Externalities and public goods are two important concepts in microeconomics that affect how markets allocate resources and how governments intervene. In this article, you will learn what they are, how they differ, and how you can apply the Coase theorem to resolve external conflicts that arise from them.
An externality is a cost or benefit that affects a third party who is not involved in the production or consumption of a good or service. For example, when a factory pollutes the air, it imposes a negative externality on the nearby residents who suffer from health problems. On the other hand, when a homeowner plants a flower garden, it creates a positive externality on the neighbors who enjoy the beauty and fragrance. Externalities can be internalized or corrected by imposing taxes or subsidies, or by creating property rights and markets.
The Coase theorem suggests that if property rights are clearly defined and transaction costs are low, private parties can negotiate to resolve externalities. For example, in a project I worked on, a factory's emissions affected nearby residents. By negotiating directly, the factory paid for the residents' installation of air purifiers, benefiting both sides without needing government intervention. Externalities are costs or benefits of economic activities experienced by third parties. Positive externalities might be a well-kept garden improving neighborhood appeal, while negative ones could be pollution affecting public health. Understanding and addressing these can lead to more efficient and harmonious outcomes.
A public good is a good or service that is non-rivalrous and non-excludable. This means that one person's consumption does not reduce the amount available for others, and that no one can be prevented from using it. For example, national defense, public parks, and lighthouses are public goods. Public goods tend to be underprovided by private markets, because there is no incentive for individuals to pay for them. This leads to a market failure known as the free-rider problem. Public goods can be provided by the government or by voluntary contributions.
Public goods are services or products that are available to everyone and don't diminish with use. Think of things like clean air or national defense. In my work, I’ve seen how investing in public goods can benefit entire communities. For instance, when we improved a public park, it boosted local well-being and property values without excluding anyone from its benefits. Public goods are crucial because they provide shared benefits that markets alone might not efficiently supply. Ensuring their availability helps promote equity and collective prosperity.
The Coase theorem is a proposition that states that if property rights are well-defined and transaction costs are low, then private parties can negotiate and reach an efficient outcome regardless of who has the initial right. For example, if a farmer and a rancher have a dispute over the use of a land, they can agree on a payment that compensates the harmed party and maximizes their joint benefit. The Coase theorem implies that externalities can be solved by the market without government intervention, as long as the conditions are met.
The Coase theorem states that if the cost of the transaction of property rights is low enough, then the property rights can be exchanged so as to internalize the externality. The transaction cost is in essence the amount of the "tax" involved in the exchange. If the marginal benefit of the property right exchange exceeds or equals the marginal cost of the property right exchange (the implicit tax, or fee), then the exchange will take place and the gains from trade represent the increase in welfare.
I’m going to push back on the notion that a fee for a service between two private parties is a “tax”. A “tax” is a mandatory contribution levied on individuals or corporations by a government entity. If the farmer and rancher mutually agree on how the land should be used and a fee is paid by one to the other, then a tax has not been paid. Coase is making the point that the government doesn’t have to be involved and participation does not have to be mandated for an externality to be addressed.
Certainly Coase was describing the free exchange of property rights in market economies, albeit without including possible externalities such as clear-cutting forests after the exchange, so then you get the next big level of abstraction as to the role of the govt in market exchanges.
Explaining this to a toddler (sometimes it's very effective instead of using technicism and long words): The Coase theorem is like a magic rule that says if two people are fighting over something, like toys, and they can talk and make a deal without any trouble, they can solve the fight themselves. For example, if one kid wants to play with a toy that belongs to another kid, they can agree that one will share the toy if the other shares their cookies. It’s all about finding a way to make both kids happy by talking and agreeing without needing a grown-up to step in.
Yes you right. I am viewing the "tax" quite broadly as something that can be collected by anyone controlling property rights, with the outcome dependent on the cost of the transaction. If each share in the cost of the transaction, then that gets built into the transaction's final cost. It is similar to real estate where there is often a buyer's agent and a seller's agent. The sum of their fees is the transaction cost of the property exchange. Governments also impose actual taxes that are part of the transaction cost.
In order to apply the Coase theorem, you must first identify the parties involved and their preferences, and assign property rights to one of the parties. Afterwards, you must determine the potential gains from trade between the parties, as well as the optimal allocation of resources. Then you need to negotiate a contract that reflects these gains and allocations, and lastly enforce and monitor the compliance of the contract.
Viewing the marginal cost of the exchange as a "tax" allows a wider perspective of how to apply the Coase theorem in the Public Finance literature and policy issues. Any government expenditure is financed ultimately by a tax under Ricardian equivalence. All taxes are avoided/evaded up to some margin whereby the marginal cost of the avoidance/evasion equals the tax rate. Therefore the correct public finance marginal evaluation of any expenditure must equate the marginal social benefit of the expenditure to the marginal social cost of the expenditure. The latter MSC equals the share of the tax that is paid times the tax rate plus the share of tax that is avoided as factored by the average cost of the avoidance per unit of goods being taxed.
The Coase theorem is a powerful and elegant tool for analyzing externalities and public goods, yet it is not without its limitations. Property rights may be ill-defined or unenforceable in some cases, such as environmental or global issues. Additionally, transaction costs may be high or prohibitive, such as legal fees, information costs, or bargaining costs. Asymmetric information or strategic behavior among the parties could also present an obstacle, such as concealing the costs or benefits. Furthermore, collective action problems or coordination failures among multiple parties can also hinder progress, like free-riding or holdouts.
I agree, but there needs to be an appreciation of the following: 1. The moral hazard in the provision of public goods. If the means of capitalisation, delivery and operations are unsustainable. An example is Private Finance Initiatives (UK) that perform poorly. By poorly we mean sub-optimal outcomes, for example the extraction of profits over positive patient outcomes for a PFI hospital. 2. Rent seeking, or strategic behaviour which can be a positive behaviour if incentives and desired outcomes are aligned with a public good. However, rent seeking is the opposing force in this example. 3. Heterogeneity of people their and risk profiles. This includes the mismatch of risk appetite of a firm vs the risk tolerance of its employees.
This MSC is the Coasian transaction cost of the property right transfer. This latter MSC is therefore a weighted average of the tax being paid and the cost of avoiding it. This is the contract entered into by any government expenditure that transfers property rights from the taxpayer to the government in return for the benefit of the expenditure. The transaction cost of this property right transfer is the MSC which is this weighted average of the tax paid and the tax avoided.
The Coase theorem can be applied to a range of real-world situations, such as noise pollution, air pollution, and fishing rights. For instance, when it comes to noise pollution, a nightclub and nearby resident can negotiate a payment that compensates the resident for the loss of quiet or a reduction of noise that satisfies the nightclub owner. Additionally, if a power plant emits harmful emissions to the atmosphere, it can pay a fee to the government or a group of affected citizens, or install a pollution control device that reduces the emissions. Lastly, if a fishery is overexploited by multiple fishermen, they can agree on a quota system or a fee system that limits the catch and preserves the fish stock.