Secondary Effects Of The Coase Theorem example essay topic

The bases of every market are the property rights of the individuals that participate in the market. Without property rights there would be no exchange and difficult to establish contract laws. Property rights were taken for granted for much of history and are now used to establish all sorts of theories, philosophies and regulation. Two excellent examples of this are the Libertarian political party and the Coase Theorem. As for the value of these two applications of private property it is important to evaluate the practicality of them.

To understand both two separate historical figure will be consulted. The first being Ludwig Von Mises and his study of Libertairnism and the second will be R.H. Coase and his Coase Theorem. Each Stated simply the Coase Theorem is as follows, If property rights are clear and enforceable, all economic agents have full information regarding the situation at hand, and transaction costs are low, then there is no need for government intervention to correct externalities because the economic agents themselves can bargain to achieve a Pareto optimal allocation of resources. Furthermore, the ability of economic agents to bargain among themselves to achieve a Pareto optimal allocation of resources does not depend on which economic agent has the property. (Zilberman 1) To begin with the Coase Theorem addresses the market problem of externalities, or otherwise known as the Spillover Effect. The problem of externalities occurs when a person other than the original purchaser of a specific good shares in the cost and benefits of the purchased good.

A common and easy to understand example of this is the placement of a new airport near residential area. Residents receive positive effects in the form of an increase in business due to the new airport but must also deal with the negative effects of the increase in nois from the airplanes using the airport. Externalities are in short anything that effects the action or welfare of an unrelated operations or persons. With such a vague description it is easy for the dilemma of externalities to become overwhelming, fogging the really issue and before you know it there is no definition. Whitley of the University of Chicago describes the parity in these terms in order to create a more clear definition.

With this very general definition, almost everything is an externality. For example, when a new firm enters production and drives up prices of the factors of production used by the industry, the firm is imposing costs on other firms. This example, is not problematic in the discussion of competitive equilibrium, however, because the external effect is completely transmitted through prices. Externalities like this, where the full external effect is captured in existing markets, are called pecuniary externalities. These externalities are no threat to the First Welfare Theorem and will not be discussed here. The externalities that will be discussed here include examples like fishing, pollution, and loud music These examples all had in common the fact that there was not a market for a particular good or action and this lack of a market is where the potential to induce equilibrium that is not Pareto optimal comes from.

(Whitley 1) It is Whitley second definition of externalities that apply to the Coase Theorem. It is this second definition that pertains directly to the issue of pollution and who is directly affected by a firms action. With a definition of externalities in hand it is important to turn to the core issue of the Coase Theorem and that is property rights. In many cases disputes over property arise because no one owns the property in question.

Even worse than property owned by no one is property owned by everyone. In that case the dispute will intensify as people try to obtain some portion larger than the other parts controlled by the other owners. In the courts these disputes are often solved by dividing up the property into privately owned sections not unlike the section off of the western territories in early United States history also known as squatter rights. As put by Svetozar Pejovich, in a collections of economic essays on property rights, the importance of property rights in Coases Theorem revolves around these simple principles of property rights.

The Coase Theorem says that (I) clearly defined private property rights are an essential requirement for resolving the conflict of interest among individuals via market exchange, and (II) and efficient allocation of resources is independent of the initial assignment of property rights as long as transaction costs are significant. (Pejovich 148) A useful concept to keep in mind is that property rights are actually a bundle of many different rights. For example I return to my airport in a residential area for guidance. A property owner is able to control planes from flying 20 feet above their yard but will be unable to stop a plane from flying 35,000 feet above their yard. Both of these controls are considered property rights. This in and of itself is not a Copernican finding but must be understood to continue.

Property rights and private ownership is an essential part of a free market. Simple day to day transactions would never be able to take place without a stable dependence on private property rights. Something as simple as typical market exchange between a buyer and seller is a complex transaction built on private property rights. It becomes exceedingly difficult for one to participate in exchange when one doesnt own any property to exchange. The same with contract law, it would be impossible to legally defend an agreement between two people without the ability to protect their right to secure a transaction involving their private property when there is no private ownership. It is under this premise that laws and precedents are set in order to protect private property and maintain a free market.

In short the workings of a free market are developed through the right to private property. Coase understood this fundamental piece of a free market, not at first might I add, Coase began his career as a socialist but slowly made the transition to more of a free market economists (Hazlett 9). Coase in his own words puts it as follows, The law of property determines who owns something, but the market determines how it will be used. Its so obvious to me that I couldnt understand the fuss.

All it says is that people will use resources in the way that produces the most value, thats all. I still think its an obvious point. You wouldnt think there was a need for a Coase Theorem. (Hazlett 3). The Coase Theorem the assignment of private property rights serve the purpose of correcting for negative externalities or the consequence of incomplete assignment of property rights. By assigning property rights this allows a solution of efficiency through private negotiation.

Unlike Coases predecessor Pigou, Coase suggests that the correct way to assign property rights is to revise legal arrangements and laws to lay out standard rules and norms. As a side note Pigou favored government intervention as a way to regulate private property while Coase would contend strongly for natural market behavior to sort out the details or in his own words, : I cant remember one (regulation) thats good. (Hazlett 6). The Coase Theorem is summed up as a private property owners working out agreement between each other in order to compensate for externalities that may have a negative effect on one or both of the partys welfare. As long as private property ownership is protected though law and maintained by the market people, according to Coase, will be able to settle disputes over externalities through private agreements.

This comes into play when discussing pollution regulations and remedies. An example of such an arrangement may occur between neighbors in a apartment complex. Say one neighbor enjoys to play video games very loudly in the early morning while another neighbor enjoys to sleep in and work evenings. The noise experienced by the second neighbor is an externality and is invading the second neighbors private property. Through negotiations an agreement is reached between the two neighbors where the noisy neighbors pay the sleepy neighbor $10 a day in order to play is video game or the other deal could be that the sleepy neighbors pays the noisy neighbor to play his video game quietly.

Either way the neighbors are paying for the private property rights of the other violated by the externality. The Coase Theorem is not without its flaws. Most debates over the Coase Theorem center around whether or not it can be applied to real life situations. It is always hard to justify a theorem that works only part of the time and only on certain situations. Here are a few of the many instances where the Coase Theorem fails: If the resource cannot be divided or segmented into separate pieces of private property. The classic example of the is air.

It is impossible to divide the atmosphere into individual segments of ownership (web). Another limitation is if the resource within the property are mobile. An example of this is ground water. Even if the oceans could be divided up into separate segments for each different fishing company it is impossible to control the fish from swimming about from segment to segment (web).

The next situation is if property rights are irrelevant to the environmental problems. The prime example of this is an explosion in population. Since an increase in population places short term strains on the land and its carrying capacity strengthening property rates would have little effect on these facts (web). The last situation is if the polluter is not the neighbor, but the owner. In other words these situations arise because the profits received from spoiling the land are highly individualized and short-term, but cost of spoiling them are socialized and long-term (web).

According to Deirdre McCloskey the reason why one can find so many faults with the Coase Theorem is that it has been misinterpreted by so many people for so long starting with George Stigler. He explains it in the following manner, The theorem (the misinterpreted version) is supposed to be that is doesnt matter where you place liability for, say, smoke pollution, because in a world of zero transaction costs the right to pollute will end up in the hands of that value it the most Coases actual point, the core of the Coasean economics, was to note what happens in the many important cases in which transaction costs cannot be neglected. If the situation does not have high transaction costs, then it doesnt matter where the liability for pollution is placed. (McCloskey 2) McCloskey continues by explain that the wrong Coase Theorem is actually an idea of Adam Smiths and others of the British Classical School and not a new idea at all (McCloskey 2). McCloskey is able to distinguish between the two different definitions because of the way transaction costs are defined in the two separate interpretations. Transaction costs are the costs of negotiating and agreement.

If there are a number of parties involved then the costs of coming to an agreement may exceed the benefits. This is not the only transaction cost, there are also cost in searching for information and in evaluated all exchange opportunities. Along with these obvious costs there are monitoring costs policing costs, to ensure that agreements are kept. Joined with monitoring and policing comes prosecution for violators of the agreement. Naturally if the net sum of these cost exceed the benefits received from a transaction then the transaction will never take place. The Coase Theorem takes into account these transaction cost even though many opponents to Coases Theorem would argue it doesnt.

Coase has expressed the fact that a world of zero transactions costs is unrealistic but adds that just because transaction costs exist doesnt mean that private property agreements cannot be reached. Some secondary effects of the Coase Theorem are those on wealth and income. It is natural that the Coase Theorem would effect these factors because both wealth and income are effect by the claims to private property. An unknown author explains that a change in private property assignments change society's overall supply and demand (web 6) This is important because these changes effect the whole economy especially if the parties involved are large firms and the government. It is also true that most people will charge less to stop an undesirable behavior than it would be to charge for continuing the damaging behavior (web).

This wealth transfer posses a problem because no one can accurately predict the future productivity of the private property in question, be it land or and company. This is easy to see when one considers a large company such as a car manufacturer buying a large plot of land for a new factory. Unfortunately Coase does not sufficiently address this problem in his theorem but just assumed that the changes in wealth and income had no effect on the outcome of the theorem. Along with transaction costs and wealth and income transfers Coases theorem also requires perfect competition to work efficiently.

This means that the market features a large number of competitors, homogenous goods, free entry and exit to a market, and perfect information. This of course leads to lower prices and higher quality goods. The opposite of perfect competition is a monopoly. Using fundamental economics it is easy to see that without perfect competition the incentive to be more efficient diminishes allowing for a greater problem with externalities. Another characteristic of perfect competition is the endless availability of information. Without all the information it makes it hard for a person to correctly maximize their utility through choices.

Principles like opportunity cost play a large role in the determination of action and with out perfect information a persons choice may not be the best. This hinders Coase theorem because it limits the extent to which one may evaluate their private property and negotiations to protect it. Of coarse, perfect competition is not obtainable in a real market but Coase argues, again, that his theorem is still applicable. One economist put it this way, Coase attempts to get around this by claiming that zero transaction costs are a proxy for perfect competition. That is, a monopoly with zero transaction costs will behave like a perfect competitor, since it will seek to maximize its efficiency and profits. Most economists find the idea of competitive or efficient monopolies hard to swallow.

But even granting Coase his point, a world of zero transaction costs is only slightly less imaginary than perfect competition. (web 8) After examining all of the faults of the Coase Theorem it may be easy to say that it has no practical use but this is not entirely true. Some of the opinions expressed above are extreme and not all together applicable to Coases theorem. Coase is may times correct when he simple says, paraphrasing of course, but, it works! One very practical use of the Coase theorem is in the creation of environmental regulations. Environmental regulations concerning externalities began in common law as it pertained to those things classified as nuisances (Clarkson 825). A recent example of an environmental nuisance case was in 1996.

The case Maddocks vs. Giles set the precedent for payment as compensation for a nuisance. In the case Maddocks owned property next to a gravel pit that contained a small spring. The gravel company, owned by Giles, began a new excavation and in doing so stopped the spring from flowing. This had no significant environment impact on the land and animals but was a nuisance to Maddocks.

The supreme court ruled that Maddocks had a legitimate right to his property and ordered the case to trial for compensation (Clarkson 825-26). This example shows that the US court system up holds the right to compensate one for an externality effecting their property. One of the more Coasean statues are those that apply to air pollution. In cases in which one factory is polluting the air in a certain community it is necessary for regulations to create incentives for that factory to cut back the amount of externality it is producing. It can either pay another company for their rights to pollute and influence that company to produce less pollution or pay in liability the effects the pollution may have on the inhabitants of the polluted community. The government, through the Clean Air Act, strongly suggests that a polluting factory cut back the pollution in their own plant or pay another plant to cut back their pollution (Clarkson 828).

This is a clear example of the Coase Theorem and the effects of externalities on property rights. Alison Butler put it the following way, The Coase Theorem proves that the equilibrium level of pollution is the same Furthermore, such an outcome is efficient. Thus, when property rights are clearly defined and there is an explicitly designated polluter and victim, the efficient outcome is independent of how the property rights are assigned. (Butler 3) All though Butler recognizes the ability of the Coase Theorem to settle pollution disputes she does point out one flaw. The Coase Theorem becomes less efficient when there are multiple polluters and many parties effected. In this case the pollution outcome may depend on the assignment of property rights unlike the statement made above (Butler 3).

Truth is that Coases theorem does work even with transactions costs and without perfect competition if applied in the way that he intended. Most opposition to the Coase Theorem come form the misunderstanding of his theorem as discussed earlier. Moreover the practical use of the Coase Theorem does exist and is applied daily to situations where externalities effect another property rights.