“The Problem of Social Cost”

Ronald Coase

EES 79903
Fall, 2001
Prof. Y. Klein
 The Problem
• Some actions of firms harm others
– Factory emits smoke which harms neighbors
– Cattle trample crops of adjacent farmers
• Standard Economic Analysis (Pigou)
– Make factory / rancher liable for damage
– Tax activity which causes damage
– Restrictive zoning of harmful activities
 Reciprocal Nature of Problem
• The presence of both parties is required for
damage to occur.
– The presence of the rancher and farmers are a
pre-requisite to cattle damaging crops
• Either party can prevent the damage.
– The rancher can fence his property or reduce
the size of his herd.
– The farmer can fence his property or leave
adjacent land uncultivated.
 Economic Optimum
• The objective should be to maximize the
value of the joint output of beef and grain.
• Consider the behavior of a single firm that
owns ranch and farm land – it will increase
the size of the herd if the value of the
additional beef exceeds the crop damage.
 Allocation of Property Rights
• The rancher is liable for any damage his
cattle cause.
– The rancher can reduce the size of his herd,
limiting his liability
– The rancher can fence his property
– The rancher can pay the farmer to leave land
uncultivated, thus mitigating his damages.
.
 Allocation of Property Rights
• The rancher is not liable for damage
– The farmer can leave land uncultivated, thus
mitigating his losses
– The farmer can fence his property.
– The farmer can pay the rancher to reduce the
size of his herd, thus mitigating his damages.
 Coase Theorem
• If the two parties negotiate freely, and in
the absence of transactions costs, then they
will arrive at the economic optimum
– The resources devoted to ranching and
farming will depend on the value of meat and
grain.
– The optimum solution is not dependent upon
the initial allocation of property rights.
 Transactions Costs
• In the presence of transactions costs, an optimal
negotiated solution may not be achieved.
• The market has created mechanisms to minimize
transactions costs.
– Single ownership of large tracts of land, commercial
or industrial projects
– Restrictive covenants
• Although market transactions are be costly, the
costs of government regulation may be greater.
 Restatement of Pigou
• Divergence between private and social cost
arises when party A, in the course of
rendering a service to B, damages C.
• Government regulation can be used to
“internalize” external costs.
– Tax on External Costs
– Establishment of liability for external damages
 Critique of Pigou
• If we tax the polluter, and compensate the
victim, this will encourage people to move
into the neighborhood to receive
compensation.
– In the absence of a Pigovian tax we have too
much smoke and too few neighbors
– In the presence of a tax we have too little
smoke and too many neighbors.