(...)
In Abb. 19 this is demonstrated by the market for electricity. Electricity is produced by using fossil fuels, like coil and gas, in power plants. The output is not only electricity but also unwanted emission like sulphur or carbon.
- The demand for electricity is described by the (inverse) demand curve D.
- The private marginal costs of producing electricity, is given by the PMC curve.
- The damage done by the pollution (acid rain, greenhouse effect) is not part of the private marginal costs. Society has to pay the electricity production costs and in addition to this, the marginal damage costs. The marginal social cost curve (SMC) represents both costs in Abb. 19.
[Abb. 19]
In case where there is no control on emission, the market clearing price would be pm and the market equilibrium production would be qm . But social benefit is maximized were the social marginal cost curve intersects the market demand curve. With social optimal price p* and optimal electricity production level q* .
Comparing the market equilibrium with the optimal social equilibrium, some conclusions can be drawn:
- Neglecting externalities results in to large output of the commodity.
- Assuming pollution as a function of production, too much pollution is produced.
- The market product price is too low.
That there is no need to intervene, under special circumstances, is stated by Ronald Coase. This statement is known as the Coase theorem.
3.6 Coase-Theorem
Ronald Coase argued that individuals could organise bargains so as to bring about an efficient outcome and eliminate externalities without government intervention (for example Pigovian taxes). The government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result.
This result, often known as the “Coase Theorem”, requires that:
- property rights are well defined;
- the number of people involved is small; and
- bargaining costs are very small.
Only if all three of these apply will individual bargaining solve the problem of externalities.
More general The Coase theorem states:
Affected parties to an externality will agree on an allocation of resources that is both Pareto optimal and independent of any prior assignment of property rights, in the absence of transaction costs.
The Coase theorem often is reduced to focus attention on property rights and transactions costs, and the debate usually turns on whether and how transactions costs can be reduced. But the Coase theorem is more complicated than these two most popular aspects of the Coase Theorem.
Originally Coase used as an example a rancher's cows destroying his neighbouring farmer's crops. But it is clearer to understand the problem to assume to{two} firms, a chemical plant and a water works plant located on a river, where the chemical plant is upstream and the water works is downstream, see Abb. 20.
If the chemical plant is allowed to emit its waste into the river, the water works suffers due to increasing costs of water purification. This situation is represented in figure Abb. 21.
[Abb. 21] Coase Theorem I
The benefit by the chemical plant is given by the marginal private benefit (MPB) curve. The area under this curve is the total benefit. The benefit may result from saving costs by not investing in a sewage treatment plant. Hence benefit is equal to the water treatment costs. If the chemical plant has the right to pollute, it will save all water treatment costs, hence it will emit the maximum amount of waste water E(with upper bar), where MPB = 0 and therefore profit is maximized. The water works suffer from the waste water, which can be represented by the marginal external cost curve (MEC). The costs are due to the fact, that the water works have to invest in a larger water-purification plant.
If the whole river is owned by the water-works, and the chemical plant has no right to emit waste water into the river, the situation will be where there is no emission by the chemical plant. This is described by point B in Abb. 21.
Both situations are not Pareto-efficient. If the chemical plant has the property rights over the river, the water works would be willing to pay the chemical plant up to E*FCD for a reduction in waste water from E(with upper bar) to E* . The area FCD represents the potential for Pareto improvements. Both can better off if the water works compensate the chemical plant for a reduction in water pollution. This is going on as long as the MEC, that is the maximum amount of money the water works will pay to reduction in water pollution, is above the MPB curve. The latter is the amount of money the chemical plant want to have to be compensated for their loss in benefit. A reduction below E* is not reasonable, since MPB is grater than MEC.
Pareto improvement is also possible if the water works controls the river water quality. In this case the chemical plant would be willing to pay the water works up to BAFE* for the right to increase it{its} stream of waste water into the river from B to E* . The maximum amount of money the chemical would be willing to pay for an increase of one unit of waste water into the river is its marginal private benefit (MPB), this is always larger as the money the water works is willing to accept for compensation due to increasing water treatment costs, represented by the MEC curve. An increase above E* is not meaningful, because marginal external costs exceeds marginal private benefit.
Since besides the Pareto optimal pollution level E* , any other pollution level E is not Pareto efficient, and has the potential for Pareto improvements. As long as this is the case, both parties will bargain as long as the potential in Pareto improvement is vanished. The Pareto optimal solution is represented by the waste water level E* . In case the property rights are with the chemical plant, the water works will pay λ* per unit of waste water reduced to the chemical plant, which summed up in compensation payment to the chemical plant to the areas (d+e) in Abb. 22. If the property right are allocated to the water works, the chemical plant has to pay λ* per unit of waste water running into the river to the water works, to compensate for the increasing water treatment costs. The compensation paid to the water works is represented by the area (b+c) in Abb. 22.
[Abb. 22] Coase's Theorem II
This result can be derived also by a non-cooperative Nash game. Lets assume that the property rights are given to the chemical plant. (...)
(...)
Conclusion
The Coase theorem states that in the absence of transaction costs, externalities will be internalised and results in a Pareto optimal outcome independent of any prior assignment of property rights. A game theoretic analyses demonstrates, that the Coase theorem did not deliver a solution for internalizing externalities, because Coase did not analyses the bargaining process, but states the axiomatic Nash equilibrium as the Pareto optimal outcome. The Coase theorem suffers from too many practical and theoretical flaws to be considered a serious proposal for environmental policy. Even if a few working examples could be found, they would be extremely rare.
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