The Coase Theorem

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Key Concept: Reciprocal externalities

The Coase Theorem refers to an important point made by Nobel laureate Ronald Coase in a 1960 paper called "The Problem of Social Cost." The most important point Coase made is not particularly controversial. Coase points out that from an economic perspective, externalities are reciprocal; they can go either way— from A to B or from B to A—depending on how the property right (or liability) is defined. He uses an example of a doctor's office located next to a confectioner, where the confectioner's noisy equipment makes it impossible for the doctor to examine patients. Coase's point is that while the noise may physically travel in one direction, the direction of the externality (in economic terms) can go either way depending on the prevailing property rights or liability rules. If a confectioner has a right to make candy at this location, then she does indeed impose an externality on the doctor. But what if the doctor has a right to a certain level of quiet (meaning the confectioner is liable for disturbing the doctor's work)? In that case, the doctor is imposing an externality on the confectioner because the doctor's right to quiet imposes a cost on the confectioner: she must either shut down the confectionary or install noise proofing.

Coase recognizes how property rights, liability, and the burden of proof related to an externality can be defined either way in the law. This is not just a trivial theoretical point. For example, most people would assume that if a rancher's cows wander into someone's flower garden and damage it, the rancher is liable for his cow's damage. Well, in Wyoming, it's the other way around: the gardener is responsible for keeping cows out of the garden. Forty years ago smokers in the United States had a right to smoke wherever they pleased, imposing an externality on the nonsmokers who would have to go outside to avoid second-hand smoke. Nowadays, society generally supports the rights of nonsmokers to clean air, so the "property right" (the prevailing institution) has been reversed and smokers, now on the receiving end of the external ity, must go outside to smoke. Indeed, in some cases the direction of the externality changes with the time of day. Typically, urban residents have the right to play music or be noisy in their homes except during designated quiet hours (e.g., from 11 P.M. to 6 A.M.) when the property right or liability is reversed so that neighbors have a right to quiet.

Coase's central idea is also relevant when external damages are uncertain. Who has a right to impose risks or "potential damage" on others? If the risks are uncertain, who should bear the burden of proof? The liability for uncertain damages can shift as the degree of uncertainty diminishes (as in the case of smoking where, between the 1960s and the present, the health risks from smoking have become accepted as fact). But even when risks are highly uncertain the liability and the burden of proof can be established either way. Here there are sharp differences between the United States and the European Union on environmental issues. In Europe, the precautionary principle seems to be widely accepted. It means that actions that have uncertain, but potentially damaging, effects on the environment should not be allowed unless it can be shown that the risks are low or the harms are small. In the United States, the precautionary principle has much less influence on policy. The precaution or burden of proof tends to run in the opposite direction: the actions of individual entrepreneurs should not be constrained unless it can be shown that they are harmful. Indeed, the different approaches taken by the European Union and the U.S. government toward climate change appear to reflect these differing perspectives, as does their approaches toward genetically modified (GM) food. In the case of GM food, the implications of the Coase Theorem and burden of proof can be quite surprising, for example, when windblown genetically modified pollen "contaminates" a farmer's crop, yet that same farmer is then held liable for stealing the patented genetically modified product (see box 5).

The second major point from Coase's paper is more controversial, in part because it is often misinterpreted. Under certain assumptions, Coase observed, it doesn't matter who gets the

Percy Schmeiser, a canola farmer in Saskatchewan, found in the mid-1990s that some edges of his fields had become contaminated with Monsanto's Roundup Ready canola from either pollen drift or truck spillage from a neighbor. Nobody knows for sure. Schmeiser was unhappy about this contamination because he had been saving and developing his own disease-resistant canola for fifty years, and Monsanto's varieties were inferior to his in this regard.

To Percy Schmeiser's surprise, Monsanto sued him in 1998 for illegally growing its Roundup Ready canola without a license, violating Monsanto's patent on the gene. Monsanto wanted Schmeiser to pay damages and legal costs that could reach several hundred thousand dollars.

To many people's surprise, the courts agreed. In June 2000 the Federal Court of Canada ruled that it didn't matter how the pollination occurred, it still infringed on Mon-santo's patent, and that any cross-pollinated canola on Schmeiser's fields was the property of Monsanto so the corporation could confiscate his crop. Essentially, the patent and property rights laws were found to override the rights of farmers in this case.

That wasn't the end of the story, however. In May 2004 the

Canadian Supreme Court ruled on the case, also finding that Schmeiser infringed on Monsanto's patents. The court prohibited Schmeiser from using Monsanto's technology in the future and required him to turnover any contaminated seed. The court found, however, that Sch-meiser did not intentionally make use of the benefits of the patented technology (by spraying the crop with Roundup), and so no financial damages were awarded to Monsanto.

This kind of ownership law and involuntary liability is a very new phenomenon. It's unclear where future rulings will lead. Laws and court interpretations may change as the scope and potential costs of rulings of this kind become more apparent—in terms of the social efficiency of the outcomes (as discussed later in this chapter).

This ruling may not be all good news for Monsanto, however. Percy Schmeiser's wife, Louise, has since filed a claim seeking $140 in damages from Monsanto for the costs of removing Roundup Ready canola plants from her organic garden. She claims that Monsanto owns and controls the gene, so the liability issue now follows the flow of the gene, making Monsanto liable for contamination and pollution of anybody's field with its product.


Property Rights and Liability with Genetically Engineered Crops property right related to an external effect (e.g., either full liability or no liability for the confectioner), the outcome could still be efficient. The reason for this is that, assuming zero bargaining or transaction costs, the two parties could bargain. If the confectioner is liable for her noise, she can offer to pay the doctor to let her operate her machinery. If the confectioner is not liable, the doctor could offer to pay the confectioner to halt operating the machinery. This part of Coase's analysis is interesting theoretically, but it's largely irrelevant to most real-world problems because transaction costs are usually prohibitively large. It's also just a restatement of a familiar point about market efficiency, applied to new kinds of "commodities": noise, pollution, or other external effects.

But this is where free market enthusiasts jump up and say, "Ah ha! No need for government; private actions like bargaining can solve environmental problems, and Coase proved it." Well, not so fast. If there are no transaction costs, then Coase is correct, an efficient outcome will occur no matter who is given the initial property right. It seems plausible that one doctor and one confectioner might actually bargain this way, but what about more realistic examples involving more than two people? What about two neighbors being affected by a third noisy neighbor late on a rainy night? What about an upstream factory and a few downstream fishing communities? What about Canadians being impacted by acid rain from Midwest power plants? As the number of individuals involved increases beyond two or three, the assumption that independent bargaining will occur becomes highly dubious. While Coase understood this, some current enthusiasts for this idea do not.

A third key point related to Coase's ideas (but not directly part of his analysis) involves just these kinds of situations where transaction costs are very high and direct bargaining just isn't going to happen. In the absence of some kind of government regulation or other policy, can we say anything about which property right (full liability versus no liability) is preferable or which is more efficient?

To answer this, we need to revisit the distinction between Pareto efficiency and social efficiency. Pareto efficiency, as explained in chapter 2, refers to a situation with an existing set of property rights, endowments, and other institutions; it assesses whether the allocation of resources in that situation could be altered in a way that would make at least one person better off without making anyone worse off. If the answer is no, then the allocation is said to be Pareto efficient for those specific initial conditions. Social efficiency, by contrast, compares different institutional arrangements and evaluates them from the perspective of net social benefits.

Let's look at an example. Consider the case of an upstream farming community whose cattle and irrigation practices reduce the water quality and river flows to downstream portions of the river. A community downstream relies on fishing, including salmon that spawn in the stream and are harmed by the upstream farming practices. The situation is depicted in figure 9.1. We want to compare two alternative property rights: full liability (FL), meaning that the party creating the physical externality (upstream) is liable for the damages they cause, and no liability (NL), meaning that the party bears no liability for those damages.

Let's assume there is no possibility of direct bargaining between the two communities, and there are no government polices such as regulation. This means that under no liability, the farming community will be unconstrained and will choose QNL since the cost to them of polluting is zero. The deadweight loss at


MB to upstream

farming community

___ Marginal external cost

to downstream fishing




0 Qfl Q*

Qnl Damage to fish habitat

Qnl (net benefit compared with the optimal allocation at Q*) is the shaded area A. If, instead, there is full liability, then the farming community will be constrained at QFL. In this situation the deadweight loss is the difference between net benefits at QFL and at the optimum, Q*, or the shaded area B.

Beginning at full liability, no Pareto improvement is possible by switching to no liability, because it makes somebody worse off. The same is true going the other direction from no to full liability. Which situation is Pareto efficient? These two property rights situations are considered "Pareto incomparable." Neither can be said to be "Pareto superior" to the other. You may notice, though, that the deadweight loss for full liability is larger than at no liability. This means that the net social benefit is greater for no liability than for full liability. So, using the criterion of maximizing net social benefit, we can say that social efficiency is higher with no liability than with full liability.

Is there a connection between the Pareto criterion and social efficiency? The connection can be made by referring to a "potential Pareto improvement." A potential Pareto improvement is a change with winners and losers, but if the winners compensated the losers for their losses, no one would be worse off and at least one person would be better off than before. If no liability has a higher net social benefit than full liability, then it has to be the case that a switch from full liability to no liability would satisfy the criterion for a potential Pareto improvement. Whether or not the compensation is actually paid is a separate question from whether the social benefits of the change would be positive.

In the example described in figure 9.1, area A is smaller than area B. If the reverse were true, as in figure 9.2, then full liability would be socially efficient. Does the social efficiency of the situation have anything to do with which property right is most likely to exist in the real world? This is an important question, and one that has spawned a lively debate. One view is that property rights tend to be established, and modified over time, in ways that maximize social welfare. This view is sometimes associated with Richard Posner, a legal scholar and U.S. federal judge. The idea is that our laws are made and modified in ways that seem to pro mote social efficiency. For example, if, at some time in the past, a situation looked like that in figure 9.1, we would expect no liability to be the established legal rule. If, over time, population increased downstream, or the value of fish increased relative to agricultural products, the situation might change to one that looked more like the situation in figure 9. 2.

If our laws are responsive to opportunities for increasing social welfare, then we would expect the laws to change from no liability to full liability. But it would be naive to think that these changes just happen automatically to maximize social welfare, especially when those who stand to lose the most will fight to retain the status quo. Smoking is an example where the liability changed as public understanding of the health costs of secondhand smoke changed. But U.S. mining law offers a counterexample, where rights and liability have not shifted much in light of changing demographics and environmental concerns. One reason has to do with the vested interests that will resist change if they are not compensated. For example, tobacco companies spent huge sums over several decades to halt or slow the erosion of smokers' rights. And oil-exporting countries, oil companies, and industries dependent on fossil fuel industry are currently waging a global campaign to undermine the science and policies to slow


/ Marginal external cost / to downstream fishing / community

MB to upstream y farming community/


0 Qfl Q*

Qnl Damage to fish habitat

climate change. These efforts can be seen as examples of "rent seeking," a topic discussed more in chapter 13.

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    What does the coase theorem proof?
    8 years ago
  • savanna
    Why is the coase theorem an important concept in environmental economic?
    8 years ago
  • ida boyette
    Why the coase theorem is an important concept in environmental economics?
    8 years ago
    How the Coase theorem could be applied to the previous smoking situation?
    1 year ago
  • procopio milanesi
    Is the coase theorem relevant to the optimal regulation of greenhouse gases?
    1 year ago
    How can the coase theorem effect the environment?
    10 months ago
  • Nora
    Is coase theorem applicable to smoking by individuls?
    4 months ago
  • marina
    How can coase theorem be used to tackle climate change?
    3 months ago
  • bisrat
    What are the problems with the coars theorem for pollution?
    2 months ago

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