Market Failure Due to Externalities 461via benefit-cost analysis), and this task is far from easy. Despite these difficulties,
the number and scope of emissions trading markets is increasing. In the United
States trading permits for sulfur dioxide (the pollutant responsible for acid rain)
has been responsible for a 50 percent drop in these emissions. The Chicago
Climate Exchange, which operated from 2003 until the end of 2010, allowed cor-
porations to trade greenhouse gas emission credits. In 2008 the Regional
Greenhouse Gas Initiative, comprising a dozen U.S. northeastern states, began
auctioning off CO 2 permits. The goal is to reduce permits (and thus emissions)
by 10 percent by 2018. In 2010, California regulators approved rules to imple-
ment the cap-and-trade system established by the state’s landmark 2006 Global
Warming Solutions Act. Other trading programs have been set up in other parts
of the country and overseas. The European Union Emissions Trading System,
established in 2005, is the largest carbon emissions trading program in the world.PRIVATE PAYMENTS When the affected parties are few in number and prop-
erty rights are clearly defined, externalities can be resolved efficiently without
government intervention.
A classic example is the case of an upstream mill that releases pollutants
into a waterway to the detriment of a downstream fishery. Table 11.1 depicts
three abatement actions the mill might take and the resulting costs to each
party. Of the three options, 50 percent abatement is the efficient solution
because this minimizes the total cost incurred by the parties. How might this
result actually come to pass? The Coase theorem (developed by Ronald Coase)
provides a simple answer: Bargaining between the affected parties will result in an
efficient outcome, regardless of the property-rights assignment.^10 To illustrate, supposeTABLE 11.1
Private Remedies for
an ExternalityFifty-percent cleanup is
the course of action
that minimizes the
parties’ total cost. This
efficient outcome can
“ be reached via self-
interested bargaining
between the parties,
regardless of who
holds the property
right concerning
water use.Mill’s Action Mill’s Cost Fishery’s Cost
0% cleanup $0 $100,000
50% cleanup 50,000 30,000
100% cleanup 120,000 0(^10) Coase, R., “The Problem of Social Cost,’’ Journal of Law and Economics(1960): 1–31.
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