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Learn the toughest concepts covered in your Macroeconomics class with step-by-step video tutorials and practice problems.


Private Solutions to Externalities: The Coase Theorem


The Coase Theorem

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Alright, so we've seen how the government can help provide solutions to externalities. Now, let's see how solutions can be found privately without government intervention. So when we talk about private solutions to externalities, we're always going to talk about this coast theorem. Okay, this coast theorem was made up by this guy Coast and Coast also won a Nobel prize for his ideas relating to solutions to externalities. So they were just popping out Nobel prizes for everyone who could find ideas related to externalities. Coast 11 here as well for his coast theorem. And anytime we talk about Coase theorem, we're talking about these private solutions to these externalities. Okay, so that's kind of the connection you should always make and that's what what his ideas were. Is that the parties can privately come up with a solution if there's these certain conditions are met. The first condition being that the property rights are clearly defined. Remember how we talked how important property rights are. So in this case this is gonna be essential that the property rights are clearly defined. And two that the transaction costs are low. Right? When I talk about transaction costs, this is the time the money coordination efforts, right? All of this has to be pretty minimal for this to work. If there's gonna be some sort of high transaction costs, like even like, you know, a language barrier between the people negotiating and you have to hire a translator, right? Anything can be a transaction costs. Um any of these things can keep a private solution from coming about. Alright, so let's go back and let's talk about this with an example, let's talk about the idea of that barking dog, right? That started our whole discussion about externalities. So let's talk about three different situations with this barking dog. Okay. Let's see how the coast theorem can come into play. So remember this dog is barking a lot and keeping the neighbors up all night, right? There's this negative externality being imposed on the neighbors because the dog is barking all night. So let's see what happens in. In this first case, let's talk about the benefit the owner has for owning the dog. All right. So it's kind of hard to quantify these things, right? Because it's kind of uh an intangible kind of concept. But let's say the owners benefit in this case for owning a dog is gonna be $500, right? So that's kind of a weird thing to think about. But I guess the way I like to consider it is he's by owning this dog. He gets the same amount of joy as if someone had just walked up to him and handed him $500 right? So it's kind of hard to quantify that. But you could imagine if someone handed you $500 you'd be this amount of happy, right? And if someone handed you 1000 I would imagine you'd be a little bit more amount of happy, right? But it's hard to kind of consider what that amount is. But let's put those numbers here to help us understand. So in this case the neighbors benefit for owning this dog is $500. Where the excuse me, the owners benefit, right? He loves the dog enough that he's got this benefit of $500. But the neighbors cost is gonna be in this case $800 all the lost sleep, right? The loss of happiness, the loss of sleep, The stress that this dog causes this neighbor gets $800 worth of cost from it. Right? So the idea here is is that the neighbor would be willing to pay $800 to shut this dog up. Right? That that would be kind of how they think about it, Right? If I paid $800 for this dog to shut up, I would be happy. Right? So that's kind of the idea of that cost to the neighbor. So now let's talk about the property rights in this case. Let's say there's no noise ordinance, right? The owner has the property rights over the noise, right? There's no noise ordinance into in in in uh enacted or ordinance, excuse me. Um, so it's the owner is allowed to make this noise, right? The dog is allowed to make the noise. They have property rights over the noise. So in this case, since the owner is allowed to make the noise, they get a benefit of 500 from owning the dog. Here's a possible solution from the coast. It's not the only solution, But this is a possible solution. The neighbor pays the owner $600, let's say some amount, $600 to get rid of dog. All right. So now in this case, the $600 that the neighbors gonna pay to the owner is more happiness than the dog than the owner gets from the dog, right? The owner only gets $500 worth of happiness from the dog here And the neighbors paying him $600. So the so the owner is going to be happy enough to take the money and get rid of the dog. I know it's very sad. Um and the neighbors gonna be happy to write because they were willing to pay up to $800 to get rid of this dog and they got rid of it for 600. So they got a benefit out of this too. Right? So in this case, we found a solution an efficient solution without the government stepping in, right? The government still held a role in the sense of they help um enforce property rights, right? That's gonna be kind of the government's role. But the government's not gonna step in with a tax a subsidy, right? They're just gonna basically help us with property rights. But other than that, um the government has no role here. So let's go ahead and see a different example in this case, let's say this owner loves their dog a little more And they love their dog. A $1,000 worth of love for this dog, right? And we'll keep this $800 cost to the neighbor and the owner will still have property rights in this case, right? There's still no noise ordinance in effect. So what's gonna happen here now the owner has $1000 benefit and the cost of the neighbor is 800 right? So there's no amount that the neighbor could pay right? The neighbors only willing to pay up to 800. If the neighbor were to offer 800 to the owner, the owner wouldn't take it because they get $1000 benefit from the dog, right? They don't want to take the $800 and get rid of the dog in this case. So in this case, what's gonna happen, there actually is gonna be no money exchanged because there can't be an exchange. And because of the situation where the owner has property rights and the situation, you know, these these dollar amounts that we have, we actually have an efficient solution already. This is already efficient because of the setup of the property rights. Since the owner has as property rights over the noise, it's the neighbor's responsibility to have considered that when they moved in there, right that there's a chance that there could be this loud dog, right? So in this case we're already efficient, there's no money gonna be exchanged, the neighbors just gonna have to deal with this dog, and that's the efficient solution in this case. Cool. So let's go ahead to one last example, right? In this case We're gonna keep the same numbers right? There's $1,000 benefit to the owner, $800 cost to the neighbor from the, from the noise. But now let's give the neighbor the property rights. Now there is a noise ordinance in effect and you're not allowed um to have a loud dog. Right now, the neighbor has essentially, let me get out of the way. The neighbor essentially has the property rights over noise here, right? Because there's a noise ordinance there, they have right to peace and quiet. So what could be a solution in this case? So since the neighbor has property rights in this case, the owner Can pay the neighbor somewhere along the lines of $900 right uh to keep the dog. So in this case, if the owner were to pay the neighbor $900, the owner is better off, right? Because he gets $1,000 benefit from owning a dog and the neighbors better off because their cost of hearing the dog was only $800 worth to them, but they're gonna get $900 out of it. So what's the conclusion we can make here look right underneath. I've got this, it doesn't matter which party has the property rights, it does not matter if the neighbor has property rights or the owner has property rights and efficient outcome is reached, no matter what. Okay, so as long as these property rights are clearly defined, which is our main takeaway here, The property rights clearly defined, these transaction costs are low, right? There's no transaction costs for them here. They're able to just exchange the money. We can reach private solutions. Okay, so this was Coast's Nobel prize winning idea, right? That we can reach an efficient solution without the government intervening. As long as these property rights are, are clearly defined and the transaction costs are low. Cool. So that is private solutions to externalities. Come from this Coast theorem. So anytime you hear Coast theorem, think about externalities and the private solutions. Cool. Let's go ahead and do some practice problems. So let's do that now in the next video.

A key element of the Coase theorem is:


Which of the following is not a way of dealing with externalities?


If the assumptions of the Coase theorem are satisfied, then


It is possible to remedy a positive externality by:


The socially optimal level of pollution: