THE COASE THEOREM

Prof. Prabha Panth

Osmania University

26-Oct-13

Market failure

• Environmental goods are non excludable.

• Due to absence of property rights.

• Since environmental does not belong to anybody, it is misused. Ex. pollution

• Imposes external costs on victims, who have to pay cost of pollution damages,

• To correct this, government regulations are needed.

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Bargaining vs. Government regulations

• In neo-classical theory, government interference is not approved.

• According to Roland Coase, there is no need for government interference to control externalities, such as pollution.

• An optimum solution, which satisfies both polluter and victims can be achieved through “bargaining”.

• This is called Coase Theorem.

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Assumptions

1. Some common property resource, e.g. river,2. Full knowledge of pollution impacts and

abatement costs.3. Pollution impacts can be measured in money

terms,4. Equal status of bargaining partners,5. Both have property rights to use the common

resource,6. No transaction costs,7. No income effects.

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• If a factory pollutes the river, then fishermen are affected.

• Their income is reduced, or their health suffers. This is the external cost of pollution

• If factory owner has to reduce his pollution, then his costs increase.

• The external costs are internalised.

• Coase shows that ‘least cost’ method can lead to optimum solution.

• This is achieved through bargaining by both parties, without government regulations.

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MCA,

MD

0

Pollution

MD

MCA

E

X0

A

B

G

H

X1 X2

Equilibrium in the Coase Theorem

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MD > MCA, so

polluters should pay

compensation to

victims = GHE, equal

to the pollution

burden.

MCA >

MD, so

victims

should

bribe

polluters

= Ab, to

reduce

their

pollution

to X0

• In the figure, MD is marginal environmental damage. It increases as pollution increases.

• It is the cost borne by the victims in terms of loss of income or health.

• MCA = marginal abatement cost. If the firm has to reduce pollution, it has to spend more on pollution control measure.

• Optimum level of pollution, is at X0, where MD = MCA.

• If optimum is not reached, then bargaining between them will achieve optimum level of pollution.

• This is independent of who has property rights, fishermen or firm.

Equilibrium

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Equilibrium in Coase Theorem1. But, if actual pollution is X1, then MCA > MD.

The firm will bargain to reduce pollution up to X0,

Paying compensation to victims = ABE.

2. If actual pollution is X2, then the cost or damage to victims is GX2.

To make firm reduce pollution to X0, cost to firm will be EGH.

Victims will pay this amount to firm to reduce the level of pollution to X0.

Thus pollution levels can be at optimum level through bargaining by both parties. Either victims should pay the polluters to reduce pollution (ABE) or polluters have to pay compensation (GHE) to those affected by pollution.

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Limitations

1. Unequal status and bargaining power of the two parties, fishermen may be too poor to bargain.

2. Transaction costs are not zero, legal fees have to be paid.

3. Environmental damage at X0 may not be optimum.

4. Open access, then there are no property rights.

5. Costs imposed on future generations not taken into account.

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