PROPERTY RIGHTS

A well defined property is an important requirement for a market to be competitive. Institutions play an
important role in allowing markets to function to allocate resources. If stealing is not illegal, then nearly
all goods are non-excludable and thus cannot be rationed using prices. A simple institutional change,
establishing enforceable property rights, makes goods excludable and thus allows market system to
operate. In the case of garbage, if no laws exist prohibiting littering, garbage is non-excludable. With
enforced prohibitions on littering, garbage excludable and the price system works to ensure proper
disposal of garbage. The basic point is that properly defined property rights make markets to allocate
goods and bads efficiently.

Consider two people, a polluter and a victim. The conventional view of the problem is that since the
polluter is the source of the problem, blame must fall on the polluter’s shoulders. However, leaving
aside any preconceptions of right and wrong, the victims could also be blamed for being next to polluter.
Without the victim, the pollution would not be a problem.

The subtle issue of who should have rights, the polluter or the victim, was raised in 1960 by Ronald
Coase. Coase(1960) asks whether it is logical to assign rights to one or other of the parties- the victim or
the polluter. Coase’s conclusion is that under some conditions, it makes no difference to efficiency
whether the polluter has the right to pollute or the victim has a right to clean air (leaving aside the
distributional consequence to each of the parties).

Coase’s arguments regarding property rights are often dubbed as Coase Theorem. There are two parts
of Coase Theorem. The first concerns the case, in which there are no impediments to buying and selling
property rights. In this case, the initial distribution of property rights does not matter. The second
involves impediments to trading property rights. Not surprisingly, in this case, the initial distribution of
rights does matter.

The polluter and the victim: Who should have rights?

To explore the Coase Theorem, consider a steel mill producing steel S and pollution emissions at a

cost C S (S). A nearby laundry produces clean clothes, L at a cost C L=( L , S ) , which depends
on the amount of steel produced because steel and pollution go together. This is a true externality,
because laundry does not choose S yet S enters into the laundry’s Cost function such that
∂C L ∂C L
>0, >0
∂L ∂S .

This means steel output depresses the laundry output or increases the cost of laundry. The price of steel

is
PS and the price of laundry is PL . Both theses prices are determined by a larger market and can
thus be assumed to stay fixed.

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What is Efficient?

Here the steel mill is causing negative externality to Laundry. How much would be produced if we could
‘internalize’ the externality? The simplest way to do this is to merge the two firms (bringing them under
sole ownership). If a single firm produces steel and laundry, then there is no externality and the profit
maximizing choices for this merged firm will be efficient, socially desirable. Both S and L are
chosen by the merged firm. Profits for the merged firm are:

Π M ( S , L)=P S S+P L L−C S (S )−C L ( L, S ) …

(1)

The merged firm will choose S and L simultaneously to maximize Π M .

Therefore the first order conditions of maximization are:

∂ΠM ∂C (S ) ∂C L ( L , S )
=P S − S − =0
∂S ∂S ∂S

⇒ P S =MC S (s )+MD L ( L , S )
[2a]

∂ΠM ∂C ( L, S )
=P L− L =0
∂L ∂L

⇒ P L=MC L ( L, S ) … [2b]

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Note that in equation [2a] there are two marginal costs for the steel mill portion of firm, S MC
,
which indicates how steel mill costs change when steel output changes. The other, marginal damages to

the laundry,
MD
L , which indicates how laundry costs change when steel output changes. Thus
equation [2a] states that the price of steel should be equal to the marginal cost to both laundry and

steel mill,
MC S +MD L .

MC S+MDL

(Social Cost) MCS

(Private cost)

Demand for steel

0 S* S0 Steel output

Fig-2.

Figure [2] shows how optimum steel output S* is chosen. The curve labeled private cost is simply the

marginal costs of steel production to the steel mill,

MC
S . The Curve labeled social costs is the
marginal costs of the steel mill plus the marginal damage to the laundry from steel production,
MC S +MD L . This is labeled social costs because it is the cost of producing steel, including the
external costs to the laundry. However, in our case the costs are all within one firm. Distinguishing the
two costs are still useful. The demand curve for steel is shown as horizontal, reflecting the fact that price
must be taken as given to the individual firm. The point at which the demand curve intersects the
marginal social cost curve is the profit maximizing amount of steel production S*.

Equation [2b] states that the price of laundry should be equal to the marginal costs for the laundry
MC L

It is important to remember that it is not always just the marginal conditions that matter. It may be
desirable to totally shut down the steel mill or the laundry. This is decision will not be apparent from

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equation [2] except that there may be no solution to equation [2] for which L*>0 and S*>0. Fixed costs
do not enter into the marginal conditions yet may determine whether revenue of a firm is sufficient to
cover costs. If they are not, the firm has no choice but to cease production.

Should the laundry close, there is no damage from smoke; so steel production will be chosen so that
marginal costs equal the price of steel:

PS =MC S ..[3]

Let us assume the solution to equation [3] occurs at steel output

S 0 . This results in profits
Π M ( S 0 ,0). Similarly let the optimum amount of laundry when the steel mill is shut down be L0

and the associated total profits, Π M ( 0 , L0 ) . If there is a solution to equation [2], (S*,L*), we should

compare Π M ( S *, L∗), Π M (S 0 , 0 ) and Π M ( 0 , L0 ) , choosing which ever is greater and letting that
dictate our shut down decisions.

THE COASE THEOREM: Marginal conditions

Having determined the conditions for an efficient amount of externality, Let us examine the case where
the two firms operate separately. We examine two property right regimes, one in which steel mill has
the right to pollute and the other in which laundry has a right to clean air, i.e., to check what levels of
steel and laundry output will be produced in each of the property right regimes.

1. Laundry has Rights to Clean Air:

First consider the case in which the laundry has a right to smoke-free environment. This means that
steel mill must compensate the laundry for any damage it does. Whatever the steel mill produces, the
laundry maximizes profits by setting the price of laundry equal to the marginal cost of producing laundry
output:

∂ΠL ∂C ( L,S)
=P L − L =P L −MC L ( L , S )=0
∂L ∂L ..[1]

Given S equation [1] can in principle be solved for L, which defines L(S ) , the amount of laundry that
will be produced when the steel mill produces S .

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If the steel mill produces S , damage would be defined as the difference in profits for the laundry
between the case of no steel production (and no smoke)and the case of steel production at the level
S.
Thus profits for the steel mill will be

Π S (s)=PS S−C S (S )−{Π L [ L(0 ), 0 ]−Π L [ L( S ), S ]} ..

[2]

Where Π L (L( S ), S ) is the profit of the laundry when it produces L while the steel mill produces
S.

So, L(S ) is the amount of laundry that will be produced when the steel mill produces S . The term
in brackets in equation [2] is the damage to the laundry from steel production S . This damage must
be paid to the laundry.

To find the optimum amount of Steel output S , we make the derivative of equation [2] w.r.t S
and set it equal to zero.

∂ Π S (S ) ∂ Π L [ L( S ), S ]
=P S −MC S (S )+ =0
∂S ∂S [3]

∂ Π L (L( S ), S ) ∂ {P L L( S )−C L [ L(S ), S ]}

=
Where ∂S ∂S [4]

∂ L ∂C L ∂ L ∂C L
=P L − −
∂S ∂ L ∂S ∂S [5]

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 ∂L
[ P L−MC L ] −MD L
= ∂S [6]

=−MD L [7]

Note two things in the derivation of equations [2] to [7]. The first term in brackets in equation [2],
laundry profit at S=0 is a constant, so it does not change when S changes. Second the term in bracket in
equation [6] is exactly zero, according to equation [1].Thus equation [7]states that the marginal cost to

the laundry of extra steel,

MD L .

Now we can combine equation [3] and [7] to obtain conditions for how much steel will be produced:

PS =MC S ( S )+ MD L [ L( S ), S ] [8]

In the previous section, we have seen the [Equation 2(a)and [2b]] the condition for steel and laundry
output if we internalize the externality.

A quick inspection of equation [1] and [8] will reveal that these conditions are same. If the steel mill is
liable for damage, it will pay those damages and the amount of steel and laundry output will be efficient.

Steel Mill Has Right to Pollute:

Now suppose that laundry has no right to clean air. We ask the same question: How much steel will be

produced? An initial reaction would be an amount such that price of steel equals
MC S . Let that

quantity be
S 0 . Now laundry might be willing to pay to reduce steel output to S . Income to the

laundry is greater at S than at S 0 ( for

S <S0 ) and laundry will be willing to pay nearly all that

increased income { {Π L [ L(S ), S ]−Π L [ L( S0 ), S 0 ]} to the steel mill to reduce steel output. The total
profit of steel mill from producing S is:

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 Π S (s)=PS S−C S (S )+{Π L [ L(S ), S ]−Π L [ L( S 0 ), S 0 ]}
[9]

Which can be rewritten as,

Π S ( S )= PS S−C S ( S )− {Π L [ L( 0 ) , 0 ]− Π L [ L( S ) , S ]}+¿ ¿
[10].

Note that in equation [10] , the terms in the last set of bracket equal a constant- the difference in
laundry profit with no steel and laundry profit with maximum amount of steel. Consequently it can be
ignored when looking at marginal profits. Without the last term in equation [10] , it is exactly same as
equation [2], profits when laundry has a right to clean air. Consequently, the marginal conditions for
choice of S and L must be the same as in that case.

We see that marginal conditions for choosing S and L are identical under either property rights
regime. Furthermore, those conditions are same for a merged firm, with externality eliminated. This is
the fundamental result of Coase that the initial assignment of rights vis-à-vis pollution does not matter
for efficiency.

But the distribution of resources certainly does depend on the assignment of property rights. Although
the marginal conditions for the steel mill are same for the two property rights regimes, the total cost
and thus profits of the steel mill are different. Compare equations [2] and [10]. When steel mill has
property rights its costs are significantly lower, by the amount the laundry paid to reduce pollution,

possibly by as much as {Π L [ L(0), 0 ]−Π L [ L(S 0 ), S0 ]} .This is essentially the value of property rights
to clean air and , in ‘no rights case’ , it is purchased by the laundry from the steel mill. After the
purchase, the two property rights regimes become identical.

Because the total costs differ under two property rights regimes, there are other outcomes that might
emerge from different assignments of property rights.

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 1. The two firms might merge, in which case externality would be eliminated since costs and
benefits of pollution control would be within the same firm.
2. Instead of paying the laundry for pollution damage, the steel mill may buy the laundry from its
owner.
3. It might also be that one of the firms cannot afford to pay for the right to clean air, in which case
that firm would go out of business. For example, if the laundry has rights to clean air, the steel
mill go out of business rather than pay pollution damage, Alternatively, if the steel mill has right
to pollute, the laundry may go out of business rather than bribe the steel mill to clean up its act.
In that case, the steel mill will pollute without concern for damage since without the laundry,
there is no pollution damage (at least given our example).

The Coase Theorem: A Numerical Example

2
Suppose the cost of producing steel is C S (S )=S +8 and the cost of producing laundry are
2
C L ( L , S )=L + LS +4 . Each firm has a fixed cost. Assume that should a firm decides to shut down

and produce nothing, that cost is not incurred. In other words, C S (0)=0 . Also assume that price of

laundry is fixed throughout our analysis at

PL =10 but we will vary the price of steel , letting it take

on three values:
PS = 8, 11 and 14.

Q.1. How much should be produced (if the firms merged) and how much will be produced under the two

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 property rights regimes?

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 A(No B(Close C (Close D(Merged E (steel mill F (Laundry
PS =8 , P L=10 Bargaining) Laundry) steel mill) firms) has rights) has rights)
4 4 0 0 0 0
2 0 5 5 5 5
Steel output
8 8 0 0 8 0
Laundry output
4 0 21 21 13 21
Steel profits
0 0 0 0 -8 0
Laundry profits
Trnsfr to
12 8 21 21 21 21
laundry
Total Profits
PS =11 , P L=10
Steel output 5.5 5.5 0 4 4 4
Laundry output 2.25 0 5 3 3 3
Steel profits 22.3 22.3 0 20 22.3 4
Laundry profits 1.1 0 21 5 2.7 21
Trnsfr to 0 0 0 0 -2.3 16
laundry
Total Profits 23.4 22.3 21 25 25 25

PS =14 , P L=10
L
Steel output 7 7 0 7 7 7
Laundry output 0 0 5 0 0 0
Steel profits 41 41 0 41 41 20
Laundry profits 0 0 21 0 0 21
Trnsfr to 0 0 0 0 0 21
laundry
Total Profits 41 41 21 41 41 41

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