Externality Experimental Results
Recall from the experiment the following set-up:
| Person | 0 Days | 1 Day | 2 days | 3 Days |
| BBQer's value | $0 | $30 | $50 | $60 |
| Neighbor's value | $35 | $30 | $20 | $0 |
| Total Social Welfare | $35 | $60 | $70 | $60 |
Remember that if you lived in Nosmoketown, the law stated that the BBQer had to get permission from the Neighbor to grill, and that if you lived in Grillsville, the BBQer could grill as much as he or she liked. If nothing else happens, in Nosmoketown, there will be no grilling allowed, because that is where the Neighbor's welfare is the highest, and in Grillsville, there will be 3 days of grilling, because that is where the BBQer's welfare is the highest.
The grilling is a negative externality here, because the private act of grilling reduces the Neighbor's well-being. The market failure is that the social costs and benefits of actions deviate from the private costs and benefits. Market failure usually produces an outcome that not the best that society can do. But, sometimes market failure is not so bad.
You then negotiated deals between Neighbor and BBQer to arrive at both the # of days of grilling, and perhaps a payment to compensate the Neighbor for the smoke or to persuade the BBQer to reduce the grilling, depending on which town you lived in.
In essence, we created a market, and internalized the externality.
Even though this was not a perfect market (the market failure being the negative externality), did we achieve a result
that is comparable to the perfectly competitive (pure competition) market?
| # of pairs that decided on x days in the 1:00 Section | In the 2:30 Section: | |
| Nosmoketown | ||
| 0 days | 0 | 0 |
| 1 day | 0 | 1 |
| 2 days | 4 | 7 |
| 3 days | 2 | 0 |
| Grillsville | ||
| 0 days | 0 | 0 |
| 1 day | 1 | 2 |
| 2 days | 6 | 5 |
| 3 days | 0 | 1 |
In both sections, no matter which town you lived in, most people arrived at 2 days of grilling. From the set-up, we see that is also the number of days which produces the most social welfare, a result that is similar to what we would see in perfect markets.
This result is known as the Coase Theorem. It basically states that, if there are externalities, the market will still produce the maximum total social welfare, as long as there are no transaction costs and if the government assigns property rights.
The property rights in this example were the laws concerning grilling. If the neighbor could prevent the BBQer from grilling, the neighbor owned the property rights. If the BBQer could grill as much as he/she liked, then the BBQer had the property rights. If you had the property rights, you received a pay-off or bribe from the other person. This pay-off is known technically as a transfer payment.
Transaction costs in this scenario would be something that decreases the transfer payment in between the time it leaves the neighbor's hands and the time it reaches the BBQer's hands in Grillsville, or vice versa in Nosmoketown. If you needed a middle man, who charged you a fee, to negotiate the number of days of grilling and the price, that would be a transaction cost.
With only two people at the negotiating table, transactions costs are not going to be very important, but what would happen if there were 5 neighbors, each with different valuations of the smoke? Maybe even some of them like the smell of grilling meat and vegetables. The more people there are that are involved, the more time consuming the negotiations. If it takes a week to agree on a set of payments and a number of days to grill, that is another form of transaction cost.
In "real life", the Coase thereom may not work so well because of transaction costs. If you live near a factory that is polluting the ground water, it will be very difficult for you or your town to negotiate with the factory to lower the pollution to the socially optimum level. You would need to get information on the amount of pollution, which would cost you time and money (transaction cost), and since pollution abatement equipment costs a lot of money, you would have to collect a fair amount from the town for the transfer payment. What does theory tell you about how much you can collect for the public good of reducing pollution? Here is another instance where government intervention might be necessary.
Inequality
Finally, even if the Coase thereom applies to some situations, and we achieve the maximum total social welfare with only minimal government intervention (the assigning of property rights), we will not achieve equality. In fact, where the government decides to assign property rights will affect who has a higher share of the total social welfare. To illustrate this, think about your payments. That transfer payment is money you no longer have to spend on things that you desire if you are the payer, and it decreases your surplus, or your welfare. If you are the payee, though, the transfer payment adds to your surplus/welfare.
To find the welfare of each person, we need to see how much the BBQer and the Neighbor values the days of
grilling that they agreed upon, and then add or subtract the amount of the transfer payment from that value.
| 1:00 | # of Days | Transfer payment | BBQer value | Neighbor value | BBQer welfare | Neighbor welfare | Total Social Welfare |
| Grillsville | value+transfer | value-transfer | |||||
| 2 | 15 | 50 | 20 | 65 | 5 | 70 | |
| 2 | 10 | 50 | 20 | 60 | 10 | 70 | |
| 2 | 51.50 | 50 | 20 | 101.50 | -31.50 | 70 | |
| 2 | 10 | 50 | 20 | 60 | 10 | 70 | |
| 2 | 65 | 50 | 20 | 115 | -45 | 70 | |
| 2 | 18 | 50 | 20 | 68 | 2 | 70 | |
| 1 | 30 | 30 | 30 | 60 | 0 | 60 | |
| Nosmoketown | value-transfer | value+transfer | |||||
| 2 | 15 | 50 | 20 | 35 | 35 | 70 | |
| 2 | 15 | 50 | 20 | 35 | 35 | 70 | |
| 2 | 20 | 50 | 20 | 30 | 50 | 70 | |
| 2 | 25 | 50 | 20 | 25 | 45 | 70 | |
| 3 | 30 | 60 | 0 | 30 | 30 | 60 | |
| 3 | 30 | 60 | 0 | 30 | 30 | 60 | |
| 2:30 Section | |||||||
| Grillsville | value+transfer | value-transfer | |||||
| 3 | 0 | 60 | 0 | 60 | 0 | 60 | |
| 2 | 17 | 50 | 20 | 67 | 3 | 70 | |
| 1 | 50 | 30 | 30 | 80 | -20 | 60 | |
| 2 | 42 | 50 | 20 | 92 | -22 | 70 | |
| 2 | 30 | 50 | 20 | 80 | -10 | 70 | |
| 2 | 10 | 50 | 20 | 60 | 10 | 70 | |
| 2 | 40 | 50 | 20 | 90 | -20 | 70 | |
| 1 | 20 | 30 | 30 | 50 | 10 | 60 | |
| Nosmoketown | value-transfer | value+transfer | |||||
| 2 | 21 | 50 | 20 | 29 | 41 | 70 | |
| 2 | 45 | 50 | 20 | 5 | 65 | 70 | |
| 2 | 40 | 50 | 20 | 10 | 60 | 70 | |
| 1 | 30 | 30 | 30 | 0 | 60 | 60 | |
| 2 | 47 | 50 | 20 | 3 | 67 | 70 | |
| 2 | 45 | 50 | 20 | 5 | 65 | 70 | |
| 2 | 20 | 50 | 20 | 30 | 40 | 70 | |
| 2 | 15 | 50 | 20 | 35 | 35 | 70 |
First, did anyone make an irrational deal? Think about what would have happened if you just couldn't agree, and what your value would be there- for the payers, this would be a value of 0. Anyone who gave a transfer payment that caused their value to be less than zero was not being rational and overpaid. You would have been better off not making a deal. This probably happened because you were new to this "game," and were learning the rules. If we were to play it again, I suspect that you would make better deals.
Extra credit to anyone who can tell me how an economist would predict a) the number of days of grilling that we should arrive at, and b) the maximum amount of the transfer payments. I am looking for a general rule that applies to both of these questions. See the answer here
Second, who is better off in most cases? In other words, who has the higher personal welfare: the BBQer or the Neighbor, and what does that depend on? How often do we achieve equality (everyone has the same personal value) under this set-up? Does this/why should this matter?
Finally, is total social welfare affected by transfer payments?