The Problem of Social Cost of Ronald Coase

“The Problem of Social Cost” of Ronald Coase William

The Problem Some actions of firms harm others • – Factory emits smoke which harms neighbours • – Cattle trample crops of adjacent farmers Standard Economic Analysis (Pigou) • – Make factory / rancher liable for damage • – Tax activity which causes damage • – Restrictive zoning of harmful activities

Reciprocal Nature of Problem The presence of both parties is required for damage to occur. • – The presence of the rancher and farmers are a pre - requisite to cattle damaging crops. Either party can prevent the damage. • – The rancher can fence his property or reduce the size of his herd. • – The farmer can fence his property or leave adjacent land uncultivated.

Economic Optimum The objective should be to maximize the value of the joint output of beef and grain. Consider the behavior of a single firm that owns ranch and farm land – it will increase the size of the herd if the value of the additional beef exceeds the crop damage.

Allocation of Property Rights The rancher is liable for any damage his cattle cause. • – The rancher can reduce the size of his herd, limiting his liability • – The rancher can fence his property • – The rancher can pay the farmer to leave land uncultivated, thus mitigating his damages. .

Allocation of Property Rights The rancher is not liable for damage • – The farmer can leave land uncultivated, thus mitigating his losses • – The farmer can fence his property. • – The farmer can pay the rancher to reduce the size of his herd, thus mitigating his damages.

Coase Theorem If the two parties negotiate freely, and in the absence of transactions costs, then they will arrive at the economic optimum • – The resources devoted to ranching and farming will depend on the value of meat and grain. • – The optimum solution is not dependent upon the initial allocation of property rights.

Transactions Costs In the presence of transactions costs, an optimal negotiated solution may not be achieved. The market has created mechanisms to minimize transactions costs. • – Single ownership of large tracts of land, commercial or industrial projects • – Restrictive covenants Although market transactions are be costly, the costs of government regulation may be greater.

Restatement of Pigou Divergence between private and social cost arises when party A, in the course of rendering a service to B, damages C. Government regulation can be used to “internalize” external costs. • – Tax on External Costs • – Establishment of liability for external damages

Critique of Pigou If we tax the polluter, and compensate the victim, this will encourage people to move into the neighborhood to receive compensation. • – In the absence of a Pigovian tax we have too much smoke and too few neighbours • – In the presence of a tax we have too little smoke and too many neighbours.