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Coasian Externality Symmetry in One Picture

October 11, 2013

coasian externality reciprocity

In Ronald Coase’s groundbreaking article, The Problem of Social Cost, he explored the symmetry of externalities and their basis in property rights. Prior to Coase, thinking about externalities was dominated by A.C. Pigou‘s analysis which suggested that externalities are one directional: A pub creates negative externalities on the people who live nearby. Their music should thus be taxed and the money used to pay the cost of that music to their neighbors.

Coase, however, disagreed. He said that externalities are a relationship and depend on the property rights which govern the interaction between various economic actors. Translated into normal people language, that means that because the pub has the right to play music, and Norman knew that when he moved there, the pub did not in fact create a negative externality on Norman, Norman created a negative externality on the pub! (by his whining).

Because of compensating differentials, paying Norman because of the music would compensate him twice. Let’s suppose everyone looking to rent that flat is bothered by pub music so much that they’d be willing to pay $300 a month to get rid of it. What would the difference be between that flat and other similar flats which do not have pub music nearby? $300.

People base their willingnesses to pay for an apartment based on the characteristics of that apartment. People pay more for a 2 bedroom than a one bedroom. People pay more if the flat has a good location, a balcony, a good internet connection, etc. etc. It is no different with noise. Because of the pub, Norman is already paying less than he otherwise would for his apartment. And here’s the interesting thing, he’s already paying less by the optimum amount. If he were underpaying by too much, the price of the flat would be bid up, and would rise. If he were underpaying by too little, he would leave and someone else would move in, or the price would drop.

In conclusion, when looking at externalities, think about property rights and think about compensating differentials.

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