Flashcards in Week 11: Coase Theorem Deck (7)
What is an externality?
An externality occurs when the activity or action of one agent directly enters and affects the utility/profit function of another agent in a way that is not reflected in market prices
What does Coase Theorem state?
As long as property rights are assigned, there is no need for government intervention to correct externalities because agents can bargain, reaching side agreements to achieve an optimal allocation of resources that minimize social cost.
What are the conditions for Coase Theorem to work?
=> everyone has perfect information
=> consumers and producers are price takers
=> there is a courtless cost system to enforce contracts
=> producers maximize profits and consumers utility
=> there are no income or wealth effects
=> there are no transaction costs
=> no dynamic response
What are potential problems with Coase Theorem?
1) Transaction costs: side agreement will only happen if the combined gains from the agreement are higher than the transaction cost (which can include finding victims/offenders, hiring lawyers, drafting and signing contracts, etc.)
2) Income effects: if marginal damage or benefit changes with income
3) Perfect information: external marginal cost and marginal net benefits might not be known by other party; incentive to exaggerate cost to obtain more compensation; incentive to downplay benefits
4) Group bargaining
Coase Theorem & NYC Water Supply
=> city paid farmers and residents for most sensitive land and for a sewer upgrade upstate West of the Hudson to deal with water pollution
=> this option was cheaper than a filtration plant in the area
Coase Theorem & Panama Canal
=> ForestRe issued a 25 year bond to pay for the replanting of forest around the Panama Canal (which acted like a reservoir -- capturing water and releasing it slowly over time)
=> asked major beneficiaries of canal (e.g. Walmart) to contribute