Naive Economics Question (related to Coase Theorem)

Factual Questions
1

I’ve been studying some economics as it relates to environmental law and I’m confused about something. One element of environmental policy is an effort to maximize social welfare–that is, a maximization of general social wealth ignoring any distributional consequences. So, for example, if we can reduce 3 units of pollution at a cost of $10 to the polluter using one method or at a cost of $20 using another method, we prefer the former–we get the same result and the cost-effectiveness is said to maximize social welfare. In a more complicated example, suppose that a factory is next to a laundry. The more the factory pollutes, the more the laundry has to pay for extra detergent. The social welfare maximizing level of pollution is the one for which the sum of the costs to the factory of reducing its pollution plus the cost to the laundry of buying detergent are minimized. This is a fairly standard tenet in economics and indeed it forms a part of the theorem that won Ronald Coase the Nobel Prize in Economics.

Ok, what I’m wondering is in what sense this can be called maximizing social welfare? Money circulates in a closed system. In the simple case of the polluter paying $10 or $20, the additional $10 no longer benefits the polluter, but it will be spent to the benefit of whomever the factory purchases the pollution-reduction technology from. Since we are ignoring distributional consequences as one of the assumptions of Coase theorum, why don’t we also ignore the distribution of the $10? Or in the case of the factory and the laundry, why do we arbitrarily exclude the social benefit to the detergent company?

I’m quite sure that I’m missing something obvious. Like I said, Coase won a Nobel Prize for his work here. What am I missing?

2

I think you might be falling into the broken window fallacy here.

We could let the factory pollute as much as they wanted, and have the laundry buy a metric butt load of detergent. That would be great for the detergent maker (as broken windows are great for the glass man) but a bad deal for everyone else, namely the laundry and its customers.

Remember that well defined property rights are the main thing about Coase.

3

[QUOTE=T_SQUARE]
I think you might be falling into the broken window fallacy here.

We could let the factory pollute as much as they wanted, and have the laundry buy a metric butt load of detergent. That would be great for the detergent maker (as broken windows are great for the glass man) but a bad deal for everyone else, namely the laundry and its customers.

Remember that well defined property rights are the main thing about Coase.
[/QUOTE]

I think you’re right to identify it as the broken-window fallacy. Thank you. But I still don’t understand why, in the context of ignoring distributional consequences, the broken window fallacy is fallacious. In my scenario, either the laundry keeps $10 or it spends $10 on detergent. Both results leave the same amount of benefit (i.e. money) in society.

4

OK, let me try it this way. I could pay someone a million bucks to dig a huge hole and fill it back in. Or, I could pay someone a million bucks to dig a huge hole and recover some valuable ore from the bottom of it. In either case, the amount of money in society is the same, but the second option clearly provides more benefit to society, right?

In the case of the laundry, what if they had to buy so much detergent that people were not willing to pay the high cost to get any laundry done. We would have too many widgets (from the factory) and not enough laundry.

5

[QUOTE=T_SQUARE]
OK, let me try it this way. I could pay someone a million bucks to dig a huge hole and fill it back in. Or, I could pay someone a million bucks to dig a huge hole and recover some valuable ore from the bottom of it. In either case, the amount of money in society is the same, but the second option clearly provides more benefit to society, right?
[/quote]

But that’s because you dig something up that has value. So the money in society is not the same. When you dig up your ore then society has $1,000,000 + value of ore.

Possible. There are of course all kinds of possible real world consequences to any level of distribution. Maybe polluting less also causes hurricanes in Australia. But of course Coase also ignored these real-world effects. There must be some matter of abstract principle I’m missing.

6

[QUOTE=Richard Parker]
One element of environmental policy is an effort to maximize social welfare–that is, a maximization of general social wealth ignoring any distributional consequences.
[/QUOTE]

The problem is you can’t ignore the “distributional consequences”. reviewTragedy of the Commons and Externalities.

There are other individuals in your system who are not part of the economic transactions between the factory and the laundry. They are harmed by the polution because there are no economic incentives to not pollute. Even if there is an economic benefit to companies that make their business from the effects of the pollition, that benefit is better spent on something positive instead of cancelling out a negative.

7

[QUOTE=Richard Parker]
But that’s because you dig something up that has value. So the money in society is not the same. When you dig up your ore then society has $1,000,000 + value of ore.
[/QUOTE]
Unless there is some reason the more expensive option’s “true” cost is overvalued for some reason, the $20 solution will have a higher societal impact on other stuff that cannot be made or a use of resources than the $10 solution. There are exceptions, of course, but otherwise people would rush in to provide the $20 solution and thus drive down prices if it was that overvalued.

(Unless for instance the $10 solution were subsidized in some way, or makes use of “free” communal resources such as air that are degraded.)

8

[QUOTE=msmith537]
The problem is you can’t ignore the “distributional consequences”. reviewTragedy of the Commons and Externalities.

There are other individuals in your system who are not part of the economic transactions between the factory and the laundry. They are harmed by the polution because there are no economic incentives to not pollute. Even if there is an economic benefit to companies that make their business from the effects of the pollition, that benefit is better spent on something positive instead of cancelling out a negative.
[/QUOTE]

This is completely non-sequiturish. It has nothing to do with the post here, and does not belong in a straightforward question about economic theory. Aside from which, ALL economic activity has negative extermnalities (such as but not limited to pollusion). Including The Happy Kitty Puppy Ice Cream Green Farm Social Collective.

And even if it weren’t a non-sequitur, it would still be incorrect. You cannot rationally assume that the negative externalities of making pollution is worse than the benefits of having the factory.

Score. Match. Game. :cool:

9

[QUOTE=Richard Parker]
But that’s because you dig something up that has value. So the money in society is not the same. When you dig up your ore then society has $1,000,000 + value of ore.
[/QUOTE]

But there is value in producing laundry, too. And it would be nice if we could get the efficient amount of laundry done with the fewest inputs. Every unit of soap consumed to negate the effects of inefficient pollution is a unit of soap that can’t be utilized elsewhere (like to do laundry near a factory that pollutes more efficiently, or barring the need for any soap, the productive capacity of soap could be utilized to make something else)

[QUOTE=Richard Parker]
Possible. There are of course all kinds of possible real world consequences to any level of distribution. Maybe polluting less also causes hurricanes in Australia. But of course Coase also ignored these real-world effects. There must be some matter of abstract principle I’m missing.
[/QUOTE]

Sure. Lots of economic theories have complications. That’s why “ceteris paribus” is such an oft used phrase in economics.

Perhaps I’m not getting your question. Can you explain what ignoring distributive consequences means to you?

10

[QUOTE=msmith537]
The problem is you can’t ignore the “distributional consequences”. reviewTragedy of the Commons and Externalities.

There are other individuals in your system who are not part of the economic transactions between the factory and the laundry. They are harmed by the polution because there are no economic incentives to not pollute. Even if there is an economic benefit to companies that make their business from the effects of the pollition, that benefit is better spent on something positive instead of cancelling out a negative.
[/QUOTE]

This may be a valid criticism of Coase, but such a criticism is not strictly necessary to understand the theorem. The man did get to go to the big shin-dig in Stockholm after all.

11

[QUOTE=Richard Parker]
But that’s because you dig something up that has value. So the money in society is not the same. When you dig up your ore then society has $1,000,000 + value of ore.
[/QUOTE]

Actually it is the same.

In the hole example, society has gotten something out of it. It has lost your labor for that period, but has gained the value of the ore. It has NOT gained the $1,000,000. That’s just breaking even. Without the ore, it lost the value of your labor to making a useless hole.

Same thing for the laundry. The money in the sysytem is the same. BUT, how that money works is different. The laundry spends $10 less. They offer more services (improving quality) or reduce prices or something. Customers are serviced more and more. They could take it as profit and spend it on themselves.

So in the first place, you spent $20 for a certain amount of goodies. Now you spend $10 for it. You can do ANYTHING with that money. You can invest it.

You might be thinking that if they spend it on themselves, nothing has been gained. But the laundry people gained. And in all future transactions, society will ned to buy less detergent and can therefore buy more of the things they want. Whatever the laundry does with their extra tenner, they’ll actually improve the wealth of the planet by $10. That may seem small, of course, but consider that it’s probably $10 per day or something. $3,650 a year. From one laundry. If 99 more laundries can do this, then the wealth of the world goes up $3,65,000. And you multiply this over and over again for every industry, and everyone becomes wealthier and wealthier.

12

Wait a minute. I was being too generous. “Tragedy of the Commons” advocates the assignment of property rights. It supports Coase.

13

A little late here, but I used to teach Public Economics,many years ago, so let me give it a shot.

The Coase theorem says that you reach the socially maximal outcome by assigning property rights to either the laundry or the factory. But it matters not whom you give the rights to, you will still get the same outcome. Except of course for income effects. The right has value, so whomever has it originally has been given something of vcalue. SO there are distributional effects. So as long as teh laundry can “buy” from the factory the right to pollute then it will end up in the hands of whomever values it most and society benefits. Such a transaction is like any other, it would only take place if it benefitted both sides and therefore was an improvement of welfare. Of course, this is welfare ijnthe strictly econic sense, emaning while the right being given to the factory initially so he can “extort” money out of the laundry may seem morally or ethically wrong, economically it has no consequence on the outcome, you will get the appropriate level of pollution, as long as property rights are assigned, enforced and tradable.

Transacation costs, however, can limit the effectiveness of this theorem in practice. A large number of affected parties, as a whole could benefit enough to make buying the right away form the single factory, but it would possibly be difficult to get folks together for such a transaction. Also, you would have a free rider problem, folks who are affected but think they can get the benefit by others buying the right.

Does that help at all???

14

[QUOTE=Gangster Octopus]

Transacation costs, however, can limit the effectiveness of this theorem in practice. A large number of affected parties, as a whole could benefit enough to make buying the right away form the single factory, but it would possibly be difficult to get folks together for such a transaction. Also, you would have a free rider problem, folks who are affected but think they can get the benefit by others buying the right.

Does that help at all???
[/QUOTE]

And Coase himself pointed out years after the initial theorem that transactions costs can’t really be ignored, so the initial assignment is important.

15

[QUOTE=T_SQUARE]
And Coase himself pointed out years after the initial theorem that transactions costs can’t really be ignored, so the initial assignment is important.
[/QUOTE]

Or the transaction costs need to be minimized or elimnated, if possible.

16

Sorry guys, I know you’re right here but you haven’t reached me yet. Don’t give up on me!

Let’s just look at the simpler example of the broken window. I break your window and it gives me a utility of 5 from the sheer joy of vandalism. Your broken window makes you pay 4 to a window fixer who repairs it. Overall social welfare has increased in two senses: as just between you and me, we have gained 1. And taking into account everyone, we’ve gained 5. The gain of 1 is, I think, recognized by economists and is one of the reasons we can’t make all of our decisions based on social utility. But I take you guys to be telling me that, for the second example, this analysis is incorrect because it doesn’t account for labor, opportunity costs, resources, etc. etc. But Coase doesn’t account for any of that stuff in his analysis. Why should that stuff only come into play when we add a third party?

Yes there is value in producing laundry, and there is value in producing detergent, why should we value one over the other? We cannot appeal to what is most efficient for the laundry since that will depend on the very question we are asking which is how much pollution the laundry will have to deal with–that is, the laundry is going to behave in the most efficient way it can no matter what, the question is whether we want to create a situation in which operating efficiently means keeping $10 or spending $10. I understand one of the central premises to be that having the laundry keep an extra $10 is better than having the laundry spend that $10 on soap. Purely from the perspective of social welfare, and ignoring all distributional consequences, why is that so?

It means we don’t care whether the factory or the laundry or the soapmaker ends up with more money, we just care that we maximize the sum of the money they end up with.

[QUOTE=Gangster Octopus]
A little late here, but I used to teach Public Economics,many years ago, so let me give it a shot…Does that help at all???
[/QUOTE]

I get the basics of the theory. What I’m asking is that since, in the Coasean world, we’re ignoring distributional consequences (which is why we can say that the initial allocation of property rights doesn’t really matter), in what sense are we maximizing social welfare by minimizing the costs* to these bargainers*. That is, while it’s true that if the laundry has to pay more their individual welfare is hurt, it is not the case that the societal welfare is hurt because some other individual gains in direct proportion to the laundry’s loss.

Smilingbandit, your point about all the things the laundry can do with the $10 applies equally well to all the things the soapmaker can do with the $10 doesn’t it?

17

[QUOTE=Richard Parker]
I think you’re right to identify it as the broken-window fallacy. Thank you. But I still don’t understand why, in the context of ignoring distributional consequences, the broken window fallacy is fallacious. In my scenario, either the laundry keeps $10 or it spends $10 on detergent. Both results leave the same amount of benefit (i.e. money) in society.
[/QUOTE]
I think the bolded part is your problem. Money is not equal to “benefit” because the value of money is not constant; it can inflate or deflate, even if the total money supply remains constant and there is no change in demand. In your two scenarios, there are two ways to clean up a quantity of pollution, one costing $10 and the other $20. (Imagine that these methods have no difference in external effects.) That money of course remains in circulation in either case. But in the first case, $10 worth of “benefit” (in the form of goods and the opportunity cost of useful labor) has been permanently used up; in the second case $20 of “benefit” has been removed from society. This consumption of “benefit” (or utility or wealth) reduces the total supply of these goods and so the value of a dollar will tend to decrease, and will decrease by more in the second case than in the first.

It may be helpful to ignore the transfers of money entirely. Just figure out how much wealth is consumed in cleaning the pollution up. Obviously you want to minimize this loss of wealth so that you maximize the remaining wealth.

Again, this misses part of the balance sheet. The window-fixer’s labor and glass, used to repair the window and valued at 4, are now permanently lost and must be subtracted from the total wealth. (In this example, where the utility of your joyous destruction exceeds the cost of the repair, the total “utility” is actually increased by your vandalism, though this is not typically the case.)

18

[QUOTE=T_SQUARE ]
Wait a minute. I was being too generous. “Tragedy of the Commons” advocates the assignment of property rights. It supports Coase.
[/quote]

I don’t think I was criticizing Coase.

19

[QUOTE=Richard Parker]
Let’s just look at the simpler example of the broken window. I break your window and it gives me a utility of 5 from the sheer joy of vandalism. Your broken window makes you pay 4 to a window fixer who repairs it. Overall social welfare has increased in two senses: as just between you and me, we have gained 1. And taking into account everyone, we’ve gained 5.
[/QUOTE]
A couple comments on this: If breaking the window is indeed worth 5 quatloos to you (and there’s zero negative utility for me from having to deal with the replacement, going without a working window for a while, or anything else), then yes, you’re correct in that society has gained by 1 quatloo. But of course in that case, you’d be willingly paying me 4.5Q (or so) for permission to break my window, and I’d be willingly taking it from you. And indeed we both gain in that case for a net gain of 1 quatloo of welfare (and how it’s split between you and me depends on how well each of us bargain).
However, society doesn’t gain by 5Q in any way. The 4 quatloos I have to pay the window-fixer are 4 quatloos I can’t spend on gold-plating my doorknobs. So the window-fixer gains, but the doorknob plater loses. [Also, the window-fixer doesn’t gain all of 4 quatloos, anyway, as he has to pay for new glass, and put his time and effort into the job, all of which have value]. In the case I didn’t take the window repair money from by doorknob-plating fund, and took it out of my savings, that means there is 4 quatloos less to invest in things that could create wealth for society in the future.

20

[QUOTE=Quercus]
The 4 quatloos I have to pay the window-fixer are 4 quatloos I can’t spend on gold-plating my doorknobs. So the window-fixer gains, but the doorknob plater loses.
[/QUOTE]

I with you for the rest of your post except this part.

Let’s make a diagram. The cost to the factory is the cost of abatement for each unit of pollution. The cost to the laundry is the cost of detergent, and the cost to the soapmaker is lost business because of abatement.



                                     
Pollution     Factory          Laundry            Soapmaker

5                   25               1                     30        
4                   20               6                     24
3                   13               15                   18
2                   10               18                   15
1                    5                24                    6
0                    1                30                    1

Ok, under Coase theory, regardless of the allocation of property rights the laundry and the factory will bargain for 2 units of pollution. This minimizes the sum cost to both parties. If, however, we add the soapmaker to the bargaining, the parties will bargain for 5 units of pollution because this maximizes the benefit to all three, right?