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09 coase theorem


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Since pollution is an externality firms will not undertake to control their pollution. The answer is in government regulations. Coase argues that in perfect competition with laissez faire, govt …

Since pollution is an externality firms will not undertake to control their pollution. The answer is in government regulations. Coase argues that in perfect competition with laissez faire, govt regulation is not needed. Instead bargaining between the polluters and their victims can lead to an optimal situation. But this pre supposes equality in bargaining, and does not take note of ecological consequences of pollution.

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  • 1. THE COASE THEOREM Prof. Prabha Panth Osmania University 26-Oct-13
  • 2. 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. Prabha Panth 2
  • 3. 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. Prabha Panth 3
  • 4. 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. Prabha Panth 4
  • 5. • 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. Prabha Panth 5
  • 6. Equilibrium in the Coase Theorem MCA MCA, MD MD MCA > MD, so victims should bribe polluters = Ab, to reduce their pollution to X0 A G E H MD > MCA, so polluters should pay compensation to victims = GHE, equal to the pollution burden. B 0 X1 X0 X2 Pollution Prabha Panth 6
  • 7. Equilibrium • 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. Prabha Panth 7
  • 8. Equilibrium in Coase Theorem 1. 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. Prabha Panth 8
  • 9. 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. Prabha Panth 9