ECON101: Principles of Microeconomics

Ronald Coase (1910–2013) was featured for his representation of the firm as a political organization. He is also known for his idea that private bargaining could address market failures, in some cases doing this more effectively than government policies.

He explained that when one party is engaged in an activity that has the incidental effect of causing damage to another, a negotiated settlement between the two may result in a Pareto-efficient allocation of resources. He used the 1879 legal case of Sturges v. Bridgman in the United Kingdom to illustrate his argument. The case concerned Bridgman, a confectioner (candy-maker) who, for many years, had been using machinery that generated noise and vibration. This caused no external effects until his neighbor Sturges built a consulting room on the boundary of his property, close to the confectioner's kitchen. The courts granted the doctor an injunction that prevented Bridgman from using his machinery.

Coase pointed out that once the doctor's right to prevent the use of the machinery had been established, the two sides could modify the outcome. The doctor would be willing to waive his right to stop the noise in return for a compensation payment. And the confectioner would be willing to pay if the value of his annoying activities exceeded the costs that they imposed on the doctor.

Also, the court's decision in favor of Sturges rather than Bridgman would make no difference to whether Bridgman continued to use his machinery. If the confectioner had been granted the right to use it, the doctor could have paid him to stop. But he would have been willing to do this if, and only if, the costs to him were greater than the confectioner's profits gained by using the machinery.

In other words, private bargaining would ensure that the machinery was used if, and only if, its use, along with a compensation payment, made both better off. Private bargaining would ensure Pareto efficiency. Bargaining gives the confectioner an incentive to take into account not only the marginal private costs of using the machine to produce candy but also the external costs imposed on the doctor. That is, the confectioner takes account of the entire social cost. To the confectioner, the cost of using the annoying machinery during the doctor's visiting hours would now send the right message. Private bargaining could be a substitute for legal liability. It ensures that those harmed are compensated and that those who could inflict harm would make efforts to avoid harmful behavior.

Whether the courts decided in favor of Sturges (the doctor) or Bridgman (the confectioner) made no difference from the standpoint of Pareto efficiency. As long as the court clearly established who had the right to do what so that the two could bargain, the result would be efficient. However, the legal decision did matter for the distribution of income between the two. Because the court decided in favor of Sturges, Bridgeman would have to pay Sturges for the right to use the machinery. Had it gone the other way, Sturges might have paid Bridgeman to stop using the machinery.

To summarize:

• The court establishes the initial property rights: In this case, Bridgman's right to make a noise or Sturges' right to quiet.
  
  
• This leads to a Pareto-efficient outcome: As long as private bargaining exhausts all the potential mutual gains, the result would (by definition) be Pareto efficient, regardless of which party owned the initial rights.
  
  
• Is this fair? We might object that the court's decision resulted in an unfair distribution of profits, but however one evaluates this concern (or if, like Coase, one puts 'questions of equity aside'), the outcome would be Pareto efficient.

Coase emphasized that his model could not be directly applied to most situations because of the costs of bargaining and other impediments that prevent the parties from exploiting all possible mutual gains. Costs of bargaining, sometimes called transaction costs⁠, may prevent Pareto efficiency. If the confectioner cannot find out how badly the noise affects the doctor, the doctor has an incentive to overstate the costs to get a better deal. Establishing each party's actual costs and benefits is part of the cost of the transaction, and this cost might be too high to make a bargain possible.

However difficult it might be for the doctor and the confectioner to acquire this information, it is often even more difficult for a government to gather the information necessary to directly impose an efficient and fair solution beyond simply clarifying the property rights in question.

Coase's analysis suggests that a lack of clear property rights and other impediments leading to high transaction costs may stand in the way of using bargaining to resolve external effects. But with a clear legal framework in which one side initially owned the rights to produce (or to prevent the production of) the external effect, there might be no need for government policies to address the market failure.

Until now, you have probably thought about property rights as referring to goods and services that are typically bought and sold in markets, like food, flights, or houses. Coase's approach suggests that we could think of other rights - in his example, the right to make a noise or to have a quiet work environment - as goods that can be bargained over and traded in return for money.

Could Private Bargaining Solve the Pesticide Problem?

Let's see how a private bargain might solve the pesticide problem. Initially, it is not illegal to use Weevokil; the allocation of property rights is such that the plantation owners have the right to use it and choose to produce 80,000 tonnes of bananas. This allocation and the associated incomes and environmental effects represent the reservation options⁠ of the plantation owners and fishermen. This is what they will get if they do not come to an agreement.

For the fishermen and the plantation owners to negotiate effectively, they would each have to be organized so that a single person (or body) could make agreements on behalf of the entire group. Let's imagine that a representative of an association of fishermen sits down to bargain with a representative of an association of banana growers. To keep things simple, we assume that there are no feasible alternatives to Weevokil, so they bargain only over the output of bananas.

Both sides should recognize that they could gain from an agreement to reduce output to the Pareto-efficient level. In Figure 11.5, the situation before bargaining begins is point A, and the Pareto-efficient quantity is 38,000 tonnes. The total shaded area shows the gain for the fishermen (from cleaner water) if output is reduced from 80,000 to 38,000. However, reducing banana production leads to lower profits for the plantation owners. Use the analysis in Figure 11.5 to see that the fall in profit is smaller than the gain for the fishermen, so there is a net social gain that they could agree to share.

The Status Quo at Point A

The situation before bargaining is represented by point A, and the Pareto-efficient quantity of bananas is 38,000 tonnes. The total shaded area shows the gain for fishermen if output is reduced from 80,000 to 38,000 (that is, the reduction in the fishermen’s costs).

Lost Profit

Reducing output from 80,000 to 38,000 tonnes reduces the profits of plantations. The lost profit is equal to the loss of producer surplus, shown by the blue area.

The Net Social Gain

The net social gain is the gain for the fishermen minus the loss for the plantation owners, shown by the remaining green area.

Figure 11.5 The gains from bargaining.

Since the gain to the fishermen would be greater than the loss to the plantation owners, the fishermen would be willing to pay the banana growers to reduce output to 38,000 tonnes if they had the funds to do so.

The minimum acceptable offer⁠ from the fishermen depends on what the plantations get in the existing situation, which is their reservation profit (shown by the blue area labeled "loss of profit"). If plantation owners agreed to this minimum payment to compensate them for their loss of profit, the fishing industry would achieve a net gain equal to the net social gain, while plantations would be no better (and no worse) off.

The maximum the fishing industry would pay is determined by their reservation option (also known as their fallback option), as in the case of the plantation owners. It is the sum of the blue and green areas. In this case, the plantation owners would get all the net social gain, while the fishermen would be no better off. As in the examples of bargaining in Unit 5, the compensation the plantation owners and fishermen agree on between these maximum and minimum levels is determined by the bargaining power of the two groups.

Why Private Bargains May Not Work

As Coase acknowledged, practical obstacles to bargaining may prevent the achievement of Pareto efficiency:

• Impediments to collective action: Private bargaining may be impossible if there are many parties on both sides of the external effect, for example, many fishermen and many plantation owners. Each side needs to find someone they trust to bargain for them and agree on how payments will be shared within each industry. The individuals representing the two groups would be performing a public service that might be difficult to secure.
  
  
• Missing information: Devising the payment scheme makes it necessary to measure the costs of Weevokil, not just in aggregate, but to each fisherman. We also need to establish the exact origin of the pollutant, plantation by plantation. Only when we have this information can we calculate the size of the payment that each fisherman must pay and how much each plantation should receive. It is easy to see that it is far harder to make a polluting industry accountable for the damage it does than to calculate the liability for damage done, for example, by a single reckless driver.
  
  
• Tradability and legal enforcement: The bargain involves the trading of property rights, and the contract governing the trade must be enforceable. Having agreed to pay thousands of dollars, the fishermen must be able to rely on the legal system if a plantation owner does not reduce output as agreed. This may require the fishermen and the courts to discover information about the plantation's operations that is not publicly known or available.
  
  
• Limited funds: The fishermen may not have enough money to pay the plantation owners to reduce output to 38,000 tonnes (we saw in Unit 9 why they would probably not be able to borrow large sums).

Source: CORE Econ, https://www.core-econ.org/espp/book/text/11.html#great-economists-ronald-coase
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