The Problem of Social Cost

The Problem of Social Cost

• Coase's article concern focuses on the weaknesses of the traditional Pigou-type analysis
• He explains that externalities have a reciprocal nature
• Transaction costs are important for proper economic analysis
• He advocates for a foundational change of approach in economics

External Effects Definition

• They arise when the actions from an individual or organization affect another without full compensation.
• External effects can be negative when one party's actions create costs or disutility for others without compensation
• Positive external effects occur when one party creates utility for others without full compensation
• The consequences of one's own actions aren't fully considered in decisions
• Property rights not being well defined, or high enforcement costs contribute to external effects
• Coase made note of this in 1960

External Effects Examples

• Environmental pollution (noise, dirt, contamination, etc.) is an example of external effects
• Smoking in the presence of others
• Vaccination (analogous: anti-virus software)
• Monopoly pricing
• Product innovations
• Monument conservation
• Network externalities

Private, external and social costs and benefits (returns)

• Private Surplus = Private Returns - Private Costs
• External Surplus = External Returns - External Costs
• Social Surplus = Social Returns - Social Costs

Distinctions of external effects

• Positive vs. negative externalities are distinct
• External effects of production vs. external effects of consumption
• Vertical vs. horizontal externalities are distinct
• Technological externalities vs. pecuniary externalities
• Direct vs. indirect externalities are distinct
• Psychological externalities also exist

Example: Lake

• Pollution (in tons) affects Profit from Chemical Production (C) and Fishing (F), Additional Profit for C, Additional Cost for F, Social Welfare
• If the lake is property of chemical producer, the outcome differs
• If the lake is the property of the fishing factory, the outcome differs
• If a filter can be installed for 200 which would abate all pollution, the outcome differs
• The maximum amount a filter can cost to make installation worthwhile calculation

Coase Theorem

• Externalities always involve two parties
• The "cost-by-cause" (polluter pays) principle is ambiguous
• Externalities induce market failure if transaction costs are sufficiently high
• In property rights approach, increasing transaction costs leads to exchange increasingly organized through nonmarket mechanisms

Transaction Costs Significance

• Significant transaction costs make it costly to remove all externalities
• Not every externality requires government intervention
• Negligible transaction costs lead to Pareto efficient allocation without government intervention (efficiency hypothesis)
• The outcome is independent from initial distribution of property rights (invariance hypothesis)

Internalizing External Costs

• This occurs through negotiations where the polluter is liable for damages

Internalizing External Costs

• This occurs through negotiations where the polluter is not liable for damages

The Coase Theorem

• Distribution of property rights affects rent distribution
• The distribution however does not affect efficiency if transaction costs are negligible
• Transaction costs are often not negligible, they are important for economic policy making
• Includes information, bargaining, decision, monitoring, and control costs.
• Common pool resources include:
  • Difficult or partly possible exclusion
  • Usage is rival where one person's or organization's use lowers the benefits of use for others
• Examples include: Ocean fishing, greenhouse gas emissions, rush hour traffic.

Example: Fishing

• Number of boats affects Value of landed fish (€), Marginal revenue of next boat (€), Average revenue per boat (€), Total Profit (with boat coast of 7000 (€))

Other Government Interventions

• Moral suasion
• Provision by government
• Coalition of affected individuals
• Direct regulation (orders and prohibitions)