Thursday, March 7, 2013

Externalities, Coase, Ostrom & Demsetz

Traditionally when it comes to environmental pollution, the general philosophy was that ‘the polluter pays’. A factory polluting the air or water should pay for the damages that are caused. In a much simpler case, if you build a house next to me and you don’t like the smell of livestock waste coming from my property, the traditional philosophy would hold that you could have the government stop my operation. In the article ‘The Problem of Social Cost’ Ronald Coase brought new insight to the way we view social costs and the principle of ‘polluter pays.’

The insight that Coase brought was the reciprocal nature of social costs and externalities and has been referred to as the Coase Theorem. The important elements of the Coase Theorem (in the context of the present example) can be demonstrated as follows:

 1) Yes it is true that my operation is harming you via air pollution

2) However, in stopping me via government or legal intervention (or taxing my waste        production) you are harming me

3) The assignment of property rights and the potential for bargaining results in behavior that is changed or altered to account for the negative impact our choices have on others, regardless of which party is initially assigned property rights

But the ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost.” –Coase, p. 8

Coase says that the issue is that no one owns the air that surrounds my livestock operation and your home. There then follows a dispute over how the air should be used- to absorb livestock odor, or to provide a scent free atmosphere in your back yard. An externality is an uncontracted effect. It’s a harm or benefit that goes uncompensated or is not captured by prices. Whenever the cost of one’s behavior is not factored into a price by which a choice can be valued, I can harm you without compensating you for it. ( i.e. a negative externality exists)

However, if I own rights to the air, then I can choose to pollute the air. If you own rights to the air, then you can prevent me from polluting it. If noone owns the air, then it is first come first served or winner takes all.

That is not the end of the story though. What Coase emphasizes is that if I own the rights to pollute, you can pay me to limit my pollution i.e. buy those rights from me. I can then use the proceeds to alter my livestock nutrition, genetics, and management to reduce the odor my operation is causing. On the other hand, if you own the rights to pollute I can purchase those rights from you, or invest in technology that will allow me to continue my operation without violating your rights. Decisions about how the air should be used will be based on the local knowledge and preferences of both parties. This can be accomplished without major government regulation, or the arbitrary imposition of a tax.

The assignment of property rights and the potential for bargaining results in behavior that is changed or altered to account for the negative impact our choices have on others, regardless of who holds the rights. This is the essence of what is known as the ‘Coase Theorem.”

The Coase Theorem holds in the case of zero transaction costs, and approximately in the presence of transaction costs that limit the bargaining process and establishment of a price that reflects local knowledge and preferences related to the externality.  In the case of high transaction costs, Coase argues that courts should do their best to anticipate the economics involved in making the initial assignment of property rights. Coase recognizes in some cases, governments may do a better job allocating resources in the face of high transaction costs, but is skeptical. Understanding the knowledge problem, and the issues related to government decision making from public choice theory make government intervention a questionable strategy for dealing with social costs.  In later work,

Other Related Work:

Based on field research and game theoretic reasoning, Elinor Ostrom concludes that in many cases social dilemmas like those recognized by Coase can be better handled through cooperation:

“If one sees individuals as helpless, then the state is the essential external authority that must solve social dilemmas for everyone. If, however, one assumes individuals can draw on heuristics and norms to solve some problems and create new structural arrangements to solve others, then the image of what a national government might do is somewhat different…National governments are too small to govern the global commons and too big to handle smaller scale problems.”

Howard Demsetz holds that technology and knowledge play a crucial role in the development and adoption of property rights:

Changes in knowledge result in changes in production functions, market values, and aspirations. New techniques, new ways of doing the same things, and doing new things-all invoke harmful and beneficial effects to which society has not been accustomed. It is my thesis in this part of the paper that the emergence of new property rights takes place in response to the desires of the interacting persons for adjustment to new benefit-cost possibilities.


 The Problem of Social Cost. R. H. Coase. Journal of Law and Economics, Vol. 3 (Oct., 1960), pp. 1-44

A Behavioral Approach to the Rational Choice Theory of Collective Action: Presidential Address,
American Political Science Association, 1997. Elinor Ostrom. The American Political Science Review
Vol. 92, No. 1 (Mar., 1998), pp. 1-22

Toward a Theory of Property Rights. Harold Demsetz
The American Economic Review, Vol. 57, No. 2, Papers and Proceedings of the Seventy-ninth
Annual Meeting of the American Economic Association. (May, 1967), pp. 347-359