Industrial dust and bargaining over externalities

One of the most famous results in welfare economics is the Coase Theorem - the idea that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without the need for government intervention). An externality is the uncompensated impact of the actions of one party on the wellbeing of a bystander. For instance, a factory that emits air pollution creates a negative externality for people who live nearby - the reduction in air quality makes the neighbours worse off.

Ronald Coase (1991 Nobel Prize winner) argued that externality problems are jointly produced - even though one party creates the externality (e.g. the factory), the problem is also created by the neighbours - if they didn't live next to the factory, there would be no externality problem (or at least, there would be no problem for the neighbours, as they wouldn't be living next to the factory!).

One of the implications of the idea that externalities are jointly produced, and the idea that parties to the externality might be able to arrive at some agreement to deal with the externality problem, is that the same solution to the externality may arise regardless of our starting point. To see why, let's consider a specific example, from this New Zealand Herald article from earlier in the year:

For more than four years, residents and workers in De Havilland Way, Mount Maunganui have complained organic dust from a nearby industrial building was making them sick.

Business owner Colin Alexander had a severe allergic reaction that laid him up for months. Resident Skye Sloan has to take a tablet every day to keep flu-like symptoms at bay. Dozens of other complaints have been recorded.

With health officials and an air quality investigation now backing their claims, they want authorities to do something about 101 Aerodrome Rd immediately.

They argue the operations - bulk storage and handling of stock feeds including palm kernel expeller, a controversial palm oil industry byproduct - must stop until the fine, inhalable dust particles that regularly blew into the hangars can be prevented or contained. 

There is some disagreement in the article about whether industrial dust is creating health issues for nearby residents, but let's take it as a given. However, as Coase noted, the externality problem is jointly created by the bulk storage firm and the nearby residents (who, it should be noted, are living in an industrial-zoned area). But if we want to follow through on the Coase Theorem, how can this externality problem be solved without government intervention?

The solution to the externality problem depends on the distribution of entitlements - primarily the property rights, but also liability rules. There are two competing sets of property rights here. The bulk storage firm has the right to operate - it is located in an industrial zone. If the firm has to restrict its operations, that takes away some of its rights. The residents have the right to clean air. The industrial dust is taking away some of their rights.

To determine the potential bargaining solution to the externality problem, we need to start by considering which party has the overriding rights. That is, whose rights (the bulk storage firm's, or the residents') are more important to uphold? That isn't a question that economics can answer, but obviously there are two options (the bulk storage firm, or the residents). Let's consider both in turn.

If the residents have the overriding rights (their right to clean air is seen as more important to uphold than the firm's right to operate), then the default solution to the externality problem is that the firm shuts down (or it installs some type of filter to prevent the escape of industrial dust, or finds some other way not to reduce the air quality). That isn't the only solution under this set of entitlements though. The alternative solution to the externality problem is that the firm continues to operate as before, but compensates the residents for any reduction in air quality. For this alternative solution to work though, the firm would need to pay the residents more than the value of their lost air quality (however they value it), but less than the cost to the firm of shutting down (or the cost installing a filter, or the cost of whatever other option they can find for avoiding the reduction in air quality).

If the bulk storage firm has the overriding rights (their right to operate is seen as more important to uphold than the residents' right to clean air), then the default solution to the externality problem is that the residents have to put up with the dust (or they keep their hangar homes shut up to prevent dust getting in, or they wear dust masks, or something else). Again, there is an alternative solution to the externality problem, which in this case is that the residents compensate the firm for the cost of shutting down (or the cost installing a filter, or the cost of whatever other option they can find for avoiding the reduction in air quality). For this alternative solution to work though, the residents would need to pay the firm more than the cost to the firm of shutting down (or the cost installing a filter, or the cost of whatever other option they can find for avoiding the reduction in air quality), but less than the value of the improved air quality the residents gain (however they value it).

Notice that which set of default and alternative solutions is available depends crucially on which party has the overriding rights, which is determined by the legal environment (as I said, economics can't answer that question). Notice also that the default solution simply upholds the existing overriding rights, while the alternative solution always involves compensation from one party to the party whose overriding rights are being foregone.

Will a bargaining solution always work? No, because as noted above it depends on the relative costs and benefits. That issue aside, many economists argue that, because of the Coase Theorem, government involvement in dealing with externalities is almost never necessary. However, the Coase Theorem depends on the parties being able to bargain without cost, and that seems unlikely. In the case of industrial dust above, even if all parties sat around a big table to talk over the issues, agreement takes time and effort (and hence, transaction costs), and is made more difficult by there being many parties involved (a firm, and many residents). Many parties creates a coordination problem, since it may be difficult even to get all parties on one side of the problem (e.g. the residents) to agree. And even if the majority agree, a small minority might then try to hold out for a better deal. And even if an agreement is struck between the parties, there needs to be monitoring of the agreement to ensure the parties follow through, and some enforcement if they don't do so, both of which entail costs.

Finally, behavioural economics suggests that even if we manage to get through all of the above, arriving at a bargaining solution that suits both parties will be made more difficult because of the endowment effect. Whichever party has the overriding rights will be most unwilling to give up those rights, and will demand extra compensation (more compensation than what they would have been willing to pay to obtain the rights in the first place!) - a point that I made in this post last year.

All of this suggests that, while the Coase Theorem is good in theory, in practice it is very difficult to execute. Most of the time, if there is an externality problem, some government intervention (even if it is just covering the transaction costs and the costs of monitoring and enforcement) will be required.