Question

The famous economist Ronald Coase proposed the following possible solution to the problem of externalities: Say there is a factory which pollutes a river that provides drinking water to a local village. The government can allocate private property rights over the use of the river to one of the parties (either to the factory owner or to each of the local villagers), and then the respective parties can simply trade (buy/sell) the right to use the river. Is this an effective solution to the externality problem? Explain your answer.

Answer 1

There are certain conditions for the proposed solution to the problem of externality by Ronald Coase. First condition is the establishment of well defined property rights. Second condition is the minimization of transaction cost or costless bargaining between the parties engaged in transaction. The third condition is that the private property rights are transferable.

In the proposed solution for the given problem, private property rights are defined by the government. Suppose factory has the property right over river water. It will then continue to pollute the river water unless villages collectively bargain with the factory owners. Under this bargaining they will purchase the property rights to have clean water and thereby compensating the factory owners. This will work only when property rights are well defined transferable and there is no transaction cost involved

Suppose villages have property right over river water. The factory owners will then negotiate with villagers to purchase the property rights over river water and continue to pollute it while compensating the villagers for the loss. This will work only when property rights are well defined and bargaining cost is zero.

In this manner the proposed solution is appropriate and will work to eliminate the concerned externality only when there are no transaction or bargaining costs which is the third condition required for working of Coase therom