Coase theorem

In opposition to Pigou, Ronald Coase claims that there is no need for govern-ment intervention because the market will create socially optimum outcomes as a result of transactions if proprietors ownership rights’ (perhaps also including the right of disposal) are well defi ned (regardless of by whom the rights are held).

To prove Coase’s statement, let us fi rst consider the example below. A wood processing plant is located beside a river, which receives the timber fl oated down the river from the nearby logging camp. The timber is protect-ed against fungal contamination by impregnation with a fungicide. Part of this chemical dissolves into the river while the logs fl oat along. Further on, the river fl ows into a lake which has a lakeside hotel. The guests at the hotel are mainly attracted by the favourable fi shing conditions in the river and the lake. However, ever since the guests have learned that chemical residues are accumulating in the food chain, they have been concerned about the pollution in the lake. A few of them have even found another place to stay.

What would Coase consider the solution to be? Let us suppose fi rst that the wood-processing entrepreneur hires the right of disposal and that the logging plant happens to be owned by the hotelier himself. The hotel owner could stop the plant from polluting the river because they have the propri-etary right. Since, however, up to a certain volume of production and level of pollution the profi ts of the plant exceed the hotelier’s loss of income from the pollution, the plant manager can compensate the hotel for the loss and continue production. This situation will continue while the plant manager’s net profi t is greater than the hotel’s marginal external cost. But what hap-pens when the hotelier is not the owner of the wood-processing plant, and the polluter is also the owner? Then the hotelier cannot prohibit the pollut-ing activity (remember: one prerequisite was that the government cannot interfere) so the timber plant manager actually has the right to pollute. In this case, the plant manager will seek to make the most profi t possible, thereby causing the hotelier considerable damage. The hotelier’s damages may be considerably higher than the profi t the plant manager generates from the increase in production. In this case, it is logical that the hotelier should compensate the plant manager for transporting less wood down the river (i.e., for his loss of profi t) – i.e., the injured party should pay to decrease the damage. This will be a profi table strategy for the hotelier as long as the potential external marginal damage is greater than the wood-processing plant’s net marginal benefi t.

To understand the example even better, take a close look at Figure 5-5.

Let us fi rst examine the case involving the injured hotelkeeper who has the right of ownership (and perhaps the right of disposal).

In this case, the starting point is certainly at the origin (at zero pollution), because the injured individual does not want to be affected by pollution. When can the deal take place? See what happens if the parties involved would like to arrive at Point d. Then polluting would be profi table according to area Oabd, causing damages to the injured party that match area Ocd. Since area Oabd is a lot larger than Ocd, the polluter can easily compensate the injured party, because even if they overpay they will be left with signifi cant profi t. It is clear

Figure 5-5. The development of the optimal level of pollution by way of a deal (Pearce–Turner, 1990, p. 72.)

that the situation in Point e would be similar; moreover, there is still reason to strike a deal as long as Point Q* (the point considered to be the social op-timum), is reached. Production at levels higher than Q* causes damage that exceeds profi t, and thus the polluter will be unable to compensate the injured party.

What happens if the polluter has rights of ownership (disposal) – is there any motivation for them to reach the economic optimum level of pollution?

Check Figure 5-5 again. In this case, we would probably start from Point Q_m because this represents the maximum possible profi t for the producer. Pollu-tion will move to point f only if the injured party is willing to pay more than the lost profi t of the polluter. As is clear, this condition exists at Point f, because the damage of the injured party (Q_mfhi area) is a lot larger than area Q_mfg, the polluter’s profi t. The injured party then, at relatively minor expense (for an amount somewhat more than Q_mfg), may be able to eliminate damage causing much greater cost. Proceeding using similar logic, we can see that the parties are motivated to arrive at a deal by even moving as far as Point j; moreover, the bargain may reach the optimal value Q*. It is obvious that such solutions may offend our sense of justice in places, but they are Pareto optimal, and thus are rational in an economic sense.

The fi gure thus proves that Coase is right: in theory there is no need for government intervention, and market mechanisms are capable of handling ex-ternalities.

Coase claims no less than for an equitable reduction in pollution it is not always the polluter that the tax should be levied on, but at times the injured should pay the polluter to reduce their emissions. The agreement is theoreti-cally feasible through negotiations between the polluter and the injured party, and the negotiation would also deal with the question of the size of any pay-ment. Coase’s model, however, involves a few suppositions which seem incor-rect in practice. One is that the transaction costs of the bargain are omitted from consideration, and another that the cost of the negotiations are not ac-counted for, which may, in the case of many producers and injured parties, be sizable. Another theoretical supposition of Coase is that free competition exists, which it does not in practice, as we know.

In addition, the following objections may be made about Coase’s theorem:

• The model does not describe the real world very accurately. Only two-player deals (in this example, anglers/hotel owners and producers) are rare or non-existent: it was also neglected from our example that the in-secticide would also endanger the living standards of further generations and harm biodiversity, and it would reduce the wellbeing and decrease the welfare of sensitive environmentalists to know that the lake is pol-luted, etc. Involving all those individuals who are affected (consumers and other injured parties) into the bargain is unrealistic, even in theory.

This is especially true if we take into consideration that the pollution may last for decades, some of the injured parties (future generations) have not yet even been born, and identifi cation of their preferences is impossible:

who then is supposed to represent them in any deal? In the case of the public goods discussed in the previous chapter, who should negotiate with whom? Another problem is that it is often hard to tell who the injured parties or the polluters are; moreover, the information needed to deter-mine the extent of injury is diffi cult to obtain, substantially increasing transaction costs.

• The transaction costs of the bargain may far outweigh any profi t. Thus we may easily arrive at the standpoint that the currently existing level of every externality is optimal, since overly high transaction costs will obviously outweigh any bargains, so indeed we have reached the Pareto optimum.

• Another important counter-argument is that only a few practical cases exist when a bargain has brought about a solution, and not even in obvi-ous cases when conditions for negotiations were ideal. On the contrary, many examples prove that parties involved in such disputes are not in-clined to reach agreement, and will rather devolve such solutions to so-ciety.

Based on the above-mentioned information, we could say that Coase’s statement about the lack of necessity for government intervention can be con-sidered a specious theory. Coase’s institutionalist approach has, however, re-cently gained signifi cance in practice. It is in Coase’s theorem where the theo-retical basis of the market for pollution rights is to be found. This is true even if the American creators of the market for pollution rights typically fail to refer to it. This is interesting, because the market for pollution rights exemplifi es an opportunity to engage in the practical realisation of the theory. As already men-tioned, the weightiest argument against Coase’s theorem has been the lack of practical examples of its application.

5.10 A few environmental-political consequences of Pigou’s and