Question

Not all externality problems can be solved by the private sector. True or False? Explain your answer making reference to the Coase Theorem.

Answer 1

The various ways through which the private sector solves externalities are:

1) Codes of moral value and ethics: Moral codes often guide individuals’ behavior. Individuals are aware that certain actions have negative externalities and not right to do or would lead to disapproving reactions from others. For example, consider littering. The probability of being fined is small, but moral codes provide an incentive to avoid littering.

2) Business mergers or transactions or contracts in the self-interest of all the relevant parties: Two businesses that create positive externalities for each other can easily merge or enter into a contract that makes both parties better off.

However, the private sector may fail to solve externalities in some cases.

The Coase theorem, developed by Ronald Coase, states that two parties will be able to bargain with each other to reach an agreement that efficiently addresses externalities. But, the theorem gives several strong conditions in order for such a solution to exist, which includes low transaction costs (the costs that the private sector incurs by negotiating and coming to agreement) and also well-defined property rights. If these conditions are likely to hold, the bargaining parties will be expected to reach an agreement where everyone is better off as externalities have been accounted for But in practice, the conditions are not always met. Transaction costs do exist and may be very high, and the bargaining process does not always run smoothly due to difference between the parties involved. As a result, private individuals often fail to resolve externalities.