Negative Externalities and the Coase Theorem, Explained

In economic activity, there are sometimes 'externalities' or spillover effects to other people not involved in the original exchange. Positive externalities result in beneficial outcomes for others, but negative externalities impose costs on others.

Prof. Sean Mulholland addresses a classic example of a negative externality, pollution, and describes three possible solutions for the problem: taxation, government regulation, and property rights. The first two options are difficult to monitor and may create perverse incentives.

A better solution to overcome the externality is property rights, as described by Ronald Coase. As long as property rights are well-defined, divisible, and defendable, parties can negotiate to reduce the impact of the pollution.

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[NickDanger]

Coase did NOT say his theorem applies when transaction costs are "low." He said it applies when there are NO transaction costs. In other words, the Coase Theorem essentially never applies. Coase states this very explicitly.

[SaskatoonBerryPie]

I was going to go on a rant about this but you clearly covered it better than I could have.

[Tamutu-]

But what if a big firm comes to these fishermen which own the lake, and pays them a significant amount of money, enough for them to not care about future implications of river pollution? This means the theorem served its purpose in the short run and both parties are satisfied, but future generations aren't consulted and are harmed as a consequence, before even seeing the river.

[lexagon]

This video almost completely glosses over the point that the applicability of Coase's theorem is wholly dependent on transaction costs. There are many cases in which the transaction costs are so high that it loses all efficacy.

For instance, producer A sells a product to 1 million customers. The product turns out to be harmful, to varying degrees. All the customers individually decide to sue A, leading to extremely high transaction costs, in the form of court and lawyers fees and highly inefficient process economy (i.e. additional externalities). In that situation, a Pigouvian tax would possibly be a more efficient solution. This is essentially the rationale behind tobacco and alcohol taxation.

Secondly, the approach presented here assumes that all negative externalities can be accounted for at the moment of their inception. Producer B and their customers might be completely blissfully unaware that the product is harmful. 30 years later the effects begin to show, by which time the product is no longer in production and B is no longer in business. In that case, the negative externalities cannot be internalized in an efficient manner. Product screening and testing (i.e. monitoring) is usually the most efficient way to deal with the issue in that situation. This is why pharmaceutical compounds are thoroughly tested before they're made available.

Summa summarum, Coase's theorem is excellent, but it's not the most efficient approach in every situation, which is something that this video attempts to paint it as.

[ChrisChong]

thank you! this was, well scripted, animated, and recorded.

[ThePeterDislikeShow]

Does it occur to people that in normal everyday life, "Pay up or I'll pollute" is called extortion?

[objectivistathlete]

Something not mentioned... it's oftentimes difficult if not impossible to actually measure the magnitude of an externality, making government intervention impractical. However, the Coase theorem goes around that by actively internalizing the externality.

[mangoswiss]

@roguas I think the video confuses the issue slightly as they show two scenarios.
1 - The farmer has the property rights for the lake and therefore he's paid by the fisherman to fish there but still has an incentive to reduce pollution.
2 - THe fisherman has the property rights to the lake and he is compensated by the farmer.

Your example is the second scenario. The landowner doesn't pay the factory. The factory pays the landowner a compensation at an agreed price.

[OhNotThat]

That worked out wonderfully for the people of Bhopal....

[richiemayne]

This is a problem that I've come to notice coming up a lot with ideas from the Chicago school. It is assumed that in every transaction each participant is on equal terms with the other, but this is rarely the case. It is something that is frequently overlooked/ignored.

[StateExempt]

@mangoswiss - I agree with your analysis, since the fishermen are the ones who are affected by the farming, the burden should be on the farmer to compensate them for the loss they suffer from his actions.

The factory should definitely be the one to pay the landowner since it is the factory that negatively affects the property of the nearby landowner.

Damaging property has the same consequential effect on the land as partially stealing it, so the farmer/factory should pay accordingly.

[donfolstar]

@bsabruzzo Thank you taking the time to answer. I do not know if it is the choppy nature of your answers, but they all seem pretty unsatisfying.
1. Are we to assume the fisherman is a marine biologist with a specialty in toxicity and has a lab adequate for testing? He would have to pay someone to do the testing. Though why should the fisherman pay to test water that other people use too? DC might be 1k miles away but field offices are a thing. Walmart doesn't fail outside Arkansas.

[heyisthatdes]

oMG THANK YOU SO MUCH SERIOUSLY. I've been struggling to understand this.

[changsam]

This is great method to some extent.
1. negative needs to be identified and could be measured accurately.
2. both "cause and effect" group or one need to be well defined.
3. two entity should be able to negotiate fairly.

with satisfied conditions, causing and affected one or group may work it out easily.

[ZT]

Even very basic economic principles which *nobody* questions anymore, like supply and demand, are based on those assumptions. If given multiple options people will almost always pick the best one. We have to start somewhere; it's a pretty good place to start and there are ways to adjust for deviations, which are surprisingly rare. Even "hard sciences" are based on general principles that have exceptions in specific cases (or at least started out and are still taught like that on an intro level.)

[noway]

3) This depends on the theory of property rights used by local courts/custom. Under the homesteading theory, it would likely be people who had been fishing in that place for some period of time. It may only include people who had been fishing since before the farmer started using fertilizer. But the exact answer would depend on the specifics of the case.

[rawheas]

I'm actually a chemical engineering student workign at an environmental lab were we test for this kind of thing and I'll tell you a few things you should know.

1. there is no such thing as burning things pollution free, no matter what there are always trace amount of everything, so literally any lawsuit could be against everyone who mows lawn or drive a car in the world.
2. air quality testing is expensive and weather dependant, it would actually be cheaper and easier to regulate pollution.

[RKAddict]

You provided an example of the Coase Theorem where it works with liberty. In many situations, it in fact does not, and is hostile to private property rights.

[RavemastaJ]

Except that I didn't advocate for the court to determine the limit, but to identify and define the specifics of rights for both individuals.

Since both individuals have vested interests, a third party would have to be designated in order to do this. This is not the same as an oversight committee, rather it lays down the groundwork for similar cases, determining what both sides can and can't do to each other.

The terms would then be created within those guidelines.

[noway]

5) This depends on the type of air pollution. If it is local smokestack pollution, then it can be dealt with in the same way. The neighbours will sue the factory. If the factory can establish that it has a "property right" to pollute in that area, then the neighbours will have to pay to get the factory to stop. Otherwise the neighbours could get an injunction against the factory.