The Coase Theorem: How to Save the Elephants

In our last discussion we talk about a particular type of market failure called externalities, which were loosely defined as an action who full cost or benefit is not reflected in the market price. The implication of which is that since the person doing the bad thing is not paying the cost to society of their bad actions, there is too much of this bad action. Conversely, since a person only gets the private benefits of their good actions, there is an under provision of good acts, and society misses out on the optimal level of a socially good action. As we aid earlier, in order to arrive at the socially optimal level, we need to figure out a scheme to internalize the external costs or benefits. Elephants are poached for ivory. Most of the solutions centered around regulation, taxation, or other forms of government intervention. A very smart man by the name of Ronald Coase came up with a scheme that, with two small assumptions, changed how everyone thought about externalities and the case for government intervention. Oh, and it also won him the Nobel Prize.
What Coase proposed had an immense effect on public policy. He said that government intervention is not necessary in order to achieve the economically optimal outcome. Rather, all we need is property rights. Let’s walk through his argument. First, he sets down two conditions: 1) The cost of bargaining is zero (or at least low), and 2) Owners of a resource can identify the source of damage to their property and can use legal methods to stop that damage. Coase said that if these two things are true, then in order to arrive at a socially optimal outcome, we only need to assign the rights to the resource to someone. It does not matter to whom we assign the rights as long as we assign the rights to someone. This powerful, but simple, statement stunned his colleagues at the University of Chicago, which included many current and future Nobel Prize winners. They called him into a meeting and twenty of them grilled him for two hours. At the end of the two hours, they all walked out changed men (economically speaking).

Let’s go through an example. Let’s say Leif is owns an aluminum smelting plant that sits on a river. This plant takes bauxite ore and turns in into soda cans and aluminum foil. As part of this process, they put all sorts of chemical into the river, a river in which Ashley, a fisherperson, earn her living. Since the pollution kills the fish, Leif’s plant is exerting damage on Ashley’s livelihood. This is a clear case of a negative externality, an inefficiently high amount of pollution producing aluminum smelting. What Coase says is that as long as either Leif or Ashley has the rights to the river, and if they can easily bargain, the socially optimal level of smelting (and fishing) will be achieved.

Let’s say the law of the land (Montana) is that Ashley has the rights to the river. In this case, she will charge Leif stop polluting. Leif will be willing to pay up to the value of his production of aluminum (at the most), and Ashley would be willing to accept the value of her lost fish (at the least). Where they actually end up is a testament to their bargaining strength. The point is that, since Leif is now paying Ashley for the chemicals he drops into the river, he will reduce his output up to the point that his benefit from polluting is exactly what is cost him plus what it costs Ashley. This is the socially optimal level.

What about if we assign the rights to Leif? In this case, Ashley would pay Leif to not pollute. Leif would be willing to not produce if Ashley compensates him for his lost income. Ashley will pay him to reduce his pollution to the point that his benefit from pollution exactly matches his cost plus the value of not having pollution to Ashley. Notice that this will be exactly the same point as when Ashley had the rights!

The astute reader will notice that the level of output is the same in either case, but one this IS very different. The person who owned the property rights is better off in the end. If Leif has to pay Ashley in order to pollute, they she is better off. If Leif owns the rights to the river, Ashley must pay him, and he is better off. Coase wrote about allocative efficiency. He, as most economists are, was concerned with the correct quantities being produced. The assignment of the rights matters for the distribution of wealth, but it does not matter for the optimal quantity.

What are some real-world examples of the Coase theorem at work? Economist Harvey Rosen points to the example of wildlife preservation in Africa. Elephants are worth more through tourism alive, than they are dead, to get their ivory. Unfortunately, because nobody owns the elephants, their public, tourism benefit is not a private benefit. The result is that the elephants get hunted. In order to stop poaching, Kenya used regulation and banned all elephant hunting in 1977. The result was that the elephant population went from 167,000 in 1977 to 16,000 in 1989. Zimbabwe, on the other hand, assigned ownership of the elephants to the local landowners. This internalized the benefit of the elephants, and made the public benefit a private benefit. The result was that during 1982 and 1995 the elephant population grew from 40,000 to 68,000, a tremendous difference!