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Environmental problems and issues are not always about the scarcity of discrete, individual things, like copper or oil. How can market thinking apply to all environmental objects and conditions (e.g. swimmable streams, diverse rainforests, clean beaches), not just traditional commodities (e.g. milk, tungsten, codfish)? In theory, if human activity makes clean air or water scarce, and I value clean air or water, I should be willing to pay for remediation of the situation. If someone else is polluting that air or water, however, and I am experiencing the effects of that deterioration downstream or further away, how could my willingness to pay be realized?

Coase Theorem A thesis based in neoclassical economics, holding that externalities (e.g. pollution) can be most efficiently controlled through contracts and bargaining between parties, assuming the transaction costs of reaching a bargain are not excessive

Many economists have addressed this problem, but the most prominent solution came from a Nobel laureate in economics, Ronald H. Coase. In 1960, Coase laid out one of the founding propositions of contemporary economics (often called the “Coase theorem”), which held that in cases of competing interests, the most efficient outcomes will occur through bargaining between property owners (Coase 1960).

What Coase proposes is that many environmental problems can be solved most effectively through contracts. Consider, for example, a family living in a beautiful valley spot in Montana next to a cattle ranch. As it turns out, the cattle ranch is both noisy and somewhat smelly. Such an effect, where one person’s economic activity comes at the expense of another, is called an externality, and as we will see later in this chapter and in Chapter 4, it is common to environmental problems. Such situations also cause lots of nasty arguments in Montana, moreover.

How can such a situation be regulated? One solution might be for the county government to ban ranching in the area, in order to protect homeowners, causing the ranch to shut down. Another would be to make it clear that cattle are more important than housing in rural areas, thus shutting down housing developments in the area. Alternatively, complex rules could be designed, telling developers how to build smell- and sound-proof housing and cattle ranchers how to move and keep their cattle more quietly. None of these solutions is necessarily socially fair or just to one side or the other. The last solution, while perhaps fairer, may be economically inefficient and far more expensive than the other alternatives. Who pays for these redesigning efforts and on what terms? What approach would produce an optimal outcome?

In Coase’s way of thinking, it would be better to let the two parties sort the problem out themselves through contracts and, in the process, discover the real costs and values of ranching, mountain views, and cattle smells. By coming to terms with one another, whatever they decide is always the most efficient outcome, no matter what the initial rights are in the situation.

If the family moved in after the ranch had long been in business, for example, or if the family had no legal right to limit the rancher’s actions, they would simply have to tolerate it, or absorb the cost of the smell by paying some higher price for property elsewhere, and moving far away from the ranch. The difference in the price of their current house and the new one reflects how much the people are willing to pay to not live around cattle. Perhaps, however, the cost of the new home is far higher than the cost they might be able to pay the rancher for simply moving the cattle shed to the other side of the property. By paying the rancher a lower sum, the family maintains its pretty view and reduces the smell while offsetting the rancher’s costs for doing so. In that case, the price of the environmental nuisance is discovered through the negotiation between the two parties (rather than by relying on a regulator), and everyone experiences an optimal outcome.

If, on the other hand, the family came first or it held some kind of county-given right to a non-smelly environment, other options emerge. In that case, the cattle owner might cease ranching, at whatever cost, and sell to a housing developer. It may be even cheaper for the rancher to directly pay the homeowners, essentially bribing them to put up with it. On the other hand, if it turns out to be even less expensive to move the cattle shed than it is to pay off the neighbors, the rancher can always choose this option.

Notably, it does not matter what the configuration of legal rights is at the outset of the scenario – ranchers might hold the right to ranch, families might have the right to be free of cattle smells, or neither may pertain. In any case, if contracts can be worked out and enforced between the two parties, they always reach a decision that is economically most efficient. Such a determination is fully in line with the market response model, but extends its crystalline logics to the complex world of environmental externalities.

Externality The spillover of a cost or benefit, as where industrial activity at a plant leads to pollution off-site that must be paid for by someone else

Coase stipulated two key assumptions, however, that were required to be true for such smooth efficiencies to prevail: property rights have to be exclusive and the transfer and protection of contracted rights has to be free. This means, for the efficiencies of Coase to be realized in the above example, 1) both the rancher and the homeowner must have the full ability to control their land and the decisions made on it and, more importantly, 2) their negotiations and contracts must not cost time or money to negotiate, write, and enforce. Put in other terms, a free market system is efficient to the degree that actually sorting out agreements, coming to understandings, and designing fair rules and restrictions are socially and economically free or cheap. Similarly, it depends on enforcement (policing, monitoring, and punishing violations) of contracts and rights having no costs.

And in reality, of course, this is totally untrue. For our rancher and homeowner, the time it takes to negotiate the contract, the possible cost in lawyers, and the hidden cost of maintaining county court houses and civil servants to process and administer the contract are indeed quite high. Defining property rights for more intangible goods and services (e.g. biodiversity) is even more daunting. Enforcing contracts over incredibly complex systems (e.g. global climate) appears all the more impossible. The problem comes in the practical difficulty of assigning private rights to “fugitive,” mobile, intangible things – like air – clearly contracting the relations between owners, and enforcing the results. For an “air market” to function, the air must be owned by someone who paid for it, who can get value from it, who has an individual interest in keeping it clean, and who can legally challenge someone else who dirties it or violates a contractual agreement over its condition.

While in some ways such a market seems inconceivable (because it is difficult to enclose, see Chapter 4), recent evidence suggests that it may be possible. Rather than assigning rights to clean air, recent efforts in the United States and elsewhere have worked to give rights to pollute. In a specific example, in the early 1990s, the United States Environmental Protection Agency (EPA) set limits on industries for the emission of sulfur dioxide, a primary cause of acid rain. But rather than setting a limit on each factory, the total allowable level of pollution was divided into units and distributed to producers, in the form of credits that could be sold. Should a company find a cheap way to reduce their sulfur dioxide production below the level for which they held credits, they could sell the spare credits for a profit. More radically, if environmental groups believe that the limit on total emissions provided in the credit system is too high, and they are willing to pay to reduce it, they have the right to buy credits on the market, like anyone else, and simply take them out of circulation. This also has the effect of raising the scarcity and cost of pollution credits, creating incentives for industry to become even more efficient. Such a market has been in operation for 15 years and is only one of many such efforts (see more on “cap and trade” later in this chapter).

Whatever the flaws in such a system, it demonstrates that markets can function for all sorts of environmental goods and services, but that – as Coase suggests – to make them work, private property rights to nature must be clearly assigned to corporations or people. This is a logical and practical prerequisite to any market solution, but certainly one with serious social, environmental, and political implications, as we shall see.