The document discusses the Coase Theorem and its implications for policymaking. It introduces the Coase Theorem, which states that with costless negotiation and clearly defined property rights, parties can negotiate efficient solutions to externalities. It provides examples of neighbors negotiating over loud music to illustrate this. However, negotiation is not always costless in the real world. Therefore, government intervention through laws, taxes, and subsidies can sometimes help increase total surplus by addressing externalities where private negotiations fail.

1. The Coase Theorem and Policy
April 24, 2013

2. Announcements
• Reminder: Jake’s section from Monday was
rescheduled to today, 5:30-6:30 pm in Econ
304.
• Homework 4 will be a practice exam
– Posted on about Friday (one week before
midterm), ungraded.

3. Last Time
• Introduced basic idea of externalities.
• Showed that private decision at odds with
public interest, caused inefficiency.
• Stated that free market solutions might
rectify: The Coase theorem.

4. The Coase Theorem
• If an outcome is not socially optimal, that means that at least
some people can be made better off without harming anyone
• This creates an incentive for individuals to take steps to
improve the situation.
• The Coase Theorem: If at no cost people can negotiate the
purchase and sale of the right to perform activities that cause
externalities, then can always arrive at efficient solutions to
the problems caused by externalities.

5. Example
• Suppose Barack likes to play loud music late at night, but it
disturbs his neighbor Mitt. Barack could stop playing music
late at night, but he enjoys doing this. The table below shows
their monthly enjoyment from being at home under different
scenarios.
• Suppose Barack and Mitt can’t negotiate with each
other, what will the outcome be?
Don’t Play Music
After 10pm
Play Music
After 10pm
Gains to Barack $50/month $70/month
Gains to Mitt $50/month $10/month

6. Example 1
• Now suppose they can easily negotiate with each other, what
will the outcome be?
• One possibility: Mitt could offer Barack $30 per month to stop
playing music.
Don’t Play Music
After 10pm
Play Music
After 10pm
Gains to Barack $50/month $70/month
Gains to Mitt $50/month $10/month

7. Example 2
• Now suppose they can still easily negotiate with each other,
but the law gives Mitt the right to make Barack stop playing
music. What will the outcome be?
• Barack won’t play music.
Don’t Play Music
After 10pm
Play Music
After 10pm
Gains to Barack $50/month $70/month
Gains to Mitt $50/month $10/month

8. Example3
• Now it’s socially optimal to play music after 10pm
• Suppose the law still gives Mitt the right to make Barack stop
playing music.
Don’tPlay Music
After 10pm
Play Music
After 10pm
Gains to Barack $50/month $70/month
Gains to Mitt $50/month $40/month

9. Which solution achieves efficiency?
A. It will be achieved automatically.
B. It will never be achieved.
C. Mitt pays Barry $10.01
D. Barry pays Mitt $10.01
Don’tPlay Music
After 10pm
Play Music
After 10pm
Gains to Barack $50/month $70/month
Gains to Mitt $50/month $40/month

10. The Role of Property Rights
• Example 1
– Regardless of whom the law favors, the efficient outcome is
achieved.
– It didn’t matter whether Barack had the right to play music, the
efficient solution was always achieved.
• Examples 2 and 3
– Laws do matter for the distribution of the surplus.
– When Barack has the right to play music, he’s better off than
when the law requires him to stop playing music.

11. Legal Remedies
• The Coase Theorem tells us that efficient solutions to externalities
can be found when parties can easily (at no cost) negotiate with
each other.
• What role do laws play in dealing with externalities?
• Is there any need for government intervention?

12. Legal Remedies
• Negotiation is not always costless.
– Not fun to get up in the middle of the night to negotiate
with your neighbor who’s playing loud music so you can
sleep.
– How do the safe drivers on a highway flag down a
speeding motorist (whose behavior is endangering others)
to negotiate with her?
– How do you trust people to live up to their end of the
bargain?
• This opens the door for the government to impose laws that
increase total surplus.

13. Examples of Laws that Solve Problems
Created by Externalities
• Noise ordinances that set quiet hours for neighborhoods.
• Speed limits& no-passing zones.
• Laws regarding broken headlights, taillights etc.
• Zoning laws—can’t build loud factories in residential areas.
• Pollution laws.
• Seat belt laws.
• Laws against theft, assault, murder.
• Building codes—how high can buildings be, and how close
to the property line?
• No talking on your cell phone in your car (or in class).

14. Taxing Negative Externalities
P
Q
S
D
P
Q
S
D
S+XC S+Tax
XC=$100 per unit Tax=$100 per unit
Also called a Pigouvian tax.
Example: Pay for Carbon output.

15. Subsidizing Positive Externalities
P
Q
S
D
P
Q
S
D
D+XB D+Subsidy
XB=$100 per unit subsidy=$100 per unit
Example: Financial aid!

16. Positional Externalities
• Positional externalities occur when an increase in one person’s
performance reduces the expected reward of another person in
situations in which reward depends on relative performance.
• Occurs in many competitive situations.
• People make investments to increase their relative standing, but
the cost of all those investments is likely to outweigh the collective
payoff—after all, only one person can be #1!
• Often leads to a prisoner’s dilemma.

17. Why would Lance dope?
• Lance Armstrong recently
decided not to fight the U.S.
Doping Agency’s allegations
that he used performance
enhancing drugs.
• Taken as a implicit admission
that the allegations are true.

18. Why Would Lance Dope?
Lance
Don’t
Dope
Dope
Alberto
Don’t
Dope
Second best
for each
Worst for Alberto
Best for Lance
Dope
Best for Alberto
Worst for Lance
Third best
for each

19. Poor Lance?
• Should we really blame the guy just because he knows a Nash
equilibrium when he sees one?
A. Yes
B. No
• Maybe, but according to the World Anti-Doping Code
– Armstrong will be stripped of his seven Tour titles, bronze medal
he won at the 2000 Olympics andall other titles, awards and
money he won from August 1998 forward.
– Armstrong also will be barred for life from competing, coaching
or having any official role with any Olympic sport or other sport
that follows the World Anti-Doping Code.
– Recently stepped down as Chair of the Board of Directors of
Livestrong.

20. Other Examples
• Arms races (arms agreements)
• Campaign spending (campaign spending limits)
• Sports gear (ban on high-tech full-body suits for swimmers)
• Educational attainment & study habits (“nerd”)
• The “rug-rat race” (accusations of being a “helicopter parent”)
• Edgy tatoos and piercings (social norms)
• Nudity, sex, violence in the media (social norms)