Unit 10 Market successes and failures: The societal effects of private decisions

10.3 Solving the problem: Private bargaining and property rights

To demonstrate that the market allocation of bananas was not Pareto efficient, we showed that if the fishermen paid the plantation owners to produce fewer bananas, both would be better off. Does this suggest a remedy for market failure that might be implemented in the real world?

Watch the video ‘How to pronounce Coasean’ to hear it said aloud.

It does. The fishermen and the plantation owners could negotiate a private bargain. Solutions of this type are often called Coasean bargaining, after Ronald Coase, who pioneered the idea that private bargaining over external effects might be preferable to government intervention.

He argued that when one party is engaged in an activity that has the incidental effect of causing damage to another, the two parties often have better information about the effects than the government does. So a negotiated settlement between the two is more likely to achieve a Pareto-efficient allocation of resources.

Coase used the legal case of Sturges v Bridgman to illustrate how bargaining could work. 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 neighbour Sturges (a doctor) 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 explained that once the doctor’s right to prevent the use of the machinery had been established by the court, 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 greater than the costs it imposed on him.
  • The confectioner would be willing to pay if his gain from using the machinery exceeded the payment.
  • If the benefit from the machinery was greater than the social cost—the sum of the costs to the two parties—a mutually beneficial payment could be found and the machinery would be used.
  • If the benefit were less than the social cost, a Pareto improvement would be impossible and the doctor’s consulting room would remain quiet.

Either way, the result would be Pareto efficient. To reach an agreement, the confectioner has an incentive to take into account not only the marginal private costs of using the machine to produce candy, but the entire social cost. Once the doctor has the right to prohibit the use of the annoying machinery, the price of doing so during the doctor’s consulting hours (including how much Bridgman would have to compensate the doctor to gain his permission) then sends the right message.

property rights
Legal protection of ownership, including the right to exclude others and to benefit from or sell the thing owned. Property rights may cover broadly-defined goods such as clean water, safety, or education, if these are protected by the legal system.
reservation option
When someone makes a choice amongst the available options in a particular transaction, the reservation option is their next best alternative option. Also known as: fallback option. See also: reservation price.

In general, Coase argued, private bargaining could ensure that those harmed would be compensated, and that those who could inflict harm would make efforts to avoid harmful behaviour. The court’s role was to establish the initial property rights of the two parties: in this case Bridgman’s right to make noise or Sturges’s right to a quiet environment. His approach demonstrates that property rights can extend beyond the ownership of goods that are typically bought and sold in markets, like food, clothes, or houses. The law may grant rights to benefit from more broadly defined goods (anything people care about), and these rights too may be bargained over and traded in return for money.

As in the case of Angela and Bruno in Section 5.8 the legal framework allocates initial property rights, determining the reservation options of the parties. Then, if Pareto improvements are possible, they can be achieved through private bargaining in which these rights are bought and sold (Section 5.9).

Bargaining over pollution

Let’s analyse how a private bargain might solve the pesticide problem. We start by assuming that the legal framework gives the plantation owners a right to use the pesticide, and does not protect the fishermen’s access to clean water. In the absence of a private agreement, the previous section showed that the plantations would produce 80,000 tons of bananas. The corresponding incomes from bananas and fish are the reservation options on each side. banana In this example, there are more than two parties involved. To negotiate effectively, the plantation owners and fishermen would each need a single person (or body) who could make agreements on their behalf. 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 will assume that, at present, there are no feasible alternatives to Weevokil, so they bargain only over the output of bananas.

Before bargaining, they are at point A in Figure 10.3, where the marginal private cost of bananas equals the price. The Pareto-efficient point is B, where the marginal social cost equals the price. Work through the steps to deduce that the fall in banana profits in moving from A to B is smaller than the gain for the fishermen, so there is a net social gain that they could agree to share.

In this diagram, the horizontal axis shows the quantity of bananas Q in tons per year, and ranges from 0 to 100000. The vertical axis shows the costs in dollars, and ranges from 0 to 900. Coordinates are (quantity, costs). An upward-sloping straight line passes through points (0, 200) and A (80000, 400) and is labelled marginal private cost. Another convex, upward-sloping curve passes through points (0, 250) and (80000, 675), is labelled marginal social cost and is above the marginal private cost line at all points. A vertical line passes through point (70000, 0). A horizontal line passes through points A and B (38000, 400) and is labelled price. A vertical line passes through point A and a vertical line passes through point B. The area between the horizontal line, the line through B, and the marginal private cost line is the plantations’ reduction in profit. The area between the line through A, the horizontal line, and the marginal social cost curve is the net social gain.
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Figure 10.3 The gains from bargaining.

The status quo: In this diagram, the horizontal axis shows the quantity of bananas Q in tons per year, and ranges from 0 to 100000. The vertical axis shows the costs in dollars, and ranges from 0 to 900. Coordinates are (quantity, costs). An upward-sloping straight line passes through points (0, 200) and A (80000, 400) and is labelled marginal private cost. Another convex, upward-sloping curve passes through points (0, 250) and (80000, 675), is labelled marginal social cost and is above the marginal private cost line at all points. A vertical line passes through point (70000, 0). A horizontal line passes through points A and B (38000, 400) and is labelled price. A vertical line passes through point A and a vertical line passes through point B. The area between the vertical lines, the marginal social cost curve and the marginal private cost line is the gains for fishermen.
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The status quo

The initial position is point A, and the Pareto-efficient point is B. The difference between MSC and MPC is the marginal external cost for the fishermen, so the total shaded area shows the gains for fishermen if output is reduced from 80,000 to 38,000.

Lost profit: In this diagram, the horizontal axis shows the quantity of bananas Q in tons per year, and ranges from 0 to 100000. The vertical axis shows the costs in dollars, and ranges from 0 to 900. Coordinates are (quantity, costs). An upward-sloping straight line passes through points (0, 200) and A (80000, 400) and is labelled marginal private cost. Another convex, upward-sloping curve passes through points (0, 250) and (80000, 675), is labelled marginal social cost and is above the marginal private cost line at all points. A vertical line passes through point (70000, 0). A horizontal line passes through points A and B (38000, 400) and is labelled price. A vertical line passes through point A and a vertical line passes through point B. The area between the horizontal line, the line through B, and the marginal private cost line is the plantations’ reduction in profit.
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Lost profit

Reducing output from 80,000 to 38,000 tons reduces the profits of plantations. The difference between P and MPC is the surplus on each ton, so the total lost profit is the shaded area below the price line.

The net social gain from moving to B: In this diagram, the horizontal axis shows the quantity of bananas Q in tons per year, and ranges from 0 to 100000. The vertical axis shows the costs in dollars, and ranges from 0 to 900. Coordinates are (quantity, costs). An upward-sloping straight line passes through points (0, 200) and A (80000, 400) and is labelled marginal private cost. Another convex, upward-sloping curve passes through points (0, 250) and (80000, 675), is labelled marginal social cost and is above the marginal private cost line at all points. A vertical line passes through point (70000, 0). A horizontal line passes through points A and B (38000, 400) and is labelled price. A vertical line passes through point A and a vertical line passes through point B. The area between the horizontal line, the line through B, and the marginal private cost line is the plantations’ reduction in profit. The area between the line through A, the horizontal line, and the marginal social cost curve is the net social gain.
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The net social gain from moving to B

The gain for the fishermen is greater than the loss for the plantations. The difference is the net social gain, shown by the shaded area above the price line.

minimum acceptable offer
In the ultimatum game, the smallest offer by the Proposer that will not be rejected by the Responder. More generally in bargaining situations, it is the least favourable offer that would be accepted.

If the fishermen had sufficient funds, they would be willing to pay the banana growers to reduce output to 38,000 tons, and in return, the plantations would be willing to give up some of their right to pollute. The minimum acceptable offer would be a payment exactly compensating the banana growers for their lost profit: the shaded area below the price line in Figure 10.3. If the offer was accepted, the fishing industry would receive the whole of the net social gain, while banana growers would be no better or worse off.

The maximum the fishing industry would pay is the whole of their own gain—the total reduction in pollution costs. In this case, the plantations would get all of the net social gain. Like Angela and Bruno in Unit 5, we expect them to agree on a payment somewhere between these maximum and minimum levels, determined by the bargaining power of the two groups.

The allocation of property rights: Efficiency and equity

Coase pointed out that as long as private bargaining exhausted all the potential mutual gains, the result would (by definition) be Pareto efficient, independently of which party owned the initial rights.

To understand this point, think about what would have happened if the court had decided in favour of the confectioner rather than the doctor, upholding the confectioner’s right to use noisy machinery. If the doctor’s costs were greater than the confectioner’s benefits from using the machinery, they could have concluded a private bargain in which the doctor paid him to stop. As before, the machinery would be used if and only if the benefit was greater than the social cost. Likewise, if the fishermen had a right to clean water, the plantations would have paid them to give up some of their right, and the resulting output of bananas would still have been the Pareto-efficient level of 38,000 tons.

But the initial allocation of property rights is also very important for determining the distribution of incomes, because it determines the reservation options of the parties. In Figure 10.3, you may have thought it unfair that the fishermen had to pay for a reduction in pollution. In the resultant allocation, the fishing industry is still suffering from pollution, and it has to pay to stop the pollution getting worse. This follows directly from the legal ‘right to pollute’ of the plantations.

In the alternative legal framework where the fishermen had a right to clean water, their reservation option would be no pollution at all. And then they could raise their incomes further by allowing 38,000 tons of bananas to be produced, in return for a payment greater than the costs imposed by the corresponding amount of pollution—overall, a much more favourable outcome for the fishermen. So, for the distribution of benefits and costs among the two parties, who has the property rights makes a big difference.

The effectiveness of bargaining in practice

If bargaining can resolve externalities without government intervention, why are there so many instances of unresolved problems?

Coase’s analysis suggests that clearly established property rights are an essential starting point. From the early 1950s, the company DuPont manufactured Teflon in West Virginia using a chemical called PFOA. The use of PFOA was not legally controlled, but it polluted water used by local farmers and residents. It was eventually shown to be responsible for serious disease and death of both people and other animals, but for many years only the company itself knew anything about its effects. Because of the lack of information, there was neither an established right for DuPont to use PFOA, nor an established right for the local population to drink water free of it. In these circumstances, any negotiation between them was impossible. In 1998, a local farmer sued DuPont for the loss of cattle, and further lawsuits followed. Although much more is now known about the effects of PFOA, and it is no longer used to make Teflon, the legal position where it is used remains unclear. In 2017, DuPont settled over 3,550 PFOA lawsuits. They paid $671 million to those who had been harmed, but denied any wrongdoing.

transaction costs
Costs that impede the bargaining process or the agreement of a contract. They include costs of acquiring information about the good to be traded, and costs of enforcing a contract.

Even if initial property rights can be established, lack of information may impede bargaining. Coase emphasized that his approach could not be directly applied to many situations because of legal fees and other costs of bargaining and agreeing a contract: the impediments to the bargaining process that prevent the parties from reaching a Pareto-efficient outcome. Transaction costs arise in particular when there is information asymmetry. 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. Determining each party’s actual costs and benefits is part of the cost of the transaction, and it might be too high to make a bargain possible.

Practical obstacles to bargaining include:

  • Impediments to collective action: There may be many parties on each side of the external effect, all affected in different ways. In the case of the fishermen and plantation owners, we supposed that each side could find someone they trusted to bargain for them, and all would be willing to abide by the outcome.
  • Missing or asymmetric information: It is necessary to be able to measure the costs of and benefits of everyone involved, in order to calculate how much each party should pay or receive.
  • Tradability and enforcement: The bargain involves the trading of property rights, and the contract governing the trade must be enforceable. The legal system must be able to obtain the relevant information if any individual reneges.
  • Limited funds: Parties wishing to purchase a property right must have the funds to do so. The fishermen, for example, may not have enough money to pay the plantations to reduce output or find a safer pesticide.

In short, Coasean bargaining alone is unlikely to be able to address complex market failures that affect many players.

Great economists Ronald Coase

Portrait of Ronald Coase

When he received the Nobel Prize in 1991, Ronald Coase (1910–2013) said he had never counted himself among the great economists, having made ‘no innovations in high theory’. Nevertheless, he changed the way we think about economics.

Coase asked questions about things that economists had previously taken for granted—about why production took place in the types of organization we call firms, the relationship between economic interactions and institutions (which we explore in Unit 5), and the factors underlying the legal and economic institutional structure of the economy.

In an influential article published in 1937 called The Nature of the Firm, he explained that whether activities would take place within firms or through markets depended on the costs of carrying out the transactions required. We use his ideas to explain firm structure in Section 6.2.

Secondly, he emphasized the role of property rights: that economic interactions involve the buying and selling of the rights to use economic resources, and these rights depend on institutions. We have used this idea from Unit 1 of The Economy 2.0: Microeconomics onwards.

Property rights were central to his famous analysis of harmful external effects in The Problem of Social Cost, published in 1960. Earlier analyses had concentrated on the question of how the harmful activity could be stopped—we often do this when we think about pollution. But Coase pointed out that it was a reciprocal problem: if A inflicts harm on B, ‘avoid[ing] the harm to B would inflict harm on A… The problem is to avoid the more serious harm’. Coase frequently added an important proviso: ‘questions of equity (fairness) aside’.

Having identified that this could be achieved through private bargaining—once property rights were established—Coase went on to show that the practical relevance of the approach depended on the costs of carrying out the transaction. His contribution is sometimes quoted in support of a claim that government intervention is unnecessary for Pareto efficiency. But that was not his own claim, since it is only true in an unrealistic world of no transaction costs (in which competitive markets wouldn’t be necessary either). Coase himself described his work as ‘as a stepping stone on the way to an analysis of an economy with positive transaction costs’.

Exercise 10.2 Bargaining in practice

  1. Using the example of plantation owners and fishermen, explain some factors that might affect the bargaining power of these parties.
  2. Referring to the example of banana plantations in Guadeloupe and Martinique (Section 10.1), suggest some reasons why the parties involved did not reach a solution via private bargaining.

Question 10.2 Choose the correct answer(s)

The graph depicts the MPC and MSC of the robot factory production in Question 10.1. The factory’s noisy production process disturbs the sleep of nurses who live nearby.

In this diagram, the horizontal axis shows output, denoted Q, ranging from 0 to 140. The vertical axis shows costs in dollars, ranging from 0 to 600. Coordinates are (output, costs). There are two upward-sloping straight lines that start from the point (0, 100), labelled marginal social cost and marginal private cost. The marginal social cost lies above the marginal private cost at all points. A horizontal line corresponding to a price of $340 intersects the marginal social cost curve at a quantity of 80 and intersects the marginal private cost curve at a quantity of 120. There are two shaded regions. The first region, labelled green, lies below the price line and is enclosed by the points (80, 260), (80, 340), and (120, 340). The second region, labelled purple, lies above the price line and is enclosed by the points (80, 340), (120, 460), and (120, 340).
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The robot market is competitive and the market price is $340. Currently, the factory is producing an output of 120, but 80 would be Pareto efficient. Read the following statements and choose the correct option(s).

  • To reduce output to 80, the factory’s minimum acceptable payment would be $1,600.
  • The maximum that the nurses are willing to pay to induce the factory to reduce the output to 80 is $2,400.
  • The factory would not reduce its output to 80 unless it received at least $4,000.
  • The net social gain from the output reduction to 80 depends on the amount paid by the nurses to the factory.
  • The minimum acceptable payment is the loss of surplus, which is area A = 0.5 × (340 − 260) × 40 = $1,600.
  • The maximum that the nurses would pay is the total gain (of reduction in noise cost) associated with the fall in output, shown by the sum of area A and area B, which is ((80 + 120) × 40)/2 = $4,000 (using the formula for the area of a trapezium).
  • $4,000 is the maximum the nurses would pay (the sum of area A and area B). The minimum acceptable payment is area A.
  • The net social gain is the difference between the nurses’ reduction in the noise cost and the loss of profit for the factory. This is area B. It is not affected by the payment, which only determines the distribution of the net social gain.

Question 10.3 Choose the correct answer(s)

Consider the situation where the noise of a factory’s production affects nurses in the dormitory next door. Suppose there are no transaction costs to impede Coasean bargaining. Read the following statements and choose the correct option(s).

  • Whether the final output level will be Pareto efficient depends on who has the initial property rights.
  • The nurses would be better off in the bargained allocation if they initially had a right to undisturbed sleep than they would if the factory had the right to make noise.
  • If the factory has the right to make noise, it will prefer not to bargain with the nurses.
  • The net social gain from robot production goes to whichever party obtains the initial property rights.
  • The final allocation will be Pareto efficient regardless of whether the factory has the right to make noise or the nurses have the right for undisturbed sleep. This is the main result of Coasean bargaining.
  • If the factory has the initial rights, the nurses will have to pay for a reduction in noise; if they have the initial rights they will gain both a noise reduction and a payment from the factory.
  • The factory can be made better off by obtaining a payment from the nurses in return for reducing output.
  • This is the maximum that the party with the initial property rights can obtain, but whether they will do so depends on their bargaining power.