class: center, middle, inverse, title-slide # Environmental Economics ## Lecture 5: Property Rights ### David Ubilava ### December 2020 --- # Coase and the Assignment of Rights With environmental goods, *non-excludability* is one of the main reasons of market failure. A way to tackle the issue is by establishing *property rights*. This simple institutional intervention makes goods excludable, and allows markets to operate efficiently. For this to work, property rights should be: - *well-defined*, - *transferable*, - *secure*, and - *complete*. --- # Coase and the Assignment of Rights Who should be assigned rights: the party creating the externality (the *culprit*) or the party affected by the externality (the *victim*)? Consider a case of air pollution. The problem arises because a culprit happens to be located too close to victims. But a polluter is only a culprit because victims happen to live too close to the polluter. So, should it be the culprit who is given the right to pollute, or should it be the victims who are assigned the right to breathe clean air? Ronald Coase raised this issue, back in 1960. His conclusion was that because the right to pollute and the right to breathe clean air are property rights that have value, as long as trade is allowed, efficiency should prevail, no matter how those rights are initially distributed. --- # Coase and the Assignment of Rights As an example, consider two firms: a steel manufacturer, which dumps the waste into the river, and a resort, which needs clean river for proper functionality. Let the firms' profits be given by: `\(\pi_s(a)\)` and `\(\pi_r(a)\)`, where `\(a\)` is the level of abatement which can go from 0 (no abatement) to 1 (full abatement and no pollution). --- # Coase and the Assignment of Rights <div class="figure" style="text-align: center"> <img src="05-Rights_files/figure-html/abatement-1.png" alt="Optimal Abatement" width="90%" /> <p class="caption">Optimal Abatement</p> </div> --- # Coase and the Assignment of Rights As depicted on the graph, the optimal level of abatement, `\(a^*\)`, is where the marginal benefit of abatement equals the marginal costs of abatement. At this level, the cumulative profit is: `\(\pi_s(a^*)+\pi_r(a^*)\)`. There are two other possible outcomes, where either one of the two facilities cease to operate. In those instances, the cumulative profit will simply be the profit of one or the other businesses, i.e., `\(\pi_s(0)\)` or `\(\pi_r(1)\)`, that has remained open. From the efficiency standpoint, the largest total profit level dictates the action to be taken. --- # Coase and the Assignment of Rights ## The Victim Has Rights Suppose the resort has the legal right to clean water; that is, the right to complete abatement, `\(a=1\)`. In this scenario, the profits of the two firms are: `\(\pi_s(1)\)` and `\(\pi_r(1)\)`. If the steel manufacturer wants to pollute (produce, that is), it will have to compensate the resort for any damage. That is, the resort's profit is guaranteed to be at least `\(\pi_r(1)\)`. At `\(a=1\)` the marginal cost of abatement exceeds the marginal benefit, so there is room for negotiation to reduce the abatement level. --- # Coase and the Assignment of Rights As it turns out, the negotiated abatement level will end up at `\(a^*\)`, where the marginal cost of abatement equals the marginal benefit. The steel manufacturer has the following options: - Operate and emit at `\(a^*\)`; the steel manufacturer pays the resort an amount of `\(\pi_r(1)-\pi_r(a^*)\)`, which leaves the steel manufacturer with the profit of `\(\pi_s(a^*)-[\pi_r(1)-\pi_r(a^*)]\)`. - Operate and emit at `\(a=0\)`; the steel manufacturer buys out the resort for `\(\pi_r(1)\)` and shuts it down, which leaves the steel manufacturer with the profit of `\(\pi_s(0)-\pi_r(1)\)`. - Go out of business, in which case the profit drops to zero. --- # Coase and the Assignment of Rights The resulted steel manufacturer's profits in the three scenarios are identical to those discussed previously except that each profit is lower by the amount of `\(\pi_r(1)\)`. The steel manufacturer will take the action that results in the highest profit. The end result will be the same as before. --- # Coase and the Assignment of Rights ## The Culprit Has Rights Suppose the steel manufacturer has the legal right to pollute; that is, the right to no abatement, `\(a=0\)`. In this scenario, the profits of the two facilities are: `\(\pi_s(0)\)` and `\(\pi_r(0)\)`. If the resort wants less pollution, it will have to compensate the steel manufacturer for its reduction of profits due to the abatement. The steel manufacturer's profit is thus guaranteed to be at least `\(\pi_s(0)\)`. --- # Coase and the Assignment of Rights As previously, the abatement will end up at `\(a^*\)`, where the marginal cost of abatement equals the marginal benefit. The resort's options are as follows: - Operate at `\(a^*\)` and pay the steel manufacturer an amount of `\(\pi_s(0)-\pi_s(a^*)\)`, which leaves the resort with the profit of `\(\pi_r(a^*)-[\pi_s(0)-\pi_s(a^*)]\)`. - Operate at `\(a=1\)` and buy out the steel manufacturer for `\(\pi_s(0)\)`, which leaves the resort with the profit of `\(\pi_r(1)-\pi_s(0)\)`. - Go out of business, in which case the resort's profit drops to zero. --- # Coase and the Assignment of Rights The resort's profits in the three scenarios are identical to those discussed originally except that each profit is lower by the amount of `\(\pi_s(0)\)`. The resort will take the action that results in the highest profit. The end result will be the same as in the previous two cases. That is, the outcome is independent of how property rights are assigned. --- # The Coase Theorem The foregoing discussion suggests that the pollution problem can be resolved as long as the involved parties are in a position to negotiate, no matter how property rights are assigned. --- # The Coase Theorem Coase's theorem states that efficiency (socially optimal equilibrium) can be achieved in the presence of an externality, regardless of the initial assignment of property rights, under the assumptions of: - perfect information; - profit-maximizing producers / utility-maximizing consumers; - price-taking economic agents; - costless enforcement of rights; - no income or wealth effects; - no transaction costs. --- # The Coase Theorem *Transaction costs* are the costs incurred during an economic exchange of a good, above and beyond the price paid for the good. The zero transaction costs is a crucial assumption of the Coase Theorem. In most real world situations, there are significant transaction costs, which limits the practical application of the Coase Theorem. When transaction costs are present, it does matter where the rights are initially vested. If the transaction costs (e.g., legal fees) exceeded the gains from bargaining, then transaction would not have taken place, and either the steel manufacturer would need to excessively abate pollution, or the resort would be burdened with excessive pollution. --- # Free-Riding Bargaining is easy between two parties, but becomes exceedingly difficult as the number of parties increase. The issue is further amplified by the public bad nature of most pollution. Moreover, damage to victims is often private information, which creates incentives of free-riding. --- # Free-Riding Consider the steel manufacturer (that is also a polluter) and households who live nearby and are thus suffering from pollution. In a scenario where the steel manufacturer is assigned the rights to pollute, the victims would need to offer a lump sum payment to the manufacturer to abate pollution. For bargaining to make sense, this payment amount should at least be equal to the costs of abatement. The payment amount, in turn, is collected from (and thus split among) the affected households. But some households (free-riders) may pretend that the pollution does not bother them, in which case the total payment is divided among the remaining households. This will increase each household's contribution, possibly to the point that it exceeds the perceived damage from pollution, thus undermining the Coasian solution to the pollution problem. --- # Free-Riding In an alternative scenario, where the individuals have the right to clean water, the polluter will need to compensate each person their damage. But individuals may overstate this damage, in which case it will be difficult - perhaps even impossible, but certainly inefficient - to strike the deal. --- # Bibliography Isaksen, E. T., & Richter, A. (2019). Tragedy, Property Rights, and the Commons: Investigating the Causal Relationship from Institutions to Ecosystem Collapse. *Journal of the Association of Environmental and Resource Economists, 6(4)*, pp. 741-781.