Externalities by Erik F.

Meinhardt

This section aims to describe in detail the problem of externalities, moves to

discuss Coase’s theorem, and concludes by disproving it.

I. What are externalities?

A. Definition—Externalities are third party effects arising from

production and consumption of goods and services wherein the third
party receives no appropriate compensation. Externalities cause
market failure if the price mechanism does not take account of the
social costs and benefits of production and consumption. They cause a
loss in social welfare because the market mechanism provides the
wrong amount of goods and services to consumers. Externalities occur
outside the market because they affect third parties—that is agents
without direct involvement in the production and consumption of a
particular good or service.

For markets to work efficiently, society must assign property rights

clearly. If no one owns a particular good, then no one has an economic
incentive to protect that good from abuse. This leads to the “Tragedy of
the Commons,” where, for example, no one owns the ocean or the fish
in the ocean so the fishing industry decimates the population of living
fish, causing a shortage.

Because of the absence of clearly defined property rights the market

fails to account them when assigning prices of goods and services. In a
situation lacking government intervention, because no one owns the
air, for example, polluting industries do not increase their prices to pay
for correcting their pollution. The fact that they do not correct air
pollution, though, leads to health problems among third parties and the
third parties must then pay for the correction of their health.

B. Examples—The following five specific examples of externalities, many

of which have an environmental theme, demonstrate their harms.

1. Smoking—Many states have made it illegal to smoke in the

workplace and public places in general. Second-hand smoke in
these places has been described as a pollutant which places high
health risks onto those breathing in second-hand smoke. It
increases the risk of breast cancer in women, premature births, and
asthma in children. Even though some people do not smoke, the
costs of smoking are externalized onto them anyway.

2. Pollution—The World Health Organization says 3 million people are

killed worldwide by outdoor air pollution annually from vehicles and
industrial emissions, and 1.6 million indoors through using solid
 fuels. Some estimates have 7-20% of all cancers resulting from air
pollution alone. Diseases carried in water are responsible for 80% of
illnesses and deaths in developing countries, killing a child every
eight seconds. Each year 2.1 million people die from diseases
associated with poor water. Contaminated land is a problem in
industrialized countries, where former factories and power stations
can leave waste like heavy metals in the soil. Agriculture can pollute
land with pesticides, nitrate-rich fertilizers and feces from livestock.
And when the contamination reaches rivers it damages life there as
well.

3. Drugs and alcohol—A York University study says heroin and crack
cocaine addiction costs the UK £19 billion a year, with each addict
costing £600 per week in crime costs and court time, health care
and unemployment benefits. Also, excessive drinking is on the rise
in the United States and the UK, costing millions of dollars in health
care costs and tens of thousands of drinking-related deaths each
year.

4. Littering—The UK estimates its cities pay about £150,000 a year on

gum removal. On London's shopping main shopping road, Oxford
Street, for example, there are more than 300,000 pieces of chewing
gum. The City Council spends more than £100,000 a year dealing
with the problem. Some people are calling for a gum tax to offset
the cost of this externality while others want the manufacturers to
pay the cost of making biodegradable forms of gum.

5. The movement of food—A UK government report found that the

environmental cost of moving food was as much as £9bn a year.
This is a result of increased truck traffic delivering the food, travel
time of the consumer to get the food, overall traffic congestion,
traffic accidents, and pollution as a result of the shipments.

II. Coase’s theorem

Coase’s theorem states that given well-defined property rights, low

bargaining costs, perfect competition, perfect information and the absence of
wealth and income effects, resources will be used efficiently and identically
regardless of who owns them.

To understand Coase’s argument, we must look at an example, first. Take an

individual who buys property directly next to a loud factory which has been
operating for 25 years. This individual then builds a music recording studio
on the side of his property directly next to the noisy factory. Assuming the
individual knew the factory created a lot of noise, are they able to file for an
injunction against the factory for making too much noise? Coase’s first step,
as I have shown with this example, is to establish that externalities (such as
the one in the last example of a noisy factory) are caused jointly by the
“polluter” and “victim.” Legal rules and statutes establish and assign blame,
and this is only efficient if the party receiving the blame can avoid the
problem at a lower cost than otherwise.

His second step is to establish that as long as bargaining parties of

externalities can readily make and enforce contracts in their mutual interest,
then direct regulation or Pigouvian taxation (or any form of government
intervention for that matter) is not needed to achieve efficiency. All the
society needs is clear property rights and magically the market will solve the
problem.

Take for example an example a case of a polluter and victim wherein the
victim has a legal right to no pollution. If the cost of eliminating the pollution
for the polluter is $80,000 and the cost of paying the victim in order to be
allowed to pollute is $60,000, the polluter will obviously pay the victim and
keep polluting. Also, in the same case, if the polluter only has to pay $20,000
to eliminate their pollution or pay the victim $60,000, then the polluter will
obviously eliminate their own pollution in order to achieve efficiency. As long
as this information is known, the market can solve the problem without an
arbitrator.

If transaction costs are zero—that is to say in other words that if any a

mutually beneficial agreement is made—then any initial definition of
property rights leads to an efficient outcome and this will always occur.

III. Contra Coase’s theorem

To briefly conclude, mechanism design models show that Coase’s theorem is

unlikely to ever actually occur. It would hardly ever happen where
information is complete among bargaining parties. His theorem thus runs
into major problems with the prisoner’s dilemma, causes a failure to trade in
some instances of that, leads to a lack of real commitments, and also leads
to overestimating one’s own and/or underestimating one’s opponents’
power, resources, and desires.

“The main conclusion of [non-cooperative bargaining] models is likely, each

bargainer knows something relevant that the other does not, such as his
payoff from a successful agreement. The inefficiencies consist of bargains
not struck that should be, excessive delay and other direct costs of
bargaining. Typically, each bargainer incurs and imposes real costs to change
the likely price to his advantage. …when people don’t know one another’s
tastes or opportunities, then experience, theory and experimental evidence
all confirm that negotiations may be protracted, costly and unsuccessful. A
potential buyer may value a house more than its prospective seller does, but
less than the seller believes “most” buyers do. He would then have trouble
persuading the seller to lower the price enough to make the deal.”