Externalities are a type of market failure that are loosely defined as an action for which the full cost or benefit of that action is not reflected in the market price. The implication of which is that since the person doing the bad thing is not paying the full cost to society of their bad actions, there is too much of this bad action.
Conversely, since a person only receives the private benefits of their good actions, rather than the full societal value, there is an under-provision of good acts, and society misses out on the optimal level of a socially good action. In order to arrive at the socially optimal level, one needs to figure out a scheme to internalize the external costs or benefits. Most solutions to externalities center around regulation, taxation, or other forms of government intervention. A very smart man, however, by the name of Ronald Coase came up with a scheme that, with two small assumptions, changed how everyone thought about externalities and the case for government intervention. Oh, and it also won him the Nobel Prize.
What Coase proposed had an immense effect on public policy. He said that, in the presence of an externality, government intervention is not necessary in order to achieve the economically optimal outcome. Rather, all we need is property rights. His argument only required two conditions: 1) the cost of bargaining is zero (or at least low), and 2) owners of a resource can identify the source of damage to their property and can use legal methods to stop that damage. Coase said that if these two things are true, then in order to arrive at a socially optimal outcome, we only need to assign the rights to the resource to someone. It does not matter to whom we assign the rights as long as we assign the rights to someone. This powerful, but simple, statement stunned his colleagues at the University of Chicago, which included many current and future Nobel Prize winners. They called him into a meeting and twenty of them grilled him for two hours. At the end of the two hours, they all walked out changed men (economically speaking).
Let’s go through an example. Let’s say Kevin is owns an aluminum smelting plant that sits on a river. This plant takes bauxite ore and turns in into soda cans and aluminum foil. As part of this process, he puts all sorts of chemicals into the river, a river in which Logan, a fisherman, earns his living. Since the pollution kills the fish, Kevin’s plant is exerting damage on Logan’s livelihood. This is a clear case of a negative externality — Kevin has no incentive to consider the negative effects of his production on Logan’s livelihood. What Coase says, however, is that as long as either Kevin or Logan owns the rights to the river, and if they can easily bargain, the socially optimal level of smelting (and fishing) will be achieved.
Let’s say the law of the land is that Logan has the rights to the river. In this case, he will charge Kevin to stop polluting. Kevin will be willing to pay up to the value of his production of aluminum (at the most), and Logan would be willing to accept the value of his lost fish (at a minimum). Where they actually end up is a testament to their bargaining strength. The point is that, since Kevin is now paying Logan for the chemicals he drops into the river, he will reduce his output up to the point that his benefit from polluting is exactly what it costs him plus what it costs Logan. This is the socially optimal level.
What about if we assign the rights to Kevin? In this case, Logan would pay Kevin not to produce aluminum. Kevin would be willing to not produce if Logan compensates him for his lost income. Logan will pay him to reduce his pollution to the point that his benefit from pollution exactly matches his cost, plus the value of not having pollution to Logan. Notice that this will be exactly the same point as when Logan had the rights!
The astute reader will notice that the level of output is the same in either case, but one thing IS very different. The person who owned the property rights is better off in the end. If Kevin has to pay Logan in order to pollute, Logan is better off. If Kevin owns the rights to the river, Logan must pay him, then Kevin is better off. In other words, Coase theorized about allocative efficiency. He, as most economists are, was concerned with the correct quantities being produced. The assignment of the rights matters for the distribution of wealth, but it does not matter for the optimal quantity.
What are some real-world examples of the Coase theorem at work? Economist Harvey Rosen points to the example of wildlife preservation in Africa. Elephants are worth more through tourism alive, than they are dead, for their ivory. Unfortunately, because nobody owns the elephants, their public, tourism benefit is not a private benefit like selling ivory would be. The result is that the elephants get hunted. In order to stop poaching, Kenya used regulation and banned all elephant hunting in 1977. The result was that the elephant population went from 167,000 in 1977 to 16,000 in 1989. Zimbabwe, on the other hand, assigned ownership of the elephants to the local landowners. This internalized the benefit of the elephants, and made the public benefit a private benefit. The result was that during 1982 and 1995 the elephant population grew from 40,000 to 68,000, a tremendous difference!