Saturday, 20 November 2010

Coase’s analysis on externalities

Assume there's two man owning two farmlands, one of them is for cattle rearing and another for wheat growing.
Externality exist when the cattle go to eat up some crops, where the cattle owner does not pay for it. In this case SC > PC.
There'll be four solutions:
1)       Forbidden the cattle to go to eat those crops.
2)       Integration among the two firms.
3)       Define private property rights to the cattle owner, i.e. they eat freely go to eat crops.
4)       Define private property rights to the crops owner, i.e., the cattle owner must pay for the crops eaten.
We will focus on case 2,3,4 where exchange still exist among the firms. Assume the market unit price of the crops is P.
Case 2: When crop owners' gain is also concerned by the cattle owner, there'll be no externalities anymore since cropland's gain is cattle owner's private benefit. Then it'll consume until MPB=MPC=P.
Case 3: When private property rights is defined to cattle owner, when the cattle eats the initial several units of crops, the farmer won't stop them since cattle owner's benefit > P, where it's not beneficial for the crop owner to beg the cattle owner to stop consuming the crops with a price higher than P.
When several consuming, MPB < P, then the crops owner will use a price of MPB (or a little bit higher) to beg the cattle owner stop consuming the crops. Since it's higher than MPB, the cattle owner will accept the exchange and the cattle owner can gain (P-MPB) from selling crops. In this case, they'll consume until MPB=P.
Case 4: When the private property is defined to the crop owners, externalities no longer exist also since the cattle owner must pay for the crops. Then it'll also consume MPB=P.
Our conclusion will be "under a well-defined private property rights, the market will emerge themselves to solve externalities.

Note: Pyhsics (Gas Law) and Economic (Efficiency and Equity) note is released on the note page.

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