Solution to Externality | The Coase Theorem

The Coase theorem describes the economic efficiency of an economic allocation or outcome in the presence of externalities. This "theorem" is commonly attributed to Nobel Memorial Prize in Economic Sciences 1991 winner Ronald Coase. The Coase Theorem states that, “if property rights and liabilities for an activity are fully assigned, then an efficient outcome will result, even in the presence of externalities. Moreover, the level at which the activity is carried out will not depend on the particular assignment of rights and liabilities.”

Coase Theorem (Part I): When there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity.

Coase Theorem (Part II): The efficient solution to an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights.

Let us take the example of a steel factory releasing waste into the river stream and a community staying near by the river stream. If firms ignore the community and continuously release waste effluents in to the river stram, then there is too much pollution. We can illustrate the Coase theorem by showing the marginal benefits and marginal costs of an economic activity that generates an externality.

Suppose, for example, a factory emits effluent into a river, polluting the water supply of a downstream community. Let us assume that the factory is currently emitting 100 units of effluent. If forced to reduce effluent to zero, the company operating the factory would have to abandon a valuable production line. Thus we can say that the company gains marginal benefits from emitting pollution, and the community incurs marginal costs through damage to the water supply.

The figure shows both marginal costs of the community and marginal benefits of the factory. The emission of 100 units of pollution clearly imposes high marginal costs on the community and brings the company lower marginal benefits. This is “too much” pollution. But suppose emissions were limited to 60 units. Marginal benefits to the company would then equal marginal costs to the community. A further limitation to, say, 20 units, would result in high additional loss to the company due to low output levels meanwile a low marginal cost imposed on the community bring only low additional benefit. The efficient or “optimal” solution, therefore, is at 60 units of pollution. At this level the extra benefit to the company from production just balances the extra cost imposed on the community through pollution.

Assigning Property Rights to the Community:

Suppose the community has the right to say how much pollution can be emitted. The company can offer them up to $200 per unit for pollution permits to allow 60 units of pollution. The company can afford to pay this much; their marginal benefits from producing 60 units exceed $200 up to the 60 units. It will also be to the community’s advantage to accept this offer, granting permits for 60 units of pollution at $200 each. The first 60 units of pollution impose less than $200 per unit of costs on the community. We can measure the total cost of pollution at this level as the area C on the graph, or $6,000. But the amount the company pays to the community will be B + C or 60 x $200 = $12,000. The community can then pay $6,000 to treat the water and still come out $6,000 ahead. The company gains A + B + C = $21,000 in benefits, pays $12,000, and has a net profit of $9,000 (area A).

Assigning Property Rights to the Company:

We can also assign the right to pollute to the company. Would they then emit the full 100 units of pollution? If they did so their gain would be areas A + B + C + D = $25,000. They can do better by negotiating with the community. The community will pay them up to $200 per unit, or areas D + E = $8,000, to cut back their pollution to only 60 units. This saves the community D + E + F = $10,667 in environmental damage or water treatment costs. They still suffer environmental costs equal to C, or $6,000. The company’s net gain will now be A + B + C + D + E = $29,000, better for them than the maximum pollution option. This approach may seem unfair to the community, but it leads to the same equilibrium solution i.e., 60 units of pollution emitted as when the community held the right to control pollution levels.

Conclusion:

The above demonstration of the Coase theorem shows that the participants reach the efficient solution regardless of who holds the property right governing pollution. Provided that right is clearly defined, the party who values it most highly will acquire it, with the result that the external costs of pollution and the economic benefits of production are balanced through the marketplace.