reciprocal Nature of the Problem"
  • "The Problem of Social Cost" (1960) showed that a ton of legal journal articles were a waste of time, that it wasn't about assigning blame
  •  Extremely different approach than Pigou
  • Invalidated a HUGE amount of law journal articles, one of the most influential papers in the history of law
  • History of how it got published….

​

7 of 26

“Coase Theorem”

  • We can get economic efficiency in the presence of externalities if there are property rights, and it doesn't matter how those property rights are assigned (subject to some conditions)
  • Property rights don't decide efficiency, but just rents (Who pays whom)
  • Key condition
    • Transactions costs of working out disputes must not be larger than the potential gain from negotiation
    • Other issues much less important

​

8 of 26

Coase & Efficiency

  • For a transaction to work, the buyer must have a higher marginal valuation than the seller
  • But neither of these are known to the other party, but each party knows her own valuation
    • Unlike Pigou where we are just guessing
    • Room for negotiation
  • Externalities are part of life
    • There is a “reciprocal nature to costs”
    • My old neighbors
    • You've got to fight for your right to PAR-TAY
    • "Coming to the nuisance" - We don't reward those who get themselves in trouble and then engage in rent seeking

​

9 of 26

Efficiency Goal

  • Maximize the value of production, inclusive of effects of externalities
  • Pigou would internalize the externality through taxes
  • We could internalize an externality between businesses by merging them, then maximizing the value of joint production
  • Coase:  Or cross payments based on property rights would get the same efficiency outcome
  • Either way, we want the low-cost avoider to adjust actions
    • We want to substitute on the lowest cost margin

​

10 of 26

Problems with Coase approach

  • Problem with identifying everyone involved
  • With many parties, dangers of “free riders” not being willing to pay for “public good” non-excludable benefits
  • Holdout Effect with multiple parties
    • Some party may strategically demand payment that would result in economic rents, then attempt to expropriate all economic rents
  • Equity issues
    • Poor communities may end up paying rich ones to avoid pollution?  
    • Income distribution and varying environmental standards
  • Rent seeking: Coming to the nuisance, Gary, Indiana

11 of 26

Coase graph (marginals shown in graph)

Areas:

  • A = $9,000
  • B = $6,000
  • C = $6,000
  • D = $4,000
  • E = $4,000
  • F = $2,667

12 of 26

Example: Cows & Crops

13 of 26

Cows & Crops: No bargaining

What if someone owned both the ranch and the farm?

What if there were separate owners and no bargaining.

Result if ranchers had all the rights? DWL?

Result if farmers had all the rights? DWL?

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

​

1

$20

$90

​

2

$35

$80

​

3

$45

$60

​

4

$50

$30

​

5

$52

$0

​

14 of 26

Cows & Crops: Bargaining

What if there were separate owners and bargaining, and bargaining was costless.

Result if ranchers had all the rights? Outcome? DWL? Payoff?

Result if farmers had all the rights? Outcome? DWL? Payoff?

​

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

$100

1

$20

$90

$110

2

$35

$80

$115

3

$45

$60

$105

4

$50

$30

$80

5

$52

$0

$52

15 of 26

Cows & Crops: *Costly* Bargaining

What if there were separate owners and bargaining, and bargaining cost $4 (paid by the party that is not favored by the law)

Result if ranchers had all the rights? Outcome? DWL? Payoff?

Result if farmers had all the rights? Outcome? DWL? Payoff?

​

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

$100

1

$20

$90

$110

2

$35

$80

$115

3

$45

$60

$105

4

$50

$30

$80

5

$52

$0

$52

16 of 26

Cows & Crops: *Costly* Bargaining

What if there were separate owners and bargaining, and bargaining cost $20 (paid by the party that is not favored by the law)

Result if ranchers had all the rights? Outcome? DWL? Payoff?

Result if farmers had all the rights? Outcome? DWL? Payoff?

​

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

$100

1

$20

$90

$110

2

$35

$80

$115

3

$45

$60

$105

4

$50

$30

$80

5

$52

$0

$52

17 of 26

Cows & Crops: Thinking outside the box

What if bargaining were costless and a fence could be built for $35 that would prevent all crop damage for a year (before needing another $35 for fixing)

What is the outcome if rights favor ranchers? Farmers?

Either way, build it and total output can go to $52 + $100 (-$35 for the fence)

​

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

$100

1

$20

$90

$110

2

$35

$80

$115

3

$45

$60

$105

4

$50

$30

$80

5

$52

$0

$52

18 of 26

No, we want a wall! A big, beautiful wall!

What if bargaining were costless and a WALL could be built for $60 that would prevent all crop damage. (And last one year, like before.)

What is the outcome if rights favor ranchers? Farmers?

​

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

$100

1

$20

$90

$110

2

$35

$80

$115

3

$45

$60

$105

4

$50

$30

$80

5

$52

$0

$52

19 of 26

Cows & Crops & Pigou

What is the optimal number of cows? What is the marginal damage to crops at that optimum?

What is the optimal Pigouvian tax per cow?

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

$100

1

$20

$90

$110

2

$35

$80

$115

3

$45

$60

$105

4

$50

$30

$80

5

$52

$0

$52

20 of 26

Cows & Crops & Pigou screws up

Do we really know where the optimum is? Do we really know the marginal damage? Isn’t it all guessing, really?

What if we guess that the tax should be $6/cow? Result? DWL?

​

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

$100

1

$20

$90

$110

2

$35

$80

$115

3

$45

$60

$105

4

$50

$30

$80

5

$52

$0

$52

21 of 26

Bargaining would never make this mistake

Do we really know where the optimum is? Do we really know the marginal damage? Isn’t it all guessing, really?

What if we guess that the tax should be $16/cow? Result? DWL?

​

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

$100

1

$20

$90

$110

2

$35

$80

$115

3

$45

$60

$105

4

$50

$30

$80

5

$52

$0

$52

22 of 26

Cows & Crops & Pigou screws up

Do we really know where the optimum is? Do we really know the marginal damage? Isn’t it all guessing, really?

What if we guess that the tax should be $16/cow? Result? DWL?

​

# of Cows

Private profit from cows

Private profit from crops

Joint profit

0

$0

$100

$100

1

$20

$90

$110

2

$35

$80

$115

3

$45

$60

$105

4

$50

$30

$80

5

$52

$0

$52

23 of 26

Coase examples

  • Trains with sparks versus wheat farmers
  • Confectioner versus the physician
  • Beer maker versus hotel nearby

​

24 of 26

Problems with scaling up Coase

  • For large scale environmental problems Coase would be difficult to implement through the courts
  • But maybe Cap & Trade would work?

​

# of people

Number of lines of communication

2

1

3

3

4

6

5

10

6

15

7

21

25 of 26

Complications

  • Dominant Firms and market power
    • MR = MC, not MSB = MC
    • Inefficiency!
    • Market Thinness
  • Assignment problem - With something like CO2, how do we assign rights?
  • Transactions Costs
    • Search and information
    • Bargaining and decision making
    • Monitoring and Enforcement 
    • Free riders
    • Hold-up problem from last to settle

​

26 of 26

Next up….

Public Goods