17.3 The Coase Theorem: Free Markets Addressing Externalities on Their Own

Coase theorem

Theorem that states costless negotiation among market participants will lead to the efficient market outcome regardless of who holds legal property rights.

13Ronald Coase, “The Problem of Social Cost,” Journal of Law and Economics 3 (1960): 1–44.

Sometimes, government does not need to step in with taxes, subsidies, or quotas to force consumers and producers to solve an externality problem and arrive at an efficient market price and quantity. In fact, under certain circumstances, individuals can address and solve the externality themselves. The reason this may be possible lies at the heart of the Coase theorem, which states that parties can reach the optimal level of an externality if they can costlessly negotiate with one another, regardless of the allocation of property rights. The Coase theorem was developed by Nobel Prize–winning economist Ronald Coase in 1960.13

As an example of how the Coase theorem can work, let’s consider the market for business school naming rights. Over the past few decades, a large number of business schools have sold the right to name their school to wealthy benefactors. The University of Michigan’s Ross School of Business, New York University’s Stern School of Business, and UCLA’s Anderson School of Management are just a few examples of many. (In fact, two of the authors, Austan Goolsbee and Chad Syverson, work at the University of Chicago Booth School of Business, named in honor of alumnus and benefactor David Booth.)

Universities have the right to sell the naming rights to their business schools, and many would happily do so in response to a large enough donation. But, there can be an externality involved with a naming decision. For whatever reason, some people—often other alumni, but possibly others as well—may want to keep the school’s original name. Thus, their utility can fall if the school sells its naming rights. Because they aren’t directly involved in the transaction between the school and its donor, this utility loss is a negative externality.

At first glance, that might seem to just be the way it is. A school has the right to sell its name, a donor has the right to buy it, and unless the law for some reason gave everyone else a right to decide whether to sell the naming rights, the folks who don’t want the naming rights to be sold are just stuck with the new name and the utility loss that it results in.

The Coase theorem, however, tells us this logic is not correct. In many situations, it doesn’t matter who has the “property rights” in the transaction—that is, who gets to decide the terms of the deal. The Coase theorem says that if market participants can negotiate, they will reach a deal that yields the economically efficient outcome regardless of the allocation of these decision rights.

To understand why and under what conditions this negotiation can take place, consider the case of the Wisconsin School of Business of the University of Wisconsin. In the mid-2000s, the university was considering selling the school’s naming rights, just as many of its competitors had done. However, some alumni felt strongly that the school should not change its name. Legally, this wasn’t their decision to make. If the university wanted to sell the school’s name, it could, with or without alumni approval. But, the Coase theorem tells us that isn’t what matters. What matters instead is how much the university values selling the business school’s name versus how much the alumni value not selling the name. To see why, suppose the alumni valued keeping the name the same more than the University of Wisconsin valued selling it. The alumni could then negotiate to pay the school to not sell the naming rights. If, as we are assuming, the willingness of the alumni to pay to keep the present name is larger than the university’s willingness to sell it, the university would be willing to accept this deal.

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This is exactly what happened. In 2007 a group of 13 alumni jointly pledged an $85 million gift to guarantee that the school would remain (just) the “Wisconsin School of Business” for at least 20 years. The school had the legal right to sell its name, but it ended up not doing so because, in effect, the externality that it would have imposed on its alumni was larger than the value the university would receive from renaming the school. The alumni ended up paying the university to not impose that externality on them.

If the valuations had been reversed, and the university valued selling the school’s name more than the alumni valued keeping the name the same, the naming rights would have been sold. What the alumni would have been willing to pay the university would not be enough to compensate the university for its lost value of selling the name.

One thing that’s very important to realize here is that the Coase theorem implies these outcomes would have been the same even if the property rights were allocated differently. Suppose for some reason that the school’s alumni had the right to veto any proposed name changes. If the university valued selling the name more than the alumni valued not selling it, the university could sell the name but then compensate the alumni for their losses, making both the university and alumni better off. If instead the alumni felt more strongly than the university, the name wouldn’t be sold.

The upshot is that in the end, the resource (here, the right to name the school) is allocated to its highest-value use regardless of who has the property rights. If the university values a renaming more than the alumni value the status quo, the name ends up being sold regardless of whether the university or the alumni have decision rights over the renaming. If instead the alumni care more about not changing the name, the name doesn’t change, again regardless of which party has the decision rights.

This example shows that when negative externalities are present, the third party incurring an external cost may be willing to pay those generating the externality to stop. (Of course, this will only occur when the external cost borne by the third party is greater than the value of the externality to those generating it.) Likewise, those generating an externality may pay for the right to impose external costs on third parties. These payments allow the efficient outcome to be reached through negotiation.

Do property rights matter at all, according to the Coase theorem? Yes—they affect who pays whom to reach the efficient outcome. Suppose again that the alumni have a greater value from the name remaining the Wisconsin School of Business than the university does from selling the naming rights. These values tell us that the efficient outcome will be for the name to remain unchanged, regardless of which party initially owns the property rights. But, whether the alumni will actually have to pay the university to not rename the school does depend on the assignment of property rights. If it’s the university’s decision to make, then the alumni will pay the university. If alumni are given the right to approve any name change, however, no money would change hands (and the name still wouldn’t change). Either way yields the efficient outcome, but in the first case the alumni pay up (as they did in reality), and in the second case they don’t.

We must be careful not to oversimplify the negotiation process and rely too much on Coase-type negotiations to sort out externality problems. The assumption that the involved parties (those creating the externality and those suffering from it) can bargain without cost incurred or costlessly is critically important. If making deals is costly—if, for instance, lawyers become involved in negotiating the dispute—the Coase theorem doesn’t have to apply.

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It can also be difficult to organize such a negotiation when there are multiple parties involved. The Wisconsin School of Business alumni managed to coordinate their actions, but it would be difficult to get millions of people living on the West Coast of North America to agree on a contract to pay factories in China to stop burning dirty coal, for example. The Coase theorem says that it doesn’t matter whether the law gives the factories the right to pollute as much as they want or requires them to obtain the permission of all breathers of air before they can burn their coal. However, when negotiation costs are daunting, the Coase theorem will fail and governments or laws may be the only way that an externality can be addressed.14

figure it out 17.3

Green Acres Fertilizer Company is located near Barney’s Dry Cleaning Service. In its production process, Green Acres emits noxious odors that are absorbed by the clothing that Barney is cleaning. The result is that Barney has lost many customers over time. Barney estimates that the odors cost his business $10,000 per year. Green Acres can eliminate its odors by altering its production process at a cost of $12,000 per year.

  1. If Green Acres has the right to emit the odors, what will the socially optimal outcome be? How will it be reached? Will any money change hands?

  2. If Barney has the right to odor-free air, what will the socially optimal outcome be? How will it be reached? Will any money change hands?

Solution:

  1. The socially optimal outcome will occur when Green Acres emits the odor. The cost of eliminating the emissions ($12,000 per year) is greater than the external cost of the odor ($10,000 per year). If Green Acres has the right to emit the odors, it will continue to do so. Barney does not value clean air enough to purchase that right from Green Acres, so no money will change hands.

  2. The socially optimal outcome will still be for Green Acres to emit the odor. The optimal outcome is determined by the relative values that Green Acres and Barney place on the resource (air). Because Green Acres values the air more highly, it should use the resource and emit the odor. However, because Barney has a right to odor-free air, Green Acres will have to purchase the right to emit odors from him. Assuming that this transaction can be done costlessly, Green Acres will have to pay Barney between $10,000 and $12,000 for that right.

Application: Sometimes the Coase Theorem Takes a While

15Hoyt Bleakley and Joseph Ferrie, “Land Openings on the Georgia Frontier and the Coase Theorem in the Short– and Long–Run,” Working paper, 2014.

Hoyt Bleakley and Joseph Ferrie looked at a particular market to test if the Coase theorem held. It did; the efficient allocation was arrived at through negotiation and exchange among individuals. But for the case Bleakley and Ferrie studied, it took a while to achieve this outcome.15 And when we say, “a while,” we mean about 150 years.

Bleakley and Ferrie’s study looked at the results of the first settlement (after the appalling expropriation and eviction of the original Native American owners) of large parts of the U.S. state of Georgia. To test the Coase theorem, they took advantage of the fact that when these lands were opened to settlement in the early 1800s, the state used lotteries to allocate different-sized plots to settlers. Some lucky settlers randomly received large plots; others received small ones. Because the smallest plots were too small to be farmed efficiently (a problem that would only get worse later as optimal farm sizes grew), the plots imposed a type of negative externality on each other; one plot’s existence made another plot too small for efficient farming.

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The Coase theorem implies that a process of negotiation and land sales would allow owners of small plots to sell their land to those with nearby larger plots (or to another owner of a small plot who could combine them) so that efficient-sized farms could be created. The economic gains from greater farming efficiency would be more than enough to compensate the owners of small plots for giving up the opportunity to try to scratch out their own livings on undersized farms. (If farmers differed in their ability, then perhaps a relatively untalented owner of a large plot would sell to a more talented farmer who had a small plot. Either way, efficient farm size would be obtained.)

Bleakley and Ferrie show this is what happened . . . after about 150 years. They found that even 50 years after the lottery, farm sizes were almost perfectly predicted by the corresponding plot sizes from the lottery. In other words, hardly any changes in plot boundaries had occurred in that half century. Land values indicated that these farms were, in fact, undersized, so it was clear that there was still an externality at work. As time moved on, however, farm boundaries gradually started to change. Finally, about 150 years after the lottery, farm sizes were no longer related to the lottery’s initial plot sizes, and plots appeared to have reached efficient size.

Why did it take so long for the Coase theorem to work? In this case, it took so long because negotiations were not costless. One issue is that farmers faced practical limitations in the plots they could buy. If a plot was the right size but too far away from the farmer’s current plot, it wouldn’t make sense for the farmer to purchase it, even if the current owner was looking to sell. There were also surely other types of negotiation costs, everything from asymmetric information problems to family squabbles. Working through all of that took time—a long time. Bleakley and Ferrie’s results offer striking evidence of just how long it can take to reach an efficient solution.

The Coase Theorem and Tradable Permits Markets

One area in which the Coase theorem has impacted the real world is in the design of government strategies to combat pollution. As we demonstrated earlier in the chapter, tradable permits can move a market with a negative externality to the socially optimal outcome, often at a lower cost than quantity mechanisms such as quotas.

The Coase theorem says that it shouldn’t matter who gets the right to pollute (i.e., the quota allotments) as long as the firms are allowed to trade freely and bargaining costs are low. Thus, the government can reach an efficient amount of pollution by setting up a market for tradable permits.

By enabling trades, the market for permits allows the most efficient reduction in emissions while sparing the government the trouble of determining how to allocate the reductions across firms. The government can achieve the efficient total level of emissions by issuing the optimal number of permits to the firms in an industry and allowing them to trade among themselves to reach the right outcome. Firms that face lower abatement costs will reduce emissions more. It gives them a way, through permit sales, to be compensated for their additional abatement costs. High-abatement-cost firms, at the same time, prefer to buy these permits because it’s cheaper for them than cutting emissions directly.

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Externalities, uncorrected, cause markets to be inefficient. But, tradable permit markets create a new market for the externality itself. Externalities are essentially extra, unpriced “products” tied to market transactions. Polluters don’t consider the external costs of their emissions because they don’t have to pay those costs. But, by creating a market for pollution, tradable permit markets actually put a price on pollution. Because the permit market makes polluting firms face this price, polluters consider the social implications of their production activity. Price mechanisms (such as Pigouvian taxes) that are used to address externalities serve the same purpose: They put a price on an externality that normally doesn’t have one, causing market participants to be aware of the externality’s effects.

We can therefore think of externalities as resulting from missing markets. The fundamental problem is that, in the absence of intervention, there is no way to do for externalities what markets do for regular goods: Provide a value for their costs and benefits to society through the price mechanism. The Coase theorem basically implies that, if you can create a market for the externality, the market’s supply-and-demand mechanism will lead to the efficient outcome.