Externalities. The Coase Theorem. Externalities. Externalities The concept of an externality is quite simple.

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1 Externalities The concept of an externality is quite simple. Externalities The concept of an externality is quite simple. John and Sam are both located along a lake. John runs a paper mill and Sam uses his property as a vacation cottage. John s actions influence the pleasure of the vacation cottage. Externalities The concept of an externality is quite simple. There is a distinction between pecuniary and non-pecuniary externalities. 1

2 Externalities The concept of an externality is quite simple. There is a distinction between pecuniary and non-pecuniary externalities. If I purchase a widget, it denies you the right to that widget. Externalities The concept of an externality is quite simple. There is a distinction between pecuniary and non-pecuniary externalities. If I purchase a widget, it may denies you the right to that widget. Since I pay the social cost of the widget, there is no efficiency loss from my purchase. Externalities Non-pecuniary externalities can lead to market failure. John and Sam constitute a non-pecuniary externality Externalities Non-pecuniary externalities can lead to market failure. The standard solution to dealing with externalities was proposed about 80 years ago by A. C. Pigou in The Economics of Welfare: 2

3 Externalities Non-pecuniary externalities can lead to market failure. The standard solution to dealing with externalities was proposed about 80 years ago by A. C. Pigou in The Economics of Welfare: Externalities arise because John does not have to pay for the impact of his paper mill on Sam. Externalities If John pays an appropriate Non-pecuniary tax for externalities each unit can of pollution, lead to market failure. the problem disappears. The standard solution to dealing with externalities was proposed about 80 years ago by A. C. Pigou in The Economics of Welfare: Externalities arise because John does not have to pay for the impact of his paper mill on Sam. The Cosian Solution There is an important symmetry. The Cosian Solution There is an important symmetry. While we think of John harming Sam, it is also possible to think of Sam harming John. 3

4 The Cosian Solution The Cattle and the Fence There is an important symmetry. While we think of John harming Sam, it is also possible to think of Sam harming John. Any reduction in the level of pollution is a harm to John. The Cattle and the Fence The Cattle and the Fence Assume the value of the crop is $1 a ton and that a fence costs $9 a year. Assume the value of the crop is $1 a ton and that a fence costs $9 a year. Consider two liability rules: The Cattle Owner is Liable and the Farmer is Liable 4

5 The Cattle Owner is Liable The Cattle Owner is Liable If the cattle owner is responsible for the damages to the farmer, he considers the damages as a marginal cost of doing business. If the cattle owner is responsible for the damages to the farmer, he considers the damages as a marginal cost of doing business. If it wants to have 1, 2, or 3 head of cattle, he will simply pay damages. If he wants 4 or more head of cattle, the fence is the cheaper operation. The Cattle Owner is Liable If the cattle owner is responsible for the damages to the farmer, he considers the damages as a marginal cost of doing business. A regulation requiring a If it wants to have 1, 2, or 3 head of cattle, he fence will simply is clearly pay damages. If wrong. he wants 4 or more head of cattle, the fence is the cheaper operation. The Cattle Owner is Liable The liability will not cause the farmer to increase the size of his crop. 5

6 The Cattle Owner is Liable The Cattle Owner is Liable The liability will not cause the farmer to increase the size of his crop. Suppose a farmer was originally there. The farmer will see no change in his income, though he may now be selling some of his crop to the cattleman rather than to the marketplace. The liability will not cause the farmer to increase the size of his crop. Indeed in some cases, it may lead to less production. Suppose that, absent the cattlemen, the farmer raised $12 of crop at a cost of $10, with a net profit of $2. If the cattleman wants only one steer, it is optimal to pay damages to the farmer. The Cattle Owner is Liable The liability will not cause the farmer to increase the size of his crop. Indeed in some cases, it may lead to less production. If he wants two or more, it will be optimal to pay the farmer to stop production or perhaps abandon a sub section of the land. Overproduction? Is it possible the cattle owner s liability could lead to over-production?. 6

7 Overproduction? Overproduction? Is it possible the cattle owner s liability could lead to over-production? Suppose the cows all move along a given path. It would cost $11 to raise $10 of crop along this path. Is it possible the cattle owner s liability could lead to over-production? Suppose the cows all move along a given path. It would cost $11 to raise $10 of crop along this path. The farmer would not plant along this path absent the cattleman, but it might be tempting to threaten to do so to get a bribe of (say) $5 from the cattleman. Overproduction? Is it possible the cattle owner s liability could lead to over-production? Suppose the cows all move along a given path. Common It would sense cost $11 suggests to raise $10 that of the crop crop along will not this be path. grown for long. It may happen The as farmer a way would of maximizing not plant along the this farmer's path absent income, the cattleman, but but only it might temporarily. be tempting to threaten to do so to get a bribe of (say) $5 from the cattleman. The General Result If the cattleman is liable for damages to the farmer, the optimal level of production will be achieved. 7

8 The General Result No Liability If the cattleman is liable for damages to the farmer, the optimal level of production will be achieved. This system requires not only liability but also that the farmer and cattleman have the ability to strike an enforceable bargain. Lets reverse the situation. The cattleman has no liability: the farmer is liable for any damages. No Liability Lets reverse the situation. The cattleman has no liability: the farmer is liable for any damages. Suppose the cattleman has three steers. Three Steers The farmer will be willing to pay $3 to reduce the herd to two steers, etc. 8

9 Three Steers Three Steers The farmer will be willing to pay $3 to reduce the herd to two steers, etc. Thus the cattleman has an opportunity cost of $3 of going from two steers to three steers. The farmer will be willing to pay $3 to reduce the herd to two steers, etc. Thus the cattleman has an opportunity cost of $3 of going from two steers to three steers. Before, the opportunity cost was in terms of payments to the farmer. Now it is in terms of forgone payments from the farmer. Three Steers The farmer will be willing to pay $3 to reduce the herd to two steers, etc. Thus the cattleman In any case, has the an farmer opportunity cost of $3 of will going not from pay two more steers than to $9 three steers. Before, the opportunity cost was in terms of payments to the farmer. Now it is in terms of forgone payments from the farmer. Strategic Behavior? Might the cattleman increase the size of his crop to get additional money from the farmer? 9

10 Strategic Behavior The General Result Might the cattleman increase the size of his crop to get additional money from the farmer? It is possible once again as a bargaining ploy, but only as a bargaining ploy. In game theory terms, the threat of increasing the size of the herd is not credible. The assignment of liability affects the direction of side payments, but not the level of production. The General Result The assignment of liability affects the direction of side payments, but not the level of production. Does the cattleman have the right to have cows unfenced? Or does he not? Applying Law and Economics-Charles W. Upton 10

11 Sturges v. Bridgeman Sturges v. Bridgeman For more than 60 years, a confectioner used two mortars and pestles. A doctor moved next door. For more than 60 years, a confectioner used two mortars and pestles. A doctor moved next door. All was peace and harmony, until the doctor built a consulting room right against the kitchen. Sturges v. Bridgeman Doctor Wins For more than 60 years, a confectioner used two mortars and pestles. A doctor moved next door. All was peace and harmony, until the doctor built a consulting room right against the kitchen. The court ruled for the doctor, but the ruling makes no difference. B Consulting Room > B Mortar and Pestle Yes Doctor Stays, no money changes hands 11

12 Doctor Wins Doctor Loses B Consulting Room > B Mortar and Pestle Yes Doctor Stays, no money changes hands B Consulting Room > B Mortar and Pestle Yes Doctor Stays, money changes hands No Doctor moves, money changes hands Doctor Loses Doctor Wins or Loses B Consulting Room > B Mortar and Pestle Yes Doctor Stays, money changes hands B Consulting Room > B Mortar and Pestle Yes Doctor Stays No Doctor moves, no money changes hands No Doctor moves 12

13 Doctor Wins or Loses Cooke v. Forbes B Consulting Room > B Mortar and Pestle All that is at issue is whether money changes No hands. Yes Doctor moves Doctor Stays Coca nut fiber matting was hung out to dry after being bleached. Cooke v. Forbes Coca nut fiber matting was hung out to dry after being bleached. The fumes were dreadful. Cooke v. Forbes Coca nut fiber matting was hung out to dry after being bleached. The fumes were dreadful. The neighbor asked for a restraining order. 13

14 Cooke v. Forbes Neighbor Wins or Loses Coca nut fiber matting was hung out to dry after being bleached. The fumes were dreadful. The neighbor asked for a restraining order. He did not get it, but got the right to sue for damages when the smell occurred. B Fumes > B peace and Quiet No Yes Mats Go Mats Stay Neighbor Wins or Loses Bryant v. Lefever B Fumes > B peace and Quiet All that is at issue is whether money changes No hands. Yes Mats Go Mats Stay Two houses of the same size. One house was torn down and rebuilt. It then caused the chimney of the original house to smoke. 14

15 Bryant v. Lefever Bryant v. Lefever Two houses of the same size. One house was torn down and rebuilt. It then caused the chimney of the original house to smoke. Bryant sued and won 40 in damages. The appeals court reversed on grounds that the plaintiff was causing the damages. Two houses of the same size. One house was torn down and rebuilt. It then caused But who really caused the the chimney of the original house to smoke. problem? Both did. The He sued and won 40 in damages. The decision is one of setting appeals court reversed on grounds that the property rights, not in terms plaintiff was causing the damages. of determining the ultimate decision. Bass v. Gregory The Cellar of the Jolly Angler was used for brewing and the air was then vented into an abandoned well on the property of the neighbor. Bass v. Gregory The Cellar of the Jolly Angler was used for brewing and the air was then vented into an abandoned well on the property of the neighbor. The defendant boarded up the well, and thus rendered the Cellar unusable. 15

16 Bass v. Gregory Bass v. Gregory The basic question was whether the Jolly Angler had the right to a current of air. The basic question was whether the Jolly Angler had the right to a current of air. The court said yes, using the doctrine of lost grant. Bass v. Gregory The basic question was whether the Jolly Angler had the right to a current of air. The court said yes, using the doctrine of lost grant. This is a different result than in Bryant v. Lefever. Bass v. Gregory The basic question was whether the Jolly Angler had the right to a current of air. The court said yes, using the doctrine of lost grant. This is a different result than in Bryant v. Lefever. Doesn t matter. All that is at issue is whether money changes hands. 16

17 Transaction Costs Transactions Cost and the Law of Nuisances rests on the assumption that rights can be rearranged at negligible cost. Transaction Costs rests on the assumption that rights can be rearranged at negligible cost. So, when the rights belong to the wrong party, the costs of transferring the rights are minor and the economically efficient solution will prevail. Transaction Costs rests on the assumption that rights can be rearranged at negligible cost. So, What when happens the rights if belong there to is the a wrong party, significant the costs transactions of transferring cost? the rights are minor and the economically efficient solution will prevail. 17

18 Bryant v. Lefever Bryant v. Lefever Lefever's new house imposes damages of 22 on each of twenty nearby houses. He gets 130 of benefits from the higher house. Lefever's new house imposes damages of 22 on each of twenty nearby houses. He gets 130 of benefits from the higher house. The new structure should not be built. But if it would cost 21 to negotiate with each of his neighbors, they will not be willing to pay him enough to stop the construction of the house. Bryant v. Lefever Lefever's new house imposes damages of 22 on each of twenty nearby houses. He If Lefever has the right to gets 130 of benefits from the higher house. build, the transactions cost The new structure should not be built. to his neighbors is high But if it would cost 21 to negotiate with each enough to preclude them of his neighbors, they will not be willing to pay him enough from to stop stopping the construction him. of the house. Bryant v. Lefever And, even if the benefits were say 800, he would not be willing to buy the rights from each of his neighbors. 18

19 Bryant v. Lefever Bryant v. Lefever And, even if the benefits were say 800, he would not be willing to buy the rights from each of his neighbors. They would want 440 in the aggregate and it would cost him 420 to make the deal. His total costs of 860 would exceed his benefits. And, even if the benefits were say 800, he would not be willing to buy the rights from each of his neighbors. They would want 440 in the aggregate and it would cost him 420 to make the deal. His total costs of 860 would exceed his benefits. In short, the assignment of property rights can make a difference here. The Law Against Nuisances Common Law protected against nuisances. The Law Against Nuisances Common Law protected against nuisances. People have a right to peaceful enjoyment of their property. 19

20 The Law Against Nuisances The Law Against Nuisances Common Law protected against nuisances. People have a right to peaceful enjoyment of their property. Property rights did not include the right to impose unreasonable externalities on others. But what is a nuisance? I am taking a nap at 3:00 PM and my neighbor decides to mow his lawn. No judge would rule that my peaceful enjoyment has been affected. I am asleep in bed at 3:00 AM and my neighbor has a loud party with the stereo full blast, windows open. Any judge would rule interference with my right of peaceful enjoyment. The Law Against Nuisances But what is a nuisance? I am taking a nap at 3:00 PM and my neighbor decides to mow his lawn. No judge would rule that my peaceful enjoyment has been affected. I When am asleep transaction in bed at 3:00 costs AM are and my neighbor has considered, a loud party with this the seems stereo full a blast, windows open. Any judge would rule interference reasonable with assignment my right of peaceful of enjoyment. property rights. The Law Against Nuisances An Airport The neighbors would object to a new airport as a violation of the law against nuisances. 20

21 The Law Against Nuisances An Airport The neighbors would object to a new airport as a violation of the law against nuisances. The courts would recognize the power of the legislature to overrule the law and grant the airport authority to operate. Coase on Pigou Coase on Pigou The Economics of Welfare recommends internalizing externalities via taxes. Coase on Pigou The Economics of Welfare recommends internalizing externalities via taxes. A railroad is considering running one or two trains a day. Each train will damage crops with a market value of $60. It costs $50 to grow the crops, so the farmer expects a net profit of $10. 21

22 The Railroad s Calculus The Railroad s Calculus If the Railroad is liable for Social Costs Lost Profits, not lost sales If the Railroad is liable for Social Costs 22

23 Liability for crops, damages doubled Liability for social costs, damages doubled Liability for social costs damages doubled The Moral Simply making the train operator liable for damages may give rise to the wrong solution. 23

24 The Moral Simply making the train operator liable for damages may give rise to the wrong solution. Considering transaction costs, the right solution is to give the railroad the right to operate. The Traffic Light Rule 1: If you go through a red light, you will be fined. That is, you pay a Pigovian tax. The Traffic Light The Traffic Light Rule 1: If you go through a red light, you will be fined. That is, you pay a Pigovian tax. Rule 2: If you go through a red light and hit a car, you are liable. That is, cars have a right not to be hit. If you come to a red light at 3:00 AM, the correct solution is probably to go through the red light. The first rule gives the wrong solution; the second rule gives the right solution. 24

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