II. Law and economic analysis
B. Foundations for the economic analysis of the common law
2. Coase and externalities (cont'd.)

    36: According to the work of Coase: "Pigou's analysis was wrong, not in one way but in three. The existence of externalities does not necessarily lead to an inefficient result. Pigouvian taxes do not in general lead to the efficient result. Third, and most important, the problem is not really externalities at all. It is transaction costs."

    a. The Pigouvian approach can be inefficient (Coaseian critique)

Example: small private lake     chemical factory owns 1/2 of shore     fishing resort owns 1/2 of shore     no one else uses it     factory pollution kills most of the fish     resort revenue falls from $50,000 to $10,000/year => damage = $40,000

    ? The Pigouvian solution? Pollution charge = $40,000.

    Control cost = $30,000

    ? Factory response?

    Stops polluting

    ? Is society better off?

    ? What would Coase say at this point?

    Maybe there is a better alternative: Factory pollutes, resort switches to horseback riding with revenue = $40,000 => $10,000 cost

    ? The best solution? Allow pollution, switch resort

    ? Does that happen with Pigouvian tax?
    Pigouvian solution was inefficient

    Finding the lowest cost solution requires consideration of possible adjustments by all affected parties.

    No universal Pigouvian rule works because the legal system does not know which party can adjust at lower cost.

    "This paper is concerned with those actions of business firms which have harmful effects on others. The standard example is that of a factory the smoke from which has harmful effects on those occupying neighboring properties.... The traditional approach has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong." (Coase 1)

    ? Why is it wrong?

" We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm." (Coase 1)

    14: "What we have are not costs imposed by one person on another but costs jointly produced by decisions made by both parties...."

    Coase perspective: an externality is not unilaterally due to one party; it is jointly determined by the affected parties

    Pigou --> cell 2
    Optimum = cell 3

    b. Externalities may not cause inefficiency

    ? Why not? Affected parties can bargain
    This possibility is captured in the Coase Theorem

    ? What does the Coase Theorem say?

    The Coase Theorem: Any initial assignment of property rights will lead to an efficient outcome as long as transaction costs are zero.

    ? How does Coase say it?
    Coase builds up to theorem using cattle vs. crops to illustrate
    "It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximizes the value of production) is independent of the legal position if the pricing system is assumed to work without cost." (Coase 7)

    Coase focus: how we bundle property rights
    (1) Does a buyer of lakeshore property buy the right to pollute or to be free of pollution?
    (2) Does ownership of a hotel pool include ownership of the sunlight falling on it?
    (3) Who owns the right to control the movement of currents of air--the air carrying the smells from the brewery into someone else's courtyard, or carrying (or not carrying) the smoke from my chimney away?

Resort example:
Factory's pollution control cost = $30K
Resort's lowest-damages with pollution: $10K of lost profit

    ? What outcome will occur if the resort has the right to a pollution-free lake?

    pollution + resort switches to horseback riding: factory can profitably bribe resort to switch.

    ? What outcome will occur if the factory has the right to pollute?

    pollution + resort switches to horseback riding: resort cannot profitably bribe factory to abate.

    ? Do economists concerned with efficiency care how the property rights are assigned?

    No--we reach efficiency either way?

    ? Do the parties involved care how the property rights are assigned?

    Yes--parties care about their wealth, not efficiency, and property rights are valuable to own.

    --In a Coase world, although we achieve an efficient outcome with any assignment of rights, we may not achieve the same outcome.

    --if a change of legal rule changes the distribution of wealth, output levels can change. (Regan, LEA 116-117)

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