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The Coase Theorem

The Coase Theorem
so in this video we're going to talk about potential private solution to the externality problem and this is called the

Coase

theorem

named after the economist who came up with this idea and here the notion or kosis insight was that the reason we're getting the inefficient level of production is because nobody has the property rights for whatever it is that is is suffering the pollution so a good example we use is what if there is a river or a lake that's being polluted and you could think about well what if there's a paper mill okay so you have a paper mill and it's putting pollutants into a lake and/or into a river that's then going into a lake and so what that's doing is it's harming the fish and other wildlife around there and so then fishermen are not able to get as much enjoyment out of going and fishing there because well there's just not as many healthy fish for them to go catch or you know what if people are using that for drinking water which hopefully they wouldn't be because usually we have separate sources what we're not people are not allowed to dump things into our reservoirs whatever the scenario we're thinking about so Kouzes insight was well you know what if you assign the property rights over that over that lake so in other words you could say hey we're going to turn this into a park and we'll give ownership of the lake to whoever is is managing the park and so their benefit from a clean lake or for...
the coase theorem
how clean the lake is is depends on how much people are then willing to come in and fish and camp and and use the the lake alternatively and so so what's what's the key there is then the paper mill would have to pay the owners of the park the owners of the lake for the right to pollute now alternatively you could actually assign the property rights so paper mill in which case the people who run the the campgrounds using the lake for the campgrounds would have to pay the paper mill to reduce pollution now his insight is that actually it doesn't matter to whom you assign the property rights in either case you should get the efficient level of pollution okay now what do I mean by the efficient level of pollution all right some of you might be thinking well isn't zero the efficient level of pollution no it's not because it's it's impossible for us to not have any kind of impact on the environment without basically knocking out all economic activity and what we mean by efficient level of pollution is well we analyzed that again using a supply and demand graph except now here what we have right our quantity here is being measured in terms of the reduction in the pollutant so now we're going to switch gears and we're going to talk about I kind of go think think back to the example we had in the previous video the negative externality with pollution being generated created when we when we generate electricity and as I mentioned right sulfur dioxide...
the coase theorem
or so2 is one of the the big pollutants that that is a negative byproduct of generating electricity so note here we have here's our marginal benefit curve and this is the marginal benefit of reducing so2 all right reducing sulfur dioxide emissions and here is the marginal cost of reducing emissions right so at zero there would be no abatement in sulfur dioxide so as we're moving from left to right we're talking about greater and greater reductions right so left to right is a more a cleaner environment so make sure you you pay close attention to that what we're how were how we're analyzing this okay now what did we mean by the efficient level of pollution and why isn't it zero all right why it wouldn't it be zero so I mean zero pollution would be you know maybe if the maximum of the total amount of was say 20 million all right that would be somewhere all the way out here go ahead and so let's say 16 so it's a little more to scale so if that's the case well why won't we just abate all all of the the so2 pollution well if you look at it right the marginal benefit in terms of the value to society of cleaning up that last unit by eliminating that last unit of sulphur dioxide is much much lower than the cost of reducing that sulfur dioxide so what is the efficient level of reduction well as always it's where marginal benefit intersects marginal cost and say well why why is this this efficient so let's say let's take as an...
the coase theorem
example let's say we are already abating 7 was it tons of of sulfur dioxide per year a question is well is it worthwhile to abate an extra one and a half tons right should we be going from 7 to 8 and a half tons of abatement per year no reduction in sulfur dioxide emissions well if we look at this right what is the marginal benefit of that additional reduction for those 1.5 tons but the marginal benefit again is given by our curve up here I put the marginal cost is only down here another way of looking at it is we can label if we take this whole area here and we can think of this one that I'm outlining in the green okay let's really make sure it's clear to you what area we're highlighting here and we can split this up into two two areas we have a which is this this triangle here and then B all right so B is the area below the marginal cost curve between seven and eight and a half and a is the area between the marginal cost and marginal benefit curves between seven and eight and a half so what is the total benefit of increasing our so2 reduction from seven to eight and a half tonnes the total benefit in going from seven to eight and a half tonnes of reduction is area a plus B right it's the area under the marginal benefit curve and so for any of you who've done differential calculus right who know how to do integration right if this curve this is the marginal benefit curve alright so total benefit is the area under the curve between our two...
quantities so the total benefit of reducing increasing our reduction from seven to eight and a half tonnes is a plus B well what is the total cost of reducing right increasing the reduction in so2 from seven to eight and a half tonnes that's the area below the marginal cost curve which is just B and so what is the net benefit of increasing our so2 reduction from seven to eight and a half that's area a all right so and you can really say this for any rate any quantity between zero and eight and a half tons anywhere where the marginal benefit of increasing our reduction right are reducing even more so2 reducing the pollution by more so the marginal benefit exceeds the marginal cost it is worthwhile to society for us to pursue an even cleaner environment but once we get beyond eight point five tonnes of reduction of so2 well at that point the marginal cost exceeds the marginal benefit and here it's important to bear in mind what do we mean by the marginal cost right we have to put resources into cleaning up right the so2 reduction either we have to use technologies that clean up and maybe capture the so2 before it's emitted out into the environment but that raises the cost of electricity for households and so that is it cost there or we could of course just say let's not use as much electricity but again that is that's going to be a cost for society right and we weigh those against the benefits of the cleaner environment and again as I said in the...
previous video it's not always clear how we try to put a dollar value on eye on the marginal benefits and even sometimes it's it's hard for us to know exactly what the costs will be so we try to make I make our best best estimates and design policy from there now one final note on the coast

theorem

in order for the

Coase

theorem

to work we have we have two conditions one is that the property rights have to be enforceable I said what do we mean well so in this case if you go back to the you know if we think about an example like this so you have utilities companies that are generating electricity well you know the US government has the ability to enforce property rights of course that means that the government has to have the ability to monitor the sulfur dioxide emissions and if we can't monitor the emissions if we don't know what's going on there then how are we going to enforce the kind of general property rights over cleaner air and the same thing if we go back to the example with the lake and the paper mill and somebody has to be able to enforce those rights now in that case if the property rights if they're on the lake belonged to the to the individuals who owned the lake and are running the the campgrounds well then they can go to the government and ensue if through the paper mill if there's right if they're seeing there's more pollution being kicked in and then was agreed upon other examples though we also have where property...
rights are not really enforceable as well what about the oceans and if we have an externality right so we have you know we talked about overfishing in in the oceans or if people are dumping pollution into the oceans well who who enforces property rights in the Pacific or the Atlantic and so that those are scenarios where the coast there really won't work because we don't have the ability to actually enforce property rights the other thing is that we need low transaction costs and you think back to the example with the paper mill in this again goes back to actually what I alluded to already is this this notion of what we have to know right how much pollution is being put in there so if the campground owners can't see how much pollution the paper mill is putting into into the lake well then they don't really know if if the terms of the agreement are being violated or not and so you need low transaction costs is that both sides need to be able to clearly and transparently see the amount of pollution that's being kicked and we also have to have a notion of what these these benefits and these costs are as well if either of these two conditions don't hold then the course

Coase

theorem

won't work next we're going to turn to government solution for dealing with externalities you