Wednesday, October 24, 2007

Can Coasean Bargaining Justify Pigouvian Taxation?

In my very next lecture on Econ211 Environmental Economics we come across Coase and Coasean bargainning for the first time.

It is again timely that the most recent Economica journal has a paper that combines Coase with Pigouvian taxes (covered last week).

Students should be able to get access to this paper. If you do not have access I am sure a friendly academic will be able to send you a PDF version if asked nicely.

This paper is not for the mathematically faint hearted.

Can Coasean Bargaining Justify Pigouvian Taxation?

* STEPHANIE ROSENKRANZ††University of Utrecht and CEPR and
* PATRICK W. SCHMITZ‡‡University of Cologne and CEPR


The fact that, according to the celebrated Coase Theorem, rational parties always try to exploit all gains from trade is usually taken as an argument against the necessity of government intervention through Pigouvian taxation in order to correct externalities. However, we show that the hold-up problem, which occurs if non-verifiable investments have external effects and parties cannot be prevented from always exploiting ex post gains from trade through Coasean bargaining, may be solved by government intervention. In this sense, the impossibility of ruling out Coasean bargaining (after investments are sunk) may in fact justify Pigouvian taxation.

Here is the first paragraph.

A standard textbook argument known by every student of public economics goes as follows.1 If the activity of party A has an uncompensated external effect on party B’s utility, then party A will not choose the socially efficient activity level. Party A can be made to internalize the externality by Pigouvian taxation. However, opponents of government intervention typically argue that Pigouvian taxation is not necessary. According to the celebrated Coase Theorem, rational parties always exploit all possible gains from trade, provided there are no frictions (specifically, if there is symmetric information).2 They will hence write a contract that induces party A to choose the efficient activity level and divide the gains from trade by appropriate transfer payments. Thus, if one does not make the assumption that the government has better information than the parties themselves (which many economists consider to be unrealistic), Coasean bargaining makes Pigouvian taxation unnecessary.

The paper concludes:

It is true that externalities per se do not automatically make intervention by the government through Pigouvian taxation necessary in order to maximize the social surplus. If the activities that have external effects are verifiable, the parties can negotiate contracts that induce an internalization of the externalities, as is suggested by the Coase Theorem. But if investments with direct externalities are unverifiable, contractual arrangements may have no value. Indeed, the very reason that contracts fail to induce first-best behaviour is the fact that (after the investments have been sunk) private partieswill always exhaust all ex post gains from trade through Coasean bargaining. A simple form of Pigouvian taxation can solve or at least alleviate the resulting hold-up problem. Our analysis illustrates that removing tax subsidies, which is a prominent item on the political agenda of many European countries, may well have negative welfare consequences, because it might aggravate hold-up problems. More generally, we emphasize that, if hold-up problems do have the importance that is suggested by recent contributions in the contract theoretic literature, then the possibility of reducing the welfare losses caused by hold-up problems with the help of government intervention should not be completely neglected.


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