The problem of social cost

The Problem of Social Cost R. H. Coase (1960) Mikhail Dubov

The problem to be examined
Some production processes create negative externalities for other firms or individuals.
Confectioner and Doctor
Farmer and cattle-raiser
Standard analysis follows Pigou
Owners of the firms liable for the damage
Place a tax equivalent to the damage (Pigovian Tax)
Remove factory from the area (zoning)

Reciprocal nature of the problem
Standard analysis obscures the nature of choice to be made
Pollutant harms others
Removing pollution will harms the pollutant
Opportunity cost is neglected
Both parties can prevent the damage
Doctor can move to another room
Confectioner can change his way of production or move

Objective
The system should minimize the total (maximize total output) of all parties involved.
This should lead to the same effect as internalizing the externality
If doctor and confectioner are a single firm it will regard the total effect of any allocation
Assumption: no transaction costs

Liability for Damage
Pollutant liable for damage
Cattle-raiser can fence the property
Decrease production (have smaller herd)
Pay the farmer not to cultivate the land
Pollutant not liable for damage
Farmer can fence his property
Farmer can leave the land
Farmer can pay cattle-raiser to decrease the number of sheep

Result
There will always be room for bargaining unless the marginal gain of one party is equal to marginal loss of the other
This result is the same as the aim set before

The Coase Theorem
If the property rights are clearly defined then the agents can reach optimal allocation by free bargaining
Final allocation will be independent from allocation of liability for pollution
Allocation will depend on relative prices
No intervention from the government is needed

Costs of Market Transactions
Transaction costs may make the optimal allocation unattainable
There are ways to minimize transactions
Single ownership of property rights
Restrictive covenants
Government intervention may be even more costly

Critique of Pigou
Failure to take into account costs imposed on pollutant
Tax equal to damage caused leads to unduly high costs.
Lack of perfect knowledge of individual preferences makes better system impossible
Bad incentives created by taxation
Too many people living in the vicinity of the factory and too low pollution

Change of Approach
Take into account opportunity cost as well as difference between private and social cost
Start analysis with the approximation of existing situation rather than think of universal cases
Think of factors of production as rights not physical entities

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The problem of social cost

by duboff on Jan 14, 2007

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The problem of social cost — Presentation Transcript