This is “Coasian Bargaining”, section 7.5 from the book Beginning Economic Analysis (v. 1.0).
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The negative externality of a neighbor playing loud music late at night is not ordinarily solved with a tax or with a quota but instead through an agreement. When there aren’t many individuals involved, the individuals may be able to solve the problem of externalities without involving a government but through negotiation. This insight was developed by Nobel laureate Ronald Coase (1910– ), and is sometimes known as Coasian bargainingSolving the problem of externalities through negotiation..
Coase offered the example of a cattle ranch next to a farm. There is a negative externality in that the cattle tend to wander over to the farm and eat the crops, rather than staying on the ranch. What happens next depends on property rightsRights that come with ownership., which are the rights that come with ownership.
One of three things might be efficient from a social perspective. It might be efficient to erect a fence to keep the cows away from the crops. It might be efficient to close down the farm. Finally, it might be efficient to close down the ranch, if the farm is valuable enough and if the fence costs more than the value of the ranch.
If the farmer has a right not to have his crops eaten and can confiscate the cows if they wander onto the farm, then the rancher will have an incentive to erect a fence to keep the cows away, if that is the efficient solution. If the efficient solution is to close down the ranch, then the rancher will do that, since the farmer can confiscate the cows if they go over to the farm and it isn’t worth building the fence by hypothesis. Finally, if the efficient solution to the externality is to close down the farm, then the rancher will have an incentive to buy the farm in order to purchase the farm’s rights so that he can keep the ranch in operation. Since it is efficient to close down the farm only if the farm is worth less than the ranch, there is enough value in operating the ranch to purchase the farm at its value and still have money left over; that is, there are gains from trade from selling the farm to the rancher. In all three cases, if the farmer has the property rights, then the efficient outcome is reached.
Now suppose instead that the rancher has the rights and that the farmer has no recourse if the cows eat his crops. If shutting down the farm is efficient, then the farmer has no recourse but to shut it down. Similarly, if building the fence is efficient, then the farmer will build the fence to protect his crops. Finally, if shutting down the ranch is efficient, the farmer will buy the ranch from the rancher in order to be able to continue to operate the more valuable farm. In all cases, the efficient solution is reached through negotiation.
Coase argued that bargaining can generally solve problems of externalities and that the real problem is ill-defined property rights. If the rancher and the farmer can’t transfer their property rights, then the efficient outcome may not arise. In the Coasian view of externalities, if an individual owned the air, air pollution would not be a problem because the owner would charge for the use and wouldn’t permit an inefficient level of pollution. The case of air pollution demonstrates some of the limitations of the Coasian approach because ownership of the air, or even the more limited right to pollute into the air, would create an additional set of problems; a case where the cure is likely to be worse than the disease.
Bargaining to solve the problem of externalities is often feasible when a small number of people are involved. When a large number of people are potentially involved, as with air pollution, bargaining is unlikely to be successful in addressing the problem of externalities, and a different approach is required.