First fundamental theorem of welfare economics requires well defined property rights.

Transcription

1 7. Property Rights and Externalities 7.1 Introduction First fundamental theorem of welfare economics requires well defined property rights. Property rights: a bundle of entitlements defining the owner s rights, privileges and limitations for the use of the resource Why are well-defined property rights important for efficient resource use? Common property externality: property right is lacking for the resource (res nullius; it belongs to nobody). Definition of well defined property rights : (i) Comprehensively assigned: All assets or resources must be either privately or collectively owned, and all entitlements must be known and enforced effectively. (ii) (iii) (iv) Exclusivity: All benefits and costs from use of the resource should accrue to the owner, and only to the owner, either directly or by sale to others. Transferability: All property rights must be transferable from one owner to another in a voluntary exchange. (Why is this important?) Enforceability: Property rights should be secure from involuntary seizure or encroachment by others. The owner has an incentive to improve and preserve a resource while it is in his or her control rather than over-exploit the assets. 1

2 Most market failures with environmental assets can be linked in some way to incomplete markets due to the failure to establish property rights. E.g. rivers and air lack of property rights, No markets for clean air or clean rivers exist. 7.2 Does the distribution of property rights matter for efficiency? Ronald Coase (1960) The Problem of Social Cost - An important paper that contributed to his winning the Nobel Prize in economics. Asked who should have property rights the victim or the polluter. One conclusion was that (under certain assumptions) it makes no difference to efficiency whether the polluter has the right to pollute or the victim has the right to a clean environment. The right to pollute is a property right that has value. If trade is allowed in those rights efficiency should prevail no matter how rights are initially allocated. Initial distribution of rights does matter for equity. Example, a neighbour's loud stereo destroys the tranquillity of an evening for someone next door. 2

3 Price of loudness, $/decibel Demand for loudness by stereo owner MC of loud music A pe C B 0 E qe qmax Loudness, decibels 3

4 Without considering the neighbour's welfare, the stereo owner chooses: Socially efficient level: How can negotiation yield the efficient solution? Neighbour bribes the stereo owner: an amount Pe for every decibel reduced. Owner will then reduce the noise to: Stereo owner is better off because: Neighbour is better off because: Now suppose the neighbour has the property right (as is the case in Ontario after 11 pm). What happens? 4

5 7.3 The Coase Theorem: Deriving the marginal conditions algebraically The efficient outcome Return to the laundry/steel example suppose the two firms are merged into one find the profit maximizing conditions Denote the profits for the merged company as π m. π = ps+ pl C ( S) C ( LS, ) m s L S L Maximize profits with respect to the choices of L and S. Will the profit maximizing quantity of steel always be positive? Property rights reside with laundry Find the profit maximizing conditions in this case. 5

6 7.3.3 Steel mill has the property right to pollute Find the profit maximizing conditions in this case. Compare the marginal conditions that have been derived in the above three cases. What are your conclusions? 6

7 Note that in the long run the assignment of property rights might matter to the result. Total costs differ depending on how property rights are assigned. When the steel mill has the property rights its total costs may be significantly lower. This will result in a lower average cost of steel production. This implies a lower price for steel in the long run, and increased demand. In the long run if the property rights reside with the polluter we might expect to see higher output of the polluting industry than if property rights reside with the party that is damaged by pollution Coase theorem: Assume a world in which some producers or consumers are subject to externalities generated by other producers or consumers. Further, assume (1) everyone has perfect information, (2) consumers and producers are price takers, (3) there is a costless court system for enforcing agreements, (4) producers maximize profits and consumers maximize utility, (5) there are no income or wealth effects, (6) there are no transactions costs. In this case the assignment of property rights regarding the externalities does not matter for efficiency. If any of these conditions does not hold, the initial assignment of property rights does matter. Transactions costs are costs of entering into a transaction above the cost for the good alone. Includes bargaining costs even psychic costs. Often significants Other impediments to reaching a bargain, especially when there are multiple polluters and/or victims. Difficulties reaching agreement about distribution of the gains. Wealth effects: Property rights affect your endowed wealth. Demand depends upon wealth so initial endowment can affect final result Problems of public bads and bargaining - Example of a power plant and a number of people around the plant - Right to pollute vested with the power plant - Individuals surrounding the plant will likely have difficulty reaching an agreement to make a payment to the plant. - Incentive to free ride on others by understating the true value of the damage caused by the plant on an individual. - If property right resides with the individuals, they will have an incentive to overstate the damage to affect the amount of compensation paid. 7

8 7.3.6 Policy significance of Coase - transactions costs may prevent reaching an efficient outcome. - when property rights are traded (eg. emissions permits) it is important to minimize transactions costs - victims of pollution should not be averse to paying polluters to reduce pollution 8