Question

A number of coal burning steam locomotives pass by several largely populated towns each day spewing sulfur dioxide. Each coal burning steam locomotive is owned by a different company.

a. Explain how the Coase theorem could work to achieve the optimal level of sulfur dioxide emissions. Explain how the achievement of the optimal level of sulfur can be hindered in reality for this particular problem.

b. Assume that the true marginal abatement cost curve for all firms is not known to a regulator. If the marginal damages from sulfur dioxide is fairly constant at all levels of sulfur dioxide levels, what is the better type of policy to implement, a quota or a tax on sulfur dioxide emissions? Give a brief explanation of why you have chosen that particular policy. Use a graph to support your explanation.

Please give a detailed explanation for the answers. Thank you!

Answer 1

Coase Theorem: Coase Theorem is a legal and economic theory that affirms that where there are complete competitive markets with no transactions costs, an efficient set of inputs and outputs to and from production-optimal distribution are selected, regardless of how property rights are divided. Further, the Coase Theorem asserts that when property rights are involved, parties naturally gravitate toward the most efficient and mutually beneficial outcome.

Breaking Down Coase Theorem:

The Coase Theorem states that where there is a conflict of property rights, the involved parties can bargain or negotiate terms that are more beneficial to both parties than the outcome of any assigned property rights. It also asserts that in order for this to occur, bargaining must be costless; if there are costs associated with bargaining, such as those relating to meetings or enforcement, it affects the outcome. The Coase Theorem shows that, where property rights are concerned, involved parties do not necessarily consider how the property rights are granted if they can trade to produce a mutually advantageous outcome.

Coase Theorem and Compensation:

Based on the bargaining that occurs during the application of the Coase Theorem, funds may be offered to compensate one party for the other's activities. For example, if a business is subject to a noise complaint initiated by neighboring households or other entities, the business may choose to offer financial compensation to the affected parties if that outcome is considered more favorable to the offending company than alternatives, such as making production changes to lower noise levels, shutting down operations or moving operations to another location.

In this instance, the neighbors of the business benefit from the financial compensation while the business avoids options that may result in higher costs. In order for the full intrinsic value of Coase’s Theorem to apply, the outcome must be discussed and negotiated between the two parties without outside interference.

Additionally, a business may offer preemptive compensation to area residents who may be affected by a nuisance once operations begin. This allows the business to begin negotiations before the full nature of the issue is known, which may strengthen its bargaining position. In exchange for the advance compensation, potentially affected residents must agree to not pursue any legal complaints against the business due to the aforementioned nuisance.

Title IV of the 1990 Clean Air Act Amendments (CAAA) established a market for transferable sulfur dioxide (SO2) emission allowances among electric utilities. This market offers firms facing high marginal abatement costs the opportunity to purchase the right to emit SO2 from firms with lower costs, and this is expected to yield cost savings compared to a command-and-control approach to environmental regulation. This paper uses econometrically estimated marginal abatement cost functions for power plants affected by Title IV of the CAAA to evaluate the performance of the SO2 allowance market. Specifically, we investigate whether the much-heralded fall in the cost of abating SO2, compared to original estimates, can be attributed to allowance trading. We demonstrate that, for plants that use low-sulfur coal to reduce SO2 emissions, technical change and the fall in prices of low-sulfur coal have lowered marginal abatement cost curves by over 50 percent since 1985. The flexibility to take advantage of these changes is the main source of cost reductions, rather than trading per se. In the long run, allowance trading may achieve cost savings of $700$800 million per year compared to an "enlightened" command-and-control program characterized by a uniform emission rate standard. The cost savings would be twice as great if the alternative to trading were forced scrubbing. However, a comparison of potential cost savings in 1995 and 1996 with modeled costs of actual emissions suggests that most trading gains were unrealized in the first two years of the program.