motor vehicle pollution involved adding the chemical substance MTBE to gasoline. Designed to promote cleaner combustion, this additive turned out to create a substantial water pollution problem. Governments may also pursue social policy objectives that have the side effect of causing an environmental inefficiency. For example, looking back at Figure 2.5, suppose that the government, for reasons of national security, decides to subsidize the production of steel. Figure 2.9 illustrates the outcome. The private marginal cost curve shifts down and to the right causing a further increase in production, lower prices, and even more pollution produced. Thus, the subsidy moves us even further away from where surplus is maximized at Q *. The shaded triangle A shows the deadweight loss (inefficiency) without the subsidy. With the subsidy, the deadweight loss grows to areas A + B + C. This social policy has the side effect of increasing an environmental inefficiency. 2.12 THE PURSUIT OF EFFICIENCY It is clear that environmental problems arise when property rights are ill-defined, and when these rights are exchanged under something other than competitive conditions. Using the definition of efficiency, we explore possible remedies, such as private negotiation, judicial remedies, and regulation by the legislative and executive branches of government. 2.12.1 Private Resolution through Negotiation The simplest means to restore efficiency occurs when the number of affected parties is small, making negotiation feasible. The individual negotiations raises two questions: (1) Should the property right always belong to the party who gained or seized it first (in this case the steel company)? (2) How can environmental risks be handled when prior negotiation is clearly impractical? These questions are routinely answered by the court system.
27 2.12.2 The Courts: Property Rules and Liability Rules The court system can respond to environmental conflicts by imposing either property rules or liability rules. Property rules specify the initial allocation of the entitlement. The entitlements at conflict in our example are, on one hand, the right to add waste products to the river and, on the other, the right to an attractive river . In applying property rules, the court merely decides which right is preeminent and places an injunction against violating that right. The injunction is removed only upon obtaining the consent of the party whose right was violated. Consent is usually obtained in return for an out-of-court monetary settlement. Note that in the absence of a court decision, the entitlement is naturally allocated to the party that can most easily seize it. Coase theorem - In a classic article, economist Ronald Coase (1960) held that as long as negotiation costs are negligible and affected consumers can negotiate freely with each other (when the number of affected parties is small), the court could allocate the entitlement to either party, and an efficient allocation would result. The only effect of the court’s decision would be to change the distribution of surplus among the affected parties. This remarkable conclusion has come to be known as the Coase theorem.
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