Since Adam Smith, we assume that rational individuals try to maximize their utilities or benefits in a competitive market and by this markets ends in an equilibrium point or Pareto optimum on which it is impossible to rearrange resources and make everyone better off. So in order to reach full efficiency we need an organized and perfectly competitive market and optimum prices.
As we all know real world is not perfect and in economics, factors called externalities causes imperfectness of markets. We can also name this as “market failure.” Basically actions of economic parties affecting other actors or society and imposing a cost on them are called negative externality. The unwanted cost that they generate is where problems arise. “The crucial feature of externalities is that there are goods people care about that are not sold on markets...It is the lack of markets for externalities that causes problems”(Varian,H.R.2006) They make our economic models imperfect because it is almost impossible to take every aspect of every economic actor into account. Thus negative externalities always considered as an excuse for government intervention to the markets. Government intervention brings about public solutions such as Pigouvian Tax, Subsidizing, Quotas, and Regulations and so on. Besides we can assert different ways of private solution to externality problems such as; internalizing the externalities, compensation by common-law or assigning property rights. The Coase Theorem, as a bargaining game model, is a response to centralized solutions. In our case here we will discuss the effectiveness of the Coase Theorem as a way of achieving efficient pollution abatement.
2- A DECENTERALIZED SOLUTION: THE COASE THEOREM
“The economic problem in all cases of harmful effects is how to maximise the value of production” (Coase, 1960)
In his seminal article “The Problem of Social Cost” (1960) R. Coase suggested that competitive markets are not the only requirement for efficiency. Indeed when markets fail the only solution is voluntary bargaining of sides.
We can define this theorem as “internalization of externalities through individually rational bargaining” (Glenn w. Harrison and Michael McKee, 1985). This is why we call this decentralized; we don’t need any central intervention to bargain. At this point one can say that he strongly stands against Pigouvian argument that government is needed to tackle with externalities. That’s true because he expects government to stay out of things, adapting a kind of laissez-faire state. “True decentralization consists in delegating decisions to those who know more about them” (J.Farrell, 1987)
He emphasizes the reciprocal nature of the problem and tries to clarify it by focusing on “...to avoid the more serious harm”. So he deliberates externalities (such as pollution) as an unavoidable consequence of maximizing the production. He considers factors of production as rights and concludes that the right to do something harmful is also a factor of production. So in our case he acknowledges some pollution as a factor of production.
He posits three basic assumptions in order to reach efficiency: initially well-defined property rights, voluntary private bargaining and zero transaction costs. So what are they? “Property rights are the rights of individuals to the use, income and transferability of resources” (L. De Alessi 1990). It is obvious that as an initial point, these rights determine the decisions of bargainers and without them it is almost impossible to bargain. There are also some critics about this: “...an efficient output can be attained not just for any initial allocation of property rights, but without property rights at all!” (D.Usher, 1998)
Now let’s assume that a factory set up near a district is emitting unnecessary amount of smoke. There are thousands of people living in that area suffering from lack of fresh air. The problem here is that the social cost of pollution is more than the private cost of production. So it’s better for society to have factory produce less. In his article Coase argued that taxing the factory as a way of controlling pollution fails to take into account costs imposed on others. He simply demonstrates taxing shouldn’t aim eliminating pollution; instead it should secure an optimum level of smoke pollution, which he characterises as the maximum value of production (Coase, 1960).
Up to now I tried to show the basics of the theorem. From now on we need to discuss three problems of this theorem.
A-Number of Pollution Victims
In his work Coase doesn’t mention any multi numbered examples of bargaining. All his examples are between two individuals. Although in literature we can find experiments with different numbers of people holding with his theorem. “...in two- and three-person situations a scholar might be able to assert with some confidence that groups will behave as if all of the Coase Theorem's assumptions were satisfied.” (Hoffman and Spitzer, 1986) he also received many critics (D.Usher, 1998). On the other hand we have to admit that it is harder to get many people to cooperate for bargaining when compared to a few. “And one could argue that government is the right institution to deal with such problem, so that the Coase theorem loses its decentralization bite.” (J.Farrell, 1987) Hoffman and Spitzer made their critics from another point. They assume that there are two types of persons; greedy and reasonable. “As the number of persons needed to complete trades increases, the likelihood that one or more greedy persons will block the transaction should increase” (Hoffman and Spitzer, 1986)
It seems to me that Coase didn’t pay much attention to participant numbers in bargaining process. Some scientists argue that it’s not only the number but also the free rider problem that undermines this theorem. “As the number who would benefit from provision of a non-exclusive public good increases, other things being equal, voluntary non-cooperative rational individual behaviour leads any group to fall further short of obtaining a group-optimal level of provision. In a society consisting of N identical individuals, each gets only (1/N) th of the total benefit of the good; therefore, each contributes too little. This problem gets worse as N increases.” (Dixit and Olson, 2000) So this finding demonstrates that in large group cases people are tended not to reveal their private information and preferring to remain as a free-rider. As this is the case for them, Hoffman and Spitzer (1986) think the opposite: “subjects in large experiments created ad hoc institutions to help the transaction process. In twenty person experiments, for example, the nineteen people always shared information about payoffs with one another”. In fact first argument sounds more reasonable when we think about the conditions of rationality. The probability of reaching an agreement (Pareto efficiency) through any method of bargaining seems impossible to me unless the government shows some coercion. Without it, large number of victims won’t be able to come together and defend their rights or to put it in a different way people won’t be able to assess the value of clean air for them. For example without scientific research results about how polluted air threatens human life, people won’t be able to defend their position against polluters.
B-Asymmetry of Information between Polluters and Victims
The argument below is also valid in this part of discussion as well. Victims, as individuals, are likely to lack enough information about pros and cons of having a factory that is polluting the air. Victims will easily be persuaded that if they can put up with “a little pollution” they would be given a job and the prices of their lands would increase so in long term they would benefit greatly. That sounds like a perfect trade-off for a rational individual. “... bargaining is typically inefficient, as is likely, each bargainer knows something relevant that the other doesn’t, such as his payoff from a successful agreement.” (J.Farrell, 1987) So in this case people won’t be able to see what is their real gain what do they lost in fact. And supposing that factory has better knowledge than each one of the victims they could easily bribe or compensate them. So the result will be an inefficient point. One of the reasons of this is “the instant endowment effect: value that individuals assign to something increases substantially as soon as individual gets the thing.” (Kahneman, Knetsch, Thaler, 1990) People will be easily convinced as soon as they receive any compensation. The logic is simple; money today is more valuable than money tomorrow!
Another problem of asymmetric knowledge is the power of bargaining. Your initial bargaining position depends on your knowledge, the more you know the easier it is for you to reach your values. “Although each may have relatively precise information about his own monetary value for the good, each will have only a probabilistic assessment of the other’s walk-away price.”(Samuelson, in Game-Theoretic Models of Bargaining, 1985) Samuelson also argued that incomplete information condition is likely to generate a trading friction or a barrier to trade. “The claim that voluntary negotiation will lead to fully efficient outcomes is implausible unless people know one another exceptionally well.” (J.Farrell, 1987) It’s probable that this is the only case that this theorem could work. If this is the case I can tell Coase’s assumption of perfect information is more than likely to fail.
C-Costs of Negotiation
In real world there are always transaction costs that every economic party should always keep in their mind. He defined transactions costs as the costs to “discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on.” (Coase 1960, cited from Coase 1990, p. 114) Although he assumed zero transaction cost for his “theorem” he was well aware that it is a bit impossible. Anyway he also suggested that government is like a super-firm and as Stiglitz (1999) argued “the cost of getting individuals together to internalize externalities voluntarily is significant.” They both regarded government as a special mechanism which may be implied as an organization to reduce these costs. It is a tough job to bring all parties that are concerned in pollution case. There are hundreds of inhabitants in that area and on the other side the representatives of the factory. In this case we can easily say that though negotiation process is costless (zero transaction cost) no one can guarantee that an efficient resolution (outcome) would be reached.
Another interesting critic about costs is this: “because the bargaining costs took the form of discounting and players had no opportunities to trade, players had no incentive to stop bargaining.” (Fadenberg, Levine, Tirole, 1985) This is also an interesting point because Coase never mentioned the costs that will come to life as the bargaining process prolongs. As we cannot expect people to come to an agreement in a very short time this theorem is unlikely to be valid.
Coase wrote his famous article to make his stance clear about government intervention to tackle with externalities. Although he never claimed that he is trying to develop a theorem, his followers turned his ideas into a theorem which is still under discussion by economists. He mentioned smoke-pollution problem in his work and suggested that Pigouvian taxation fails to take into account the costs that are imposed on other people and “there is no reason to suppose that one of these results is necessarily preferable.” (Coase, 1960) In my opinion his critics about taxation seems favourable which is; “the aim of such a regulation should not be to eliminate smoke pollution but rather to secure the optimum amount of smoke pollution, this being the amount which will maximise the value of production.”
To sum up, although his arguments about internalizing the externalities seem sound at first sight, it is not compatible with the real life situations as;
· It’s not easy to get large numbers of probably clashing, at least not overlapping interests into a voluntary bargaining process.
· Without government’s coercion or delimitations of property rights it’s not realistic to expect sides to meet in a reasonable point of agreement.
· There is no situation without a transaction cost.
· Coase, R. H., The Firm, the Market and the Law, University of Chicago Press, 1988.
· Coase, R.H., The Problem of Social Cost, Journal of Law and Economics, Vol. 3, Oct. 1960, pp. 1-44.
· De Alessi, L., “Development of the Property Rights Approach” in Eirik G. Furubotn, R. Richter, ed. The New Institutional Economics, Texas A&M University Press, 1991.
· Dixit, A., Olson, M., Does Voluntary Participation Undermine the Coase Theorem? Journal of Public Economics 76 2000 309–335.
· Farrell, J., Information and the Coase Theorem, Economic Perspectives, vol.1 number 2, fall 1987, pp. 113-129.
· Fudenberg, D., Levine, D., Tirole, J., Infinite-horizon Models of Bargaining with One-sided Incomplete Information, in Roth, A. ed. Game-theoretic Models of Bargaining, Cambridge University Press, 1985.
· Harrison, G.W., McKee, M., Experimental Evaluation of the Coase Theorem, Journal of Law and Economics, Vol. 28, No. 3 Oct., 1985, pp. 653-670.
· Hoffman, E., Spitzer, M.L., The Coase Theorem: Some Experimental Tests Journal of Law and Economics, Vol. 25, No. 1 Apr., 1982, pp. 73-98.
· Hoffman, E., Spitzer, M.L., Experimental Tests of the Coase Theorem with Large Bargaining Groups, Journal of Legal Studies, vol. 15, 1986, pp. 149-171.
· Kahneman, D., Knetsch, J.L., Thaler, R.H., Experimental Tests of the Endowment Effect and the Coase Theorem, The Journal of Political Economy, Vol. 98, No. 6 Dec., 1990, pp. 1325-1348.
· McKelvey, R.D., Page, T., An Experimental Study of the Effect of Private Information in the Coase Theorem, Experimental Economics, vol. 3,2000, pp. 187–213.
· Robson, A., Skaperdas, S., Costly enforcement of property rights and the Coase theorem, Economic Theory (2008) vol. 36, pp. 109–128.
· Samuelson, W., A Comment on the Coase Theorem, in Roth, A. ed. Game-theoretic Models of Bargaining, Cambridge University Press, 1985.
· Usher, D., The Coase Theorem is Tautological, Incoherent or Wrong, Economics Letters 61 1998 3–11.
· Varian, H.R., Intermediate Microeconomics: a Modern Approach, 7th ed. W.W. Norton, c2006.