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9.7: Alternatives to Government Intervention

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    Market Based Solutions (Coase Theorem)

    Direct government intervention into the market is not the only way to correct for market miscommunication. An external cost can sometimes be settled by negotiation between the party creating the cost and the party having to bear the external cost.

    The party that bears the external cost can sometimes pay the source to stop the behavior that causes the external cost. With negotiation, it may be less expensive to correct for this sort of market failure.

    The economic basis for the negotiated settlement is called the Coase Theorem, after Nobel Prize winner Ronald Coase.

    Suppose that there is a box maker and a brewer in a community. There is a lake between them. The box maker uses the lake to dump pollution from its factory, but the brewer needs clean water from the lake as the major input for beer. Coase would point out that the external cost in this case is not necessarily imposed by the box maker on the brewer – rather, it comes from the incompatible activities of the two parties. Furthermore, if Coase were to examine the particulars of this example, he would point out that the external cost is the result of both the box maker dumping pollutants into the lake and the location of the brewery next to the lake.

    According to Coase, the efficient solution to this problem (i.e., internalizing the external cost) depends on which party can avoid the problem at the lower cost.

    Coase argues that when property rights are established (i.e., who has the right to do what to whom), the two parties will agree on the efficient (least-cost) solution to an external cost problem. An important aspect of the Coase Theorem is that the efficient solution will be reached regardless of which party gets the property right.

    Problems with the Coase Theorem

    If negotiation is the miracle fix for this type of market failure, then why do we still have problems associated with pollution? There are two problems that can make the Coase Theorem unworkable: free riders and high transaction costs.

    Free Rider

    Let us return to the box maker/brewer example from the video. Suppose the box maker has the right to pollute, but that doing so is inefficient--pollution control is cheaper than pollution cleanup. Further suppose that there are one hundred brewers that use the lake water for their brewing process.

    With only one brewer, there would be no problem--he would offer to pay the box maker for the cost of the pollution control equipment (and, perhaps a little extra to sweeten the deal). But a hundred brewers face what economists call a public good problem. If ninety of them put up the money and ten do not, the ten get a free ride--no pollution and no cost for pollution control. Each brewer has an incentive to refuse to pay, figuring that his payment is unlikely to make the difference between success and failure in the attempt to pay the box maker to eliminate its pollution. If the attempt is going to fail even with him, then it makes no difference whether he contributes. If it is going to succeed even without him, then refusing to contribute gives him a free ride. Only if his contribution makes a difference does he gain by agreeing to contribute.

    High Transaction Costs

    High transaction costs are another problem that can prevent the Coase Theorem from achieving an optimal outcome. Transaction costs are what economists call the expense associated with negotiations. With many millions of people involved in a negotiation process, it is hard to imagine any plausible way in which the negotiating parties could come to some agreement that is less expensive than the actual external cost.

    This page titled 9.7: Alternatives to Government Intervention is shared under a not declared license and was authored, remixed, and/or curated by Martin Medeiros.

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