Coase Theorem & Review of Regulation

1. ECON 100 Mar 9, 2009 Coase Theorem& Review of Regulation

2. Negative Externalities & Property Rights • “Common” Property Problem • No one “owns” the air/water; therefore no one benefits from managing (pricing) its usage • One solution is to assign the property right to one party and allow them to trade its use in the marketplace • Coase Theorem

3. Problem of the Commons • An example from Fisheries • No one “owns” the fishery; therefore no one benefits from “economically” optimally managing its usage • Rivalry in consumption; but non-excludable resource • Solution is to assign/auction the property rights to catch “x” fish to one or more party (parities) and allow them to trade the permit in the marketplace • Coase Theorem solution

4. Coase’s Theorem • If property rights exist and transaction (bargaining) and information costs are low • Then parties will be able to bargain among themselves (without government intervention) to obtain an efficient outcome

5. An Example of the Coase Theorem • Marketplace • Firm upstream from a farmer • Firm produce a good valued by consumer but dumps pollutants into the river as a byproduct • Cost of using the river to the firm is $0 • Farmer • Downstream from the firm • Uses water to irrigate his agricultural products • Pollution affects/degrades his product

6. Assigning the Property Rights • If assigned to the firm • Farmer is willing to “bribe” the firm to reduce pollution • Willing to pay firm to reduce gallons discharged up to marginal value of crop damage due to pollution • Firm: willing to accept payments that are >= marg costs of treatment/reduction

7. Assigning Property Rights • Assigned to the Farmer • Firm is willing to pay farmer up to the marginal value of “avoided” treatment costs • Farmer is willing to accept payments >= marginal cost of crop damage • Either way: socially efficient (marginal value = marginal cost) solution • However, there are different income effect • Concluding which is best => normative statement

8. Criticism of Coase’s Theorem • If more than 1 farmer • Transaction costs of getting all affected parties together may be too great to get to optimal solution if rights assigned to firm • Demsetz (1964): “when transaction costs are too high; status quo may be optimal” • Leffler: “if it exists, it’s optimal. But, why?” • Use of the government to lower transaction costs • Strategic behavior • Last individual may “hold” out (lower bribe/higher payment) as key to agreement • Fire protection example

9. Tradable permits proposed to slow deforestation • Environmental groups are pushing for the use of market mechanisms to address one of the world's largest sources of greenhouse gas emissions: deforestation. • Similar to carbon trading, the CR plan would award tradable "credits" to countries that voluntarily reduce their deforestation rates below historical baseline levels • countries could then sell the credits to other nations that are unable to meet their emissions reduction goals. • To ensure the validity of countries' claims, compensation would be given only after a specific period of time and after sufficient satellite and on-the-ground observation. • According to Environmental Defense and its partner groups, the clearing and burning of tropical forests is responsible for as much as 25 percent of human-created GHG emissions. • South America's Amazon Forest alone holds some 60 gigatons of carbon • more carbon than all countries release from cars, power plants, and other human-related activities in a decade. • current rates of destruction, forest losses in Brazil and Indonesia alone will negate nearly 80 percent of the emissions reductions achieved under the Kyoto Protocol by 2012. • Slowing deforestation has the additional benefit of preserving biodiversity in threatened tropical forests, the groups note.

10. Application to Fisheries • Fishing Industry • ITQs: Individual Transferable Quotas • Boats bid for the right/license to catch pre-determined amount of fish • Then can either use the license to catch fish; • or resell license to another boat • Boat owners will be willing to sell license if the price offered > profits from catch • Licenses will go to highest valued/most efficient use

11. Fisheries • Other approaches • Quotas • Total catch for the fishery • Quota for each boat • Maximum Sustainable Yield (Biologists)

12. Regulatory Effectiveness • What are the goals? • Allocative Efficiency • Marginal Value (benefits) to consumers = Marginal costs (including opportunity costs) of the resources used to produce the goods • Productive Efficiency • Firms produce at minimum costs • Technological Innovation • Other considerations • Administrative Costs • Dynamics

13. Regulatory Effectiveness • Regulatory prohibitions • Prohibiting Anti-competitive behavior • Sherman Anti-trust Act, Clayton Act • Designed to prevent “monopoly-like” behavior • Should improve all 3 goals • But: • Lag behind what’s actually occurring in the marketplace • Depends on getting caught and convicted • Long judicial process

14. Regulatory Effectiveness • Standards • Prohibit emissions/pollution beyond a “threshold” • Can be designed to get to “optimal” level of pollution • But: • Don’t change prices/costs in the marketplace • Don’t provide incentives for tech innovation • Don’t allocate quotas in a least cost manner • Not dynamic • High administrative costs (2x taxes admin costs)

15. Regulatory Effectiveness • Incentive Mechanisms • Price caps, taxes and tradable permits • Taxes • Correct market signal -> raises costs -> raises price • Productive/allocative efficient; provides incentive for tech innovation (adopt least cost technology) • Administratively less costly than standards • Easier to adjust for dynamic/market changes than standards

16. Regulatory Effectiveness • Price Caps • Provide “correct” price signal • Adjust for inflation and incentive to innovate from use of average industry productivity • Allocative/productive efficient • Administrative costs less than rate-of-return regulation • No incentive to “goldplate” costs (AJ Effect) • Fewer rate reviews/hearings

17. Final Comments • Remember the goals • Economic efficiency • Low Administrative Costs • Flexibility to adjust • Competitively neutral • Simplicity • Sappington’s myths of deregulation

18. Regulatory Effectiveness • Tradable Permits • Fisheries, pollution • License to catch “x” fish or emit “x” pollutants • Can be designed to attain “optimal” level of pollution/fish catch • Market Value of permit (resalable) ensures marginal benefit (keeping permit) = opportunity cost • Allocative/productive efficiency • Incentive to adopt cost-savings technology • May be better at adjusting to changes in the marketplace than taxes > standards