Replacing the Polluter Pays Principle with the Cheapest Cost Avoider Principle
Chapter 4: Reaching Efficiency: Coase versus Pigou
In this section we define several scenarios and show for each scenario, first, that with zero transaction costs the Coase Theorem holds; second, we analyse the impact on welfare that can be expected from a Pigovian tax. We then compare the Coasian and the Pigovian solution to the externality problem in the presence of high transaction costs. As it will be demonstrated, relative to the status quo, a Pigovian tax can decrease or increase welfare or simply leave welfare unaffected – depending on the circumstances. The analysis will be structured around the concept of economic rents. 4.1 Rents and Social Welfare A rent consists of the difference between what a factor of production earns in a given activity and what it could earn in the best alternative activity. The latter amount is called the opportunity costs of the engagement of the factor of production in the activity under consideration. In Figure 2.1, for example, the opportunity costs of the transport industry at producing Q1 are the total private costs of the production of Q1. The rent (or producer surplus) corresponds to the area between the y-axis, the marginal cost curve and P1, that is, P0E1P1. The role of rents in decision making is well described by Coase: The factors engaged in an activity would be willing to pay an amount of money up to slightly less than the sum of their rents to allow their employment in that activity to continue. Even after taking this payment into account they would be...
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