Pigou and Coase Part 1

Posted: March 12, 2014 in Uncategorized

We explored the externality issues of climate and environmental concerns, and how they are an important factor in the need for clean energy systems. To expand off that idea, I want to take a small look into two topics of economic theory that can be applied to this topic. Ronald Coase and Arthur Pigou are two important figures in the development of economic theory and each has an interesting approach to externality concerns, and both ideas have been implemented in various forms, including energy markets.


We will start with Pigou and his idea, known as a pigouvian tax, as a solution to externality issues. You may also know of this by the term “sin tax” and is the idea that we place taxes on a market product that has negative externalities connected to it. If we apply this concept to the energy market and greenhouse gas emissions, this idea would assert that we place an emissions fee that would cover the damage done by the emissions. By applying this fee, we would reset the market price to one that now accounts for the externality. In this case, the externality is negative and so because the price is higher, it helps to decrease the incentive to produce these emissions.

Coase argued a different view of this problem. His theorem asserts that actors will solve the issue in the market as long as 1) property rights are well defined and 2) the transaction costs area low enough to allow for the actors to find an efficient outcome. This theory implies that private markets may act more efficiently than government regulation by allowing market forces to take the leading role and have the actors negotiate and find some level of marginal benefit. If the two conditions are not met, applying this theorem would not be practical as market forces would have a much more difficult time find an efficient outcome. If the costs of bargaining are low and the property rights (in this case the right to emissions) are defined, then the market can facilitate an efficient outcome to this problem. An example of this system playing out is the idea of Cap-and-Trade where the “right to pollute” can be traded amongst firms.

Of course, there is the “cap” side which sets the max on total emissions, and this is not the idea of Coase. Perhaps we should just think of Coase playing out in a similar way to the carbon credits and thereby creating a market for them. But, the cap leads us to the regulatory possibility that we can use as a potential solution. I am not going to speak much on this, some in part because it is fairly straight forward and also because I do not believe regulation is an optimal strategy for us to rely on. This post is our introduction to what I think are the two more valid approaches to dealing with externalities, at least at this point. We will explore them further, but until then, follow me on Twitter @devinxcombs.


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