Since pollution is an externality firms will not undertake to control their pollution. The answer is in government regulations. Coase argues that in perfect competition with laissez faire, govt regulation is not needed. Instead bargaining between the polluters and their victims can lead to an optimal situation. But this pre supposes equality in bargaining, and does not take note of ecological consequences of pollution.

1. THE COASE THEOREM
Prof. Prabha Panth
Osmania University
26-Oct-13

2. Market failure
• Environmental goods are non excludable.
• Due to absence of property rights.
• Since environmental does not belong to
anybody, it is misused. Ex. pollution
• Imposes external costs on victims, who have
to pay cost of pollution damages,
• To correct this, government regulations are
needed.
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3. Bargaining vs. Government
regulations
• In neo-classical theory, government
interference is not approved.
• According to Roland Coase, there is no need
for government interference to control
externalities, such as pollution.
• An optimum solution, which satisfies both
polluter and victims can be achieved through
“bargaining”.
• This is called Coase Theorem.
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4. Assumptions
1. Some common property resource, e.g. river,
2. Full knowledge of pollution impacts and
abatement costs.
3. Pollution impacts can be measured in money
terms,
4. Equal status of bargaining partners,
5. Both have property rights to use the common
resource,
6. No transaction costs,
7. No income effects.
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5. • If a factory pollutes the river, then fishermen are
affected.
• Their income is reduced, or their health suffers. This
is the external cost of pollution
• If factory owner has to reduce his pollution, then his
costs increase.
• The external costs are internalised.
• Coase shows that ‘least cost’ method can lead to
optimum solution.
• This is achieved through bargaining by both parties,
without government regulations.
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6. Equilibrium in the Coase Theorem
MCA
MCA,
MD
MD
MCA >
MD, so
victims
should
bribe
polluters
= Ab, to
reduce
their
pollution
to X0
A
G
E
H
MD > MCA, so
polluters should pay
compensation to
victims = GHE, equal
to the pollution
burden.
B
0
X1
X0
X2
Pollution
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7. Equilibrium
• In the figure, MD is marginal environmental damage. It
increases as pollution increases.
• It is the cost borne by the victims in terms of loss of income or
health.
• MCA = marginal abatement cost. If the firm has to reduce
pollution, it has to spend more on pollution control measure.
• Optimum level of pollution, is at X0, where MD = MCA.
• If optimum is not reached, then bargaining between them will
achieve optimum level of pollution.
• This is independent of who has property rights, fishermen or
firm.
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8. Equilibrium in Coase Theorem
1. But, if actual pollution is X1, then MCA > MD.
The firm will bargain to reduce pollution up to X0,
Paying compensation to victims = ABE.
2. If actual pollution is X2, then the cost or damage to victims is
GX2.
To make firm reduce pollution to X0, cost to firm will be EGH.
Victims will pay this amount to firm to reduce the level of
pollution to X0.
Thus pollution levels can be at optimum level through bargaining
by both parties. Either victims should pay the polluters to
reduce pollution (ABE) or polluters have to pay
compensation (GHE) to those affected by pollution.
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9. Limitations
1. Unequal status and bargaining power of the two
parties, fishermen may be too poor to bargain.
2. Transaction costs are not zero, legal fees have to be
paid.
3. Environmental damage at X0 may not be optimum.
4. Open access, then there are no property rights.
5. Costs imposed on future generations not taken into
account.
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