2 Economics of pollution 2.3 How to meet optimal pollution - The Coase Theorem Property rights? Property right of Environment? Suppose that we have two groups: Polluters and Receptors Governmental decision/regulation: • Not any pollutants can be emitted into environment • All kinds and amounts of pollutants may be emitted into environment What defines property rights? Property rights are established by formal and informal rules about the privileges and limitations on the ownership, use, and transfer of goods and resources These rights are specified in various municipal ordinances, other legislation, court decisions (common law), tradition and custom Property rights need to be: 1) clearly defined 2) exclusive 3) enforceable 4) transferable Coase Theorem • Insight: root of the inefficiencies from externalities is the absence of property rights • The Coase Theorem states that once property rights are established and transaction costs are small, then one of the parties will bribe the other to attain the socially efficient quantity • The socially efficient quantity is attained regardless of whom the property rights were initially assigned Illustration of the Coase Theorem • Recall the steel firm / fishery example If the steel firm was assigned property rights, it would initially produce Q1, which maximizes its profits • If the fishery was assigned property rights, it would initially mandate zero production, which minimizes its damages Figure 5.3 Coase Theorem – assign property rights to steel firm • Consider the effects of the steel firm reducing production in the direction of the socially efficient level, Q* This entails a cost to the steel firm and a benefit to the fishery: – The steel firm (and its customers) would lose surplus between the MB and MPC curves between Q1 and Q1-1, while the fishery’s damages are reduced by the area under the MD curve between Q1 and Q1-1 – Note that the marginal loss in profits is extremely small, because the steel firm was profit maximizing, while the reduction in damages to the fishery is substantial – A bribe from the fishery to the steel firm could therefore make all parties better off Coase Theorem – assign property rights to steel firm • When would the process of bribes (and pollution reduction) stop? – When the parties no longer find it beneficial to bribe – The fishery will not offer a bribe larger than it’s MD for a given quantity, and the steel firm will not accept a bribe smaller than its loss in profits (MB-MPC) for a given quantity – Thus, the quantity where MD=(MB-MPC) will be where the parties stop bribing and reducing output – Rearranging, MC+MPC=MB, or MSC=MB, which is equal at Q *, the socially efficient level Coase Theorem – assign property rights to fishery • Similar reasoning follows when the fishery has property rights, and initially allows zero production – The fishery’s damages are increased by the area under the MD curve by moving from to On the other hand, the steel firm’s surplus is increased – The increase in damages to the fishery is initially very small, while the gain in surplus to the steel firm is large – A bribe from the steel firm to the fishery could therefore make all parties better off Coase Theorem – assign property rights to fishery • When would the process of bribes now stop? – Again, when the parties no longer find it beneficial to bribe – The fishery will not accept a bribe smaller than it’s MD for a given quantity, and the steel firm will not offer a bribe larger than its gain in profits (MB-MPC) for a given quantity – Again, the quantity where MD=(MB-MPC) will be where the parties stop bribing and reducing output This still occurs at Q* 10 Graphical Analysis, Implications • Result 1: R1[...]... units pollution Community incurring costs of $17,000 (C+D+E+F) A = $9000 F=$3000 E = $4000 B = $6000 C = $6000 D=$4000 Case 2 Company owns “right”, Community wants to reduce pollution Offers to make pmt of $200 unit to cutback output Cont’d Both parties benefit, thus, both agree Community has 1 Eliminated $11,000 in pollution costs (D+E+F) 2 Made pmts of $8,000 (D+E) 3 Left with pollution costs of $6,000... actual transactions @ output that emits 90 units of effluent Coase Theorem says same “optimal” outcome obtained via market transactions Case 2 Company owns “right” to determine how much pollution they make Begin with maximizing benefits of $25000 (A+B+C+D) and creating 100 units pollution Community incurring costs of $17000 (C+D+E+F) 2 Economics of pollution The Coase Theorem If there are no legal,... “optimal” @ output producing 60 units of pollution MBcompany = MCcommunity “Optimal” amount of pollution “Equitable” to Coase Theorem says same “optimal” outcome obtained via market transactions Case 1 Community owns “right” to determine how much pollution is permissible Begin with zero pollution Company would like to produce output & gain benefit But, creates Pollution Both parties benefit, thus,... Community has 1 pollution costing $6000 (C) 2 3 What has been achieved? $12000 new income (B+C) Same “Optimal” result obtained via Market Net Gain $6000 Company has 1 Made pmts of $12000 (B+C) 2 Gained benefits of $21000 (A+B+C) 3 Net profit of $9000 (A) A = $9000 B = $6000 C = $6000 Case 2 Company owns “right” to determine how much pollution they make Begin with output that creates maximum benefits of $25,000... position 0 units Pollution $12,000 Pmt rec’d 6,000 Pollution permitted Company $0 Benefits $12,000 Pmt made 21,000 Benefit from new output & pollution End position $6,000 Remain after $9,000 Remain benefit after pmts Improvement $6,000 $9,000 Change in pollution pmts used to clean up pollution 0 units (60 units created, but cleaned up) Coase Theorem Assumptions: Problems: • Given distribution of wealth and... pollution costs of $6,000 4 Total Outlay (to What has been achieved? For community F=$3000 get rid of all pollution) E = $4000 $14,000 (C+D+E) vs,$17,000 C = $6000 D=$4000 Company has 1 Reduced output & pollution, giving up benefit of $4,000 (D) 2 Received pmts of $8,000 (D+E) 3 Retains existing benefit of $21,000 (A+B+C) 4 Existing benefit plus pmts = Total Benefit $29,000 (A+B+C+D+E) What has been... • Source of externality well defined • Example: Several firms with pollution • Not relevant with high transaction costs or illdefined externality • Example: Air pollution 11 Coase Theorem Building the graph Producer creates ⇑ output Creates benefits “marginal” benefits (diminishing) ⇑ pollution Building the graph Producer creates ⇑ output Creates benefits “marginal” benefits (diminishing) ⇑ pollution. .. D=$4000 Company Holds Rights Community Beginning position $17,000 Pollution costs 8,000 Pmts made 11,000 ⇓ Pollution costs 6,000 Remain Costs Ending position $14,000 Total pmts made & remain costs $3,000 Improvement Change in Pollution 40 unit Reduction Company Text p53 $25,000 Benefits $8,000 Pmts rec’d 4,000 ⇓ Lost benefits from ⇓ output & pollution 21,000 Remain benefits $29,000 Total pmts rec’d & remain... Company Building the graph, cont’d With ⇑ pollution Community experiences ⇑ Costs clean up health care lost tourism Total Costs to Community “Optimal” solution (max social benefit) without actual transactions ?? Total Benefit to Company Total Costs to Community “Optimal” solution (max social benefit) without actual transactions ?? @ 100 units pollution ⇓ output /pollution ⇓ benefits ‹ ⇓ Costs to community... Coase Theorem • Sometimes there are legal impediments to what society considers immoral This can effect the achievement of an economically efficient solution Problems With The Coase Theorem • Sometimes there are costs of determining, writing, and enforcing an agreement in a world of bounded rationality, imperfect communication, private information, observation and verification difficulties, and opportunism