Externalities 1

An externality is a situation where actions of one have impacts on others. Here we focus on negative externalities, where the impact is costly. Some law professor named Coase, which rhymes with “dose” like in a dose of medicine, looked at a series of examples and made some conclusions that have come to be known as the Coase Theorem. The basic example we will work with (like the one Coase worked with) is a confectioner (candy maker that I will call C) while making candy creates lots of noise and it disturbs a doctor (I will call D). In each example we will have $ amounts of earnings and loses caused and other details to help us see Coase’s conclusions. By the way, up until the time of Coase’s work the typical response of economists was to shut down or tax the disturber. 2

3 Example 1 C will earn $40 by operating but cause D to lose $60. If C is liable for damages caused it would have the following options: - Close and earn 0 - Operate and earn 40 but pay 60 in damages for net loss of 20. So, C will close and doctor will gain the $60 he was losing. Summary of net benefits C 0 D 60 Total 60 What we see here is under the legal rule of having the damager be liable for damages the person stops what they are doing. Next let’s look at what would happen if they are not liable for damages (a different legal rule).

4 If C is not liable for damages C will want to operate and make 40. D will then have to think about what to do. D could close and have 0, or stay open and lose 60. But D could also decide to pay C to close and pay something in the range of 40 to 60 (not less than 40 because C won’t take less and not more than 60 because D only loses 60). Thus D would gain more than 0 but not lose 60. So D will pay C to close (let’s just say C will take 40). Summary of net benefits C 40 D 20 Total 60 Note that under either legal rule C will close. Resources will not flow to candy making because the benefit there is less than the cost. From an economic perspective we say if is efficient to close C. Also note while society is best off with C closed under either legal rule, C and D care which legal rule is adopted because of how much each makes.

5 Example 2 C will earn $60 by operating but cause D to lose $40. (Note how numbers are reversed.) If C is liable for damages caused it would have the following options: - Close and earn 0 - Operate and earn 60 but pay 40 in damages for net gain of 20. So, C will operate and doctor will close but get the 40 in damages. Summary of net benefits C 20 D 40 Total 60 What we see here is under the legal rule of having the damager be liable for damages the person operates and pays damages.

6 If C is not liable for damages C will want to operate and make 60. D will then have to think about what to do. D could close and have 0, or stay open and lose 40. D can not get enough to pay off C Summary of net benefits C 60 D 0 Total 60 Note that under either legal rule C will operate. Resources will flow to candy making because the benefit there is more than the cost. From an economic perspective we say if is efficient to operate C. Also note while society is best off with C open under either legal rule, C and D care which legal rule is adopted because of how much each makes. How much each makes is a distributional effect. For distribution effects the law matters, for efficiency the law does not matter.

7 Example 3 uses example 1 as base with an addition. C will earn $40 by operating but cause D to lose $60. C can buy soundproofing machine that eliminates the noise and it cost $20. If C is liable for damages caused it would have the following options: -Close and earn 0 - Operate and earn 40 but pay 60 in damages for net loss of 20. -Operate with the sound system and get 40 – 20 = 20. So, C will operate and doctor will gain the $60 he was losing. -Summary of net benefits C 20 D 60 Total 80 What we see here is under the legal rule of having the damager be liable for damages the damager operates because he can eliminate the problem relatively cheaply.

8 If C is not liable for damages C will want to operate and make 40. D will then have to think about what to do. D could close and have 0, or stay open and lose 60. But here D can give C 20 for the soundproofing. Summary of net benefits C 40 D 40 Total 80 Note that under either legal rule C will operate. How much each makes is a distributional effect. For distribution effects the law matters, for efficiency the law does not matter.

9 Example 4 uses example 3 as base with an addition. C will earn $40 by operating but cause D to lose $60. C can buy soundproofing machine that eliminates the noise and it cost $20. D can move to other side of building at a cost of $18 If C is liable for damages caused it would have the following options: -Close and earn 0 - Operate and earn 40 but pay 60 in damages for net loss of 20. -Operate with the sound system and get 40 – 20 = 20. –Pay D to move and gain 40 – 18 = 22 So, C will operate and doctor will gain the $60 he was losing. -Summary of net benefits C 22 D 60 Total 82 What we see here is under the legal rule of having the damager be liable for damages the damager operates even when D can eliminate the problem relatively cheaply.

10 If C is not liable for damages C will want to operate and make 40. D will move his stuff because it is cheaper than paying for soundproofing. Summary of net benefits C 40 D 42 Total 82 Note that under either legal rule C will operate. How much each makes is a distributional effect. For distribution effects the law matters, for efficiency the law does not matter.

11 In our 4 examples so far we have seen that no matter what the law says we get the efficient outcome. Implicitly we have assumed that the cost of each party negotiating the outcomes is 0. In the first two examples the gain of C by operating was different than the lose D incurred. Whichever was higher determined who stayed open and each outcome was efficient. The next two examples highlight the idea that either party may be able to solve the problem at relatively low cost and both can get some benefit. Next we want to see what might happen if there are negotiation costs.

12 Example 5 uses example 2 as a basis. C will earn $60 by operating but cause D to lose $40. C can soundproof for $20 and it costs $25 to negotiate between the 2. If C is liable for damages caused it would have the following options: - Close and earn 0 - Operate and earn 60 but pay 40 in damages for net gain of 20. -Operate and earn 60, have no negotiation, soundproof and pay 20 for net earning of 40. Since D is entitled to his 40 he won’t want to pay any negotiating cost and C can solve problem by paying 20 and not the 25 of negotiating. C operate with soundproofing. Summary of net benefits C 40 What we see here is under the legal rule of having D 40the damager be liable for damages C does the Total 80 cheapest thing on his own because he stills makes $.

13 If C is not liable for damages C will want to operate and make 60 and not want to soundproof or pay any cost of negotiating. D has only 40 to gain but the soundproofing is 40 and the negotiating cost is 25, so D can not make out by working with C. Summary of net benefits C 60 D 0 Total 60 Note that under either legal rule C will operate. While C operates under both legal rules in this example in one case we get soundproofing and in the other we do not. Since soundproofing is a use of resources, we do not get the same efficient outcome here under the different legal rules. So, when negotiations are costly the efficient outcome may not result under different legal rules. Here we need a liability rule to get the efficient outcome.

14 Example 6 C gets 60 by operating, D loses 40 but can move at a cost of $18 and negotiating costs are $25. If C is liable for damages he can operate and pay D for a net gain of 20, or could think about paying D to move. Since D will not want to pay to move or any negotiating cost D will hold out under this rule. Summary of net benefits C 20 D 40 Total 60. D does not move.

15 If C is not liable C will want 60 and not want to negotiate or pay D to move. D only gains 40 by moving and does not gain enough to payoff C so D will just move and have net gain of 22. Summary of net benefits C 60 D 22 Total 82. What this example shows is that making damager liable may not lead to the efficient outcome because maybe the person harmed can solve the problem really cheaply on their own.