Negative Externalities & the Coase Theorem


Standard economic theory states that any voluntary exchange must be beneficial to both parties in the trade because no one would ever knowingly and voluntarily enter into a trade that somehow left them worse off. However, economic activities can cause additional effects on third parties not directly involved in the exchange. These effects are called externalities, because they are not borne by the people making the decision about the activity. They are also known as spill-over effects, and they can be negative (e.g., health problems caused by pollution from a factory), or positive (honey bees kept for honey that also pollinate crops).

When externalities are present, market prices fail to correctly signal the complete cost of goods or services, resulting in a misallocation of resources. In particular, negative externalities are a concern because they result in the market producing costs that subtract from social welfare. The following video explains the concept of negative externalities in micro-economic terms.

In Khan’s view, which corresponds to the standard neoclassical understanding of externalities, the solution to problems of external cost is to internalize the costs. In Khan’s example, simply raising the price of plastic bags by charging the bag producers (or consumers, it doesn’t matter) for social costs such as cleaning up litter will decrease plastic bag production and free up resources (capital, energy, material, labor) to produce other goods that people ultimately find more satisfying.

If plastic bags kill animals (or people), the economist asks “What are consumers willing to trade (in money) for these lost lives?”

Simply find that number, and adjust the price of bags accordingly until the enjoyment from the last bag produced (the marginal bag) is equivalent to the distress (i.e., cost) of the last (marginal) life loss.

This simplistic view of internalization is not particularly concerned with problems of distribution — i.e., who is killed, or who benefits (e.g., from plastic bags). The primary concern in the Khan video is allocation (how much to produce of which goods).  Internalization of external costs solves the allocation problem, but could still result in problems of distributional injustices.

“Solutions” to Negative Externalities

The following video reveals three theoretical ways to address the allocation problem of externalities, including: 1) taxation, 2) regulation, and 3) property rights. Taxation places the financial burden of external costs on the producer. Regulation can be in the form of requiring a technological fix or limiting the quantity of goods and/or pollution produced. The property rights solution is also known as the Coase Theorem, developed by Nobel Prize winner Ronald Coase. The theory states that optimal allocation of resources is achievable without any government intervention, provided that transaction costs are low and property rights are pre-determined. In this case, Coase claims that the polluting and damaged parties will negotiate a transfer of payments between them to either accept damage or reduce pollution — whichever is more profitable.

The Coase Theorem does not consider whether the Farmer or the Fishermen drive the harder bargain. That is, so long as profits (or enjoyment) as a whole are optimized, then the Coase Theorem is satisfied. But what if property rights are assigned to the Farmer? Suppose the Farmer would profit 10 (dollars, or whatever) from fertilization of the corn field. The fisherman enjoy fishing so much that they’d be willing to pay 15 to fish. According to Coase, the Fishermen complain to the Farmer that the fertilizer is killing fish, but the Farmer says that without the fertilizer, his profits would be reduced to 10. So the Fisherman offer to pay 6 to the Farmer to persuade him to stop using the fertilizer.

The Farmer’s profits are now 11 (5 from unfertilized corn farming and 6 from payments received from Fishermen) and the Fisherman pay only 6 for something that they enjoy as much as 15. Everyone is better off.

But what if the Farmer drives a hard bargain? Maybe he thinks, “If these crazy, rich Fishermen will pay 6, then they’ll probably pay 7, or 8.” Even in the case of ideal conditions for Coasian bargaining, there is nothing to guarantee that the moral implications of the externality will be resolved, partly because Coase is concerned only with the optimal allocation of resources and not the optimal distribution of benefits (or profits) resulting from the economic activity.

When the Farmer controls the property rights, and is under no obligation to sell them, the Farmer-Fishermen interactions can be modeled as The Dictator Game, wherein the Farmer can capture all the benefits of fishing for himself!

Aside from this distributional issue, and the moral problems that it creates, other obstacles often prevent Coasian bargaining. Coase himself admits that in reality, transaction costs are rarely low enough to allow for efficient bargaining. Moreover, direct causality is often difficult to prove.

Imagine the Farmer claiming, “My fertilizer doesn’t kill fish. The fish love my fertilizer.”

If the Fishermen don’t realize what is killing fish, then how would they know to approach the Farmer with an offer?

Or, what if the Fishermen value the fish highly, but simply have no money to pay? Perhaps instead of the recreational fishermen represented in the video, they are subsistence fishermen who use the lake to feed themselves. To the Fishermen, the fish are priceless. But a willingness to pay does not equate to an ability to pay!

The External Costs of Climate Change

Richard Tol wrote in his 2009 paper entitled, The Economic Impact of Climate Change, that “Climate change is the mother of all externalities: larger, more complex, and more uncertain than any other environmental problem”. The reason for this complexity is that emissions of green-house gases from any geographical location on the Earth’s surface travel to the upper atmosphere and play a role in affecting climate globally. Hence, the impact of any particular emission of greenhouse gases (GHGs) is not realized solely at its source, either individual or geographical; impacts are dispersed to other actors and regions of the Earth. Furthermore, GHG emissions are responsible for a myriad of impacts including changes to Earth’s climate system, manifested in events such as drought, floods, sea-level rise, temperature changes, extinction of species, and spread of disease.

This video draws attention to the fact that climate change will adversely impact people that are unable to protect themselves and did little or nothing to create the problem.

The moral complexities surrounding global climate change beg the ethical questions, “What are the developed world’s obligations to the developing countries? And should the developed countries risk their own sense of well-being to meet these obligations?”

Lastly, economists might ask “If property rights were well-defined, could Coaseian bargaining resolve the problem of global climate change?”

The Externalities Game (TEG)

The following video will relate the above concepts of negative externalities and the Coase Theorem to TEG. In TEG you will be able to test Coase’s theory directly with your classmates and students at another University.

Now you know the basics of TEG. This last presentation will tell you the specifics of how TEG will be played in your class. There is also a game schedule provided at the end of the presentation.

If you still have questions about the game, feel free to ask your peers. You may also direct questions to your instructor or send a message to TEG Administrator on ethicsCORE. Good luck!


67 thoughts on “Negative Externalities & the Coase Theorem

  1. After witnessing the way the class came together to optimize the class participation points, one would think that everyone will work together on the externalities game to get the best grade possible for the class. I think that this thought will hold true in the initial stages of the game, but as the game continues on and people have to continually work together day after day, and our class has to work with people that we have never met in our lives, there will be some people that will see a chance to better their grade and will take that option. Annoyances will come up that may push people to decide to try and look out for themselves and not the rest of the class. This is something that we as students have not really witnessed before. When taking tests, we have never been able to work together to ensure that everyone gets to optimize their grade. Yes we have worked together in group projects, but never before have I had to work with not only my class, but another class somewhere else in the world to decide the fate of my grade, and the grade of my classmates. I am also curious to see how well two classes that are hours apart from each other work together.

    • My guess is that the participants will mostly cooperate.

      There actually is a cost to competing, because it makes others lose faith and also compete. Then everyone loses. In games like this, the amount of total good created can be maximized, and that maximum does not correspond with everyone being selfish. It simply does not pay for everyone to be selfish.

      I learned two important things from Drew’s leadership. 1) The collective good can triumph when people have faith and work together. 2) Rules, at times, can and should be bent for the greater good. We need to find a way to beat the system again, to cooperate and organize and keep people honest. Our success depends on the limits of our creativity, will, and solidarity.

      Let the games begin.

    • Let’s hope that the cooperation can continue. Like you, I’m afraid that a few will refuse to play nicely and trigger a domino effect of others justifying selfish play and ultimately we’re all going to pay a price.

      • I would say that Drew showed such a good leading talent! I imagined him as a ship captain! Would a ship actually move just by having a number of workers or employees? Don’t think so!
        We needed in a way a person who could tell us how to work together in a way that we could gain the most from one another!

        I am looking forward for the next class discussion about sharing points! But, I am thinking that we won’t need such thing because we did a good job cooperating together today. BUT, i do still have some fears from the Indian side of the world!

  2. My hypothesis is that all the students will try work together just like we did on Thursday to get the highest grade possible. However, I believe that towards the end of the game, students that have the opportunity to boost their grade up will take advantage of that because they can act anonymously.

    • It will be interesting to see what happens but you don’t know that the Indian students will agree with your class on how to work together. Try to brace yourself for any decision or result that may occur, including your own actions. Good or bad.

  3. When it comes down to it, people all have the same basic desires & act in ways to guarantee these desires are filled. What happened in class on Thursday was really beautiful. Before Drew stood up & presented this formula, one of my group members kept saying how “evil” this all is & I completely agreed with him. It was wonderful to see a class of students who don’t know each other go from this untrusting “dog-eat-dog” mentality and slowly ease into opening up & offering transparency & honesty. People want safety & security when it comes to their shelter, their food & water…and their grades!

    As many students have previously expressed, before Thursday my hypothesis would have been completely different. Now that I have seen our class making the individual decisions to take the risk for the betterment of all, I am shocked but extremely happy. My hypothesis now is that we can totally do this again. I definitely believe that there will be people who will decide to lie to others or not join the group in fairly dividing up points to everyone, but I think that people in our class especially will be more apt to work as a group since we have experienced proof that it can work. As far as the classes in India, as I previously stated, I believe that as people & as students we all have very common basic desires. The key to this working though, is transparency: transparency in our position (luxury, intermediate, or subsistence), transparency in our decisions, transparency in our communications with “TEG Administrator”, etc. The reason that people will be more apt to “defect”, whether it be in our class or in the India classes, is because of the anonymity offered in this setting versus an in-person classroom setting where a person can be called out on their actions. Anonymity breeds suspicion whereas transparency breeds trust.

    • I agree that it was a beautiful thing — but it wasn’t just Drew.

      Drew presented the plan, and he sat down.

      Then Charlie got up and he was the one that actually convinced people they should follow the plan.

      When Charlie sat down, Yannick got up. And Yannick said, “Everybody hand in your sheets to ME.”

      It was a remarkable, spontaneous hand-off of leadership.

  4. Based on the enthusiasm from some of the students in the other classes, I predict some plan will be cooked up and everyone will attempt to follow it. However, I doubt that all 200 will do so. I’m betting some luxury player will get 150 % on this project due to changing their mind at the end. There’s enough anonymity for someone to feel secure in looking out for themselves.

  5. I really had no hope from the beginning of this game. I felt students would want to get a good grade, but there had to be students who wanted to get a GREAT grade. Thanks to Drew I feel this game might work a little better. However I still don’t feel everyone will get an A.

  6. On one hand, the small demo game that we had on Thursday was a very beautiful and also i would say “Perfect” example of cooperation and team-work and somehow we all came up with an agreement that satisfied everyone. On the other hand, i am kind of not seeing that could happen in the real game because of two main reasons :
    1-Bigger number: comparing our small number (~70) to the number of the real game (~220) that will create issues, lots of disparagements and its gonna be very hard to satisfy everyone.
    2-Trust!!: Could you each one of us gain the others trust! some of us never met before! even between our small class number, we didn’t fully trust one another.

    these were just the most two terrifying concepts will rise up! but i am pretty sure there will be more into it than this!
    Finally i wish everyone the best luck!

  7. Based on the videos and the game play on Thursday I think that our class will find a way to work together for the greater good of the class. I’m not sure how it will work out with the other classes, hopefully we can find a way to trust and work with them as well. I predict that we’ll all get decent grades.

  8. Given these videos and the feedback from Thursday’s mini-game, I predict that TEG will play out whereby a large group of participants will cooperate and act as a grade buffer by dominating the production and pollution results. This nucleus will form out of individuals’ fear of getting throttled by the chaos of a free-for-all. At the same time, a small number of students will manipulate the efforts of the majority through the shadows of anonymity in order to enact their own agendas. Some of these deviants will simply panic at the end of the game and operate in a self-serving manner to come out ahead, but a rare few will enter the game with the sole intent of “rocking the boat” and subsequently cannot be reasoned or negotiated with in any way that benefits the welfare of the other 222 students.

  9. It will be interesting to see how the game turns out. It is tough to hypothesis on how the game will turn out. After the game on Thursday I am hopeful that the class will be able to work together to get a decent grade for everybody. It will be challenging because their are more variables in this game that will need to be addressed. It will also take everybody’s will to get it done. In the end I believe that everybody can work together and get a decent grade.

  10. I think everyone will end up finding a way to work together and achieve the best possible grade. Like the game in class, everyone was able to work together to get an “A.” As long as we can communicate with the students in India and get them to jump on board, there is no reason why we can’t all get a good grade.

  11. My hypothesis is that all of the students in all of the classes will work together and find a way to maximize everyone’s grades, just as we did in the game we played in class. I feel this way because I believe most people will find it in their best interest, which is good motivation to work together.

  12. My prediction is that there will be a few moral leaders to lead the classes towards a good strategy that most people will use. There will be a pretty large handful of people who go against whichever strategy is calculated and will only worry about maximizing their own points. But I think in general there will be a lot of good coordination so that everyone can do well.

    •, Marina Meza
      I agree with you Andrea when you point out that there will probably be few moral leaders to lead the crowd into cooperation and strategy. There is always people who worry way too much about their grade to leave it in someone else´s hands or who simply can´t fully trust someone. This will test our ability to establish trust which is great because in the real world, everyone depends on someone else to carry out projects. If we are able to get past those fears and insecurities, then we can do a good job.

  13. After Thursday’s class, I feel like there will be at least one person who will be driven to come up with a way for everybody to come out with a good grade. However this will take a lot of cooperation from the students in India. They have a lot more people playing the game and they will be able to communicate more effectively with each other than we can with them. Their numbers means that they will have more power over the outcome of the game. In the end I feel that the anonymous nature of the game will lead to deals that are not kept in ultimately people will get screwed over.

  14. I would like to believe that the majority of students in the class will work together to ensure a decent grade for everyone, however I know that it may be wishful thinking at this point. One factor is that our class is so outnumbered by the three classes in India. The only way to ensure success is to keep open lines of communication between us and the other three classes.

    I think that we will see a lot of group effort among the people in the S group since this group has to work harder to overcome the effects of pollution. Then I think we will see less of a team effort and more people working on their own in the I group, and even less in the L group. In a perfect situation, the game would work out the way that it did in class where everyone decided to work together to ensure the whole class was successful, however when a bigger chunk of their grade is on the line I think that people will be more likely to underhand their peers if it means their own success.

  15. After what happened in Thursday’s class, I think that we will all attempt to work together to maintain our scores, including the students in India. However, I think that the lack of trust in those whom we do not know will ultimately rule for some when it comes time to submit our production numbers. As unfortunate as it sounds, I believe there are some people in every group that will act in their own self interest not necessarily because they only care about themselves, but that they don’t trust others to keep their word.

    • Completely agree with your hypothesis Krista. Before Thursday’s class, my TEG hypothesis would have been that each group WITHIN our class (Luxury, Intermediate, Subsistence) would try to protect themselves. However, our game session in Thursday’s class proved to me that good communication & successful cooperation within our class can be done (even with the occasional individuals with trust issues as you artfully pointed out). What remains to be seen in my opinionCompletely agree with your hypothesis Krista. Before Thursday’s class, my TEG hypothesis would have been that each group WITHIN our class (Luxury, Intermediate, Subsistence) would try to protect themselves. However, our game session in Thursday’s class proved to me that good communication & successful cooperation within our class can be done (even with the occasional individuals with trust issues as you artfully pointed out). What remains to be seen in my opinion is how well we are able to communicate with the 3 classes from India. They outnumber our class by more than a 2:1 ratio (153 players to 70 players). For this reason, all of our grades will depend HEAVILY on how well we are able to convince them to act cooperateively in search of the optimum production for ALL players in TEG.

      • My apologies everyone for the sloppy comment post above. This is what happens when copy and paste is done POORLY. The above comment should read the following:

        Completely agree with your hypothesis Krista. Before Thursday’s class, my TEG hypothesis would have been that each group WITHIN our class (Luxury, Intermediate, Subsistence) would try to protect themselves. However, our game session in Thursday’s class proved to me that good communication & successful cooperation within our class can be done (even with the occasional individuals with trust issues as you artfully pointed out). What remains to be seen in my opinion is how well we are able to communicate with the 3 classes from India. They outnumber our class by more than a 2:1 ratio (153 players to 70 players). For this reason, all of our grades will depend HEAVILY on how well we are able to convince them to act cooperateively in search of the optimum production for ALL players in TEG.

  16. For a brief moment I was very hopeful after our short game play on Thursday. Then I saw some of the angry faces of people who were thwarted (I assume) in their shafting of everybody else. I wonder what those people do with the rest of their lives? Where do they draw the line of right and wrong? It would be nice if we didn’t separate moral responsibility and the workplace/classroom.
    I think the majority of the people in this game will contribute responsibly to the environment (meaning not shafting others), and a few people will try to get as many points as they can.

    • I agree with this hypothesis. I think that most of the students will choose to cooperate and accept less production to reduce the externalities. I think a few people will refuse to cooperate and try to get ahead on their own, but that their choices will have little impact on the group as a whole.

    • I also agree with this hypothesis. I think most people will try not to negatively impact the environment (or others grades,) but a few people won’t care and be greedy.

    • I absolutely agree with your hypothesis. There will always be those few who choose not to cooperate because they want to maximize their own points, but it should not be a significant amount. These few who choose not to cooperate will not affect the group as a whole and they will be loosing out on the opportunity of learning essential group skills including trust and communication in the workplace.

  17. Seeing what happened on Thursday makes me believe we can all come out on top. I believe this class can work together to maintain an excellent grade for everyone! India may be a problem, but are they not thinking the same thing about us? They will reach out to us as much as we are willing to reach them. Communication is key. They want what we want, surely we can succumb to some agreement that benefits everyone.

    In TEG, MDI and ASU share property rights. We both have a grade we want to maintain and we all have a set standard for what we think that grade should be. Because of this, our grade has become valuable to one another!

  18. Global climate change is a complex dilemma. There are certainly things we can do to reduce our future pollution, but our climate is changing regardless of what we do in the future. Could we attack this problem a different way? What if we applied to Coase Theorem differently? There are millions of people in Bangladesh and countries like it who will be displaced from their property due to rising sea levels. We use this as an opportunity to provide them an education and help them set up a home and buy property somewhere else Combating the negative externalities of climate change should come on two fronts, reducing pollution and providing for people in impoverished countries to adapt to a new way of life.

  19. I think that after what happend in class today it is likely that our class will be able to work collaboratively and effectively. The unknown is still the students in India, who outnumber us so what they do effects us greatly. I think that we need to talk to them and encourage them to work with us so that everyone in the game can reap the benefits.

    • Communication can be a great hurdle to jump when attempting collaboration across different cultures. Unpredictable adversity can arise not only in getting your message halfway across the world, but also making sure your message is clear, translatable and applicable. Small variances in language patterns, tones, use of idioms and many other linguistic variables can serve to open the gap of the communication rather than close it. These issues are relatively trivial in a classroom setting. In a political climate, they can be the difference between peace and war.

    • I’m not sure I would call that outcome likely. This time around, we all have much greater anonymity. Many who were intent on screwing the class over on Thursday were halted by the wave of uninhibited transparency, something which will be much more difficult to achieve across our class this time around. Also, even if someone again proposes a method of optimization that we should all buy into, players can now point to the threat of India and claim that any guarantee of optimization is frivolous at best.

      • So to clarify my hypothesis, I think the result will be a game that starts out looking like the previous game, with a few people taking charge and organizing a procedure for maximizing everyone’s grade. And it will still succeed, but not to the degree it did before. The class generally seems willing to go along with what everyone else is doing when the class is watching, but more anonymity this time around will generate more greed, or at least more expressions of greed, once class has ended and people are making their decisions by themselves. I wouldn’t be surprised if most people produce on average about 1.5 times as much as they agree to in class.

  20. Honestly I’ve never been much of the sustainable type of person. I have a lot of speculation that media flares it up for financial gain. However I do think that there are still pollution problems that need to be handled all the way down to the individual. I thought the video on how the undeveloped parts of the world are suffering the most due to something that is not their fault at all was very eye opening. To think that as “privileged” Americans we could subtly change our life styles to help everyone, including the ones powerless to help themselves, it amazes me that so many people think it’s such an inconvenience. It’s impossible to fully understand the effects without being in those individuals’ shoes and seeing the horrific effects, but it is an important message that should be constantly remembered to help us all better OUR world.

    • There will (probably) always be entities looking to profit from social trends and buzz words like sustainability, but that doesn’t necessarily mean those trends and buzzwords don’t have underlying worth. As engineers, it will very much be our job to sift through hype and evaluate concepts and processes on a fundamental level. Often this will mean separating our personal definition of things from the media hype.

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