Coase Theorem

Property Rights and the Coase Theorem:

The tragedy of the commons can obviously be solved in those cases there it is possible to assign property rights to one party. However, this is not always possible and maybe not the most efficient solution. The Swedish law gives the general public the right to pass over another person’s land and to pick mushrooms and berries in the forest (however one has to keep a proper distance to the owners’ house and not disturbed them etc.) The owner of a forest area would not find it profitable to erect fences around his forest and to charge an entry fee and the economic losses from mushrooms and berry-picking are very small. There are an awful lot of forests in Sweden so risk of overexploitation of these rights is small (and it is not allowed to cut down trees and hunt or fish without permission)

In other cases the interaction between people may become more strained. An example of a negative consumption externality is noise-pollution. Disturbances between neighbors in apartment buildings are common and there are local regulations, or contract clauses in the rental contracts, that regulate this. One may not be allowed, for example, to play music (loudly) or to shout or laugh excessively after 9pm (or some other nearby time).

This type of conflict between two parties can be solved by giving one party the legal right to engage in a certain activity. The disadvantaged party cannot demand (by appealing to the law) that the other party quits the activity, but could instead offer him/her a “bribe”. This would be a mutually advantageous trade. For example, assume that I have been given the right to play music as loudly as I want and that my marginal utility from each hour of music (from 5pm to 1am), and the marginal disutility (=marginal cost) to my neighbor is:

I have the right to play music as long as I want, and this would be until my marginal utility is equal to zero for eight hours (until 1 am). My total utility is: 7 + 6 + 5 + 4 + 3 + 2 + 1 = 28, and the total disutility (or total cost) for May neighbor is also 28. For “society” the net utility is zero by my music playing since the neighbor becomes increasingly irritated. If I only play music for an hour it will not bother him at all and the surplus is 7, two hours gives an additional surplus of 5, and thus 12 in total. It is clear from the table above that the total surplus is maximized at four hours, which is the Pareto optimal level of my music playing (the total surplus is maximized at 16).

Let’s assume that my neighbor offers me a payment of 2kr for not playing 8th hour. This will give me a surplus of 1 and him a surplus of 4 (if I agree which I will of course). If he offers me a payment of 6 to reduce my playing by two hours I will lose 3 in utility from lost music playing but wins 6 in direct monetary compensation (total surplus = 5). If he offers me, e.g. 10 to stop playing after four hours, my surplus will be 4 and his 5. He would like me not to play the fourth hour either, but his disutility is only 3 and my utility 4 from this hour, so there is no mutually advantageous deal to be made. Hence, the prediction is that if we are efficient bargainers we will come to an agreement where I will reduce my music playing by four hours (and play for exactly four hours). This is of course the Pareto-optimal level.

This result, that private property rights, together with efficient negotiations, can solve the externality problem was pointed out in 1960 by Ronald Coase. He showed that it doesn’t matter which side has the right. If my neighbor had the right to be free from disturbing noises (all day) I could strike a deal with him which would be better for both of us. Efficient bargaining would again lead to me playing music for four hours. Of course, I would be better off by having the right on my side and would prefer the first scenario. However, this has to do with the allocation of final utility and not whether the final level of the activity is Pareto optimal or not.

The so called, Coase-theorem says that private negotiations with clearly defined (and legally protected) property rights will lead to Pareto efficiency no matter how the property rights have been allocated, given that there are not transaction costs, and if preferences exhibits no income effects. The presence of transaction costs may make it too expensive to perform the negotiations and to write contracts and the two parties may not be able to reach a negotiated solution. In this case the government may step in and by legislation mandate directly the likely outcome of (the failed) negotiation, i.e., to give me the right to play music until 9pm.

In his article Coase gave an example of a coal power plant which emitted soot into the air which had a negative effect of on a laundry downwind. In this case there were two firms involved, and they may be more used to negotiations when to private persons in an apartment building. In this situation it may be quite likely that transactions costs are low enough so that they can solve the problem without outside interference.

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