Fundamental theories of environmental policy 77

Finally, in Switzerland the tax with downstream targets places new carbon taxes
on top of already existing mineral oil energy taxes. Moreover, where it is difficult
to recognize CO2 emissions reductions through voluntary initiatives, additional
taxes are called for. Switzerland already imports all of its fossil fuels, and taxes are
imposed upon their arrival from abroad and transferred to consumers. The levied
funds are returned to citizens and industries depending upon the amount paid.
Moreover, while in Europe, carbon taxes have a strong tendency to become gen-
eral funds, in Japan what is being debated is returning the carbon taxes levied to
environmental policies. Current carbon taxes are explained in detail in Chapter 4,
Section 4.1.

Section 3.3: Resolutions through direct negotiations

Coase theorem
Usually, solutions to environmental problems are believed to need government or some
other sort of third-party intervention. However, this section points out ways by which
stakeholders alone can produce solutions through direct transactions and negotiations.
More specifically, what are the direct dealings that stakeholders could possible utilize?
To elaborate on this, this section turns to a factory wastewater emission precedent.
Assume there is a water reservoir upstream from a house that some people have pur-
chased, and nearby, a new factory has been constructed. The water that the plant emits
leads to large increases in the phosphorus and nitrogen in the reservoir, both of which
provide nutrients to algae. This leads to the increased breeding of algae in the reser-
voir, which results in a bad odor that emanates from the lake. At this point, the govern-
ment could implement the law that sets the standard for the amount of liquid emissions
from the plant into the reservoir. In order to abide by the law, the plant would then
be coerced to implement liquid waste-processing equipment and reduce phosphorus
and nitrogen emissions to levels below legal standards. Furthermore, if environmental
taxes were instituted to enforce regulations, tax fees would be levied according to the
amounts of phosphorus and nitrogen present within liquid emissions, which would
potentially lead to emissions reductions. After calculating and comparing the marginal
costs of production and tax fees, the factory would eventually reduce liquid emissions
to a certain standard. However, as 1991 Nobel Prize for Economics recipient Ronald
Coase purports, even without relying on such problem-resolution methods brought
forth by the government, issue stakeholders can use such market mechanisms as vol-
untary transactions to realize effective problem-solving policies. Depending upon who
possesses the water reservoir, related parties can work jointly to bring about solutions.
In other words, Coase stresses the fact that even through such government policies as
environmental taxes, market failures can be avoided. This is known as the Coase theo-
rem. Issue stakeholders decide on the rights to emit pollutants amongst themselves, and
those involved in the pollution can leave it to direct, voluntary negotiations amongst
themselves to naturally come to mutual agreements, which leads to the realization of
78 3 Fundamental theories of environmental policy

efficient resource distribution. In other words, because the total social welfare can be
maximized, government intervention is unnecessary. Thus, in the end, the distribution
of privileges, whether they are greater among polluters or those who suffer damages,
does not change.
Coase stressed that if the following conditions were fulfilled, inefficiencies such as
externalities could be solved through negotiations:

1. Cases where the right for certain entities to use the environment is clearly agreed
upon by the whole of society, or in other words, if rights of possession are in place.
2. Cases where regulations regarding the responsibility of paying damage compen-
sation are clearly determined.
3. Cases where there are no transaction costs.

Consider, for example, the factory operations in a given region in order to expand
upon the idea of conditions conducive to direct negotiations among assailants and
victims. One could assume that the noise produced by factory operations is a con-
stant nuisance to the nearby residents. Similarly, the production activities of polluters
located upstream of a river yield waste that is unprocessed and dumped into the river,
regardless of the harm it would inflict on businesses or residents located downstream.
Another example is the relationship between divers and fishermen. Those in the fish-
ing industry have priority access to nautical space for fishing (fishing rights), which
has supposedly been the cause of decreased catches among divers. Furthermore, the
relationship between smokers and nonsmokers who suffer from secondhand smoke is
another pertinent example.
Here, consider the conditions through which both assailants and victims mutually
affect each other. First, assume that people have the fundamental right to enjoy a
­pollution-free environment, otherwise known as a right to the environment. When
victims possess such rights, in order for assailants to proceed with pollution activities
(e.g. production activities through factory operations or smoke produced from smok-
ers), they must pay damage compensation demanded by victims. To do this, as they
pollute, polluters have to calculate the costs they will incur through payouts for the
damages in compensation funds or decreases in the utility of victims. On the other
hand, when polluters possess the right to pollute, this can be thought of as the permis-
sible right to yield negative externalities. Consider examples where smokers have the
right to smoke in smoking sections, and where there are no construction restrictions
when houses are being built. In these circumstances, because negative externalities
are being produced, social surpluses are not at optimal levels. Therefore, in order to
curtail pollution activities, those responsible must pay compensation. In that case, the
polluters naturally include compensation for pollution reductions into their profit and
loss calculations.
The important point of the Coase theorem is that regardless of whether vic-
tims or assailants possess environmental rights, the point of ultimately realizing a
socially efficient distribution of resource is not lacking in either scenario. With a
single glance, it is easy to consider the resultant effect that transactions will have on
 Fundamental theories of environmental policy 79

resource distributions because of how the existence of rights affect subsequent trans-
actions. However, as stressed by the Coase theorem, there is no relation between the
existence of those rights and optimal resource distribution.

An illustration of the Coase theorem

Scenario where residents have rights
The task at hand is to use a diagram to confirm the effect that differences in the existence
of rights have on resource distribution. First, assume that a factory operates in a given
locality. Also assume that the pollution emitted by the economic entity performing the
production activities (i.e. the factory management) inflicts harm on nearby residents.
In this scenario, factory profits increase alongside increases in pollution emissions
(and operating hours), so the marginal benefit curve takes the shape of segment FT1
depicted in Figure 3.3.1. When pollution emissions are to be reduced, factory owners
will at first only make reductions to the extent that they do not harm profits, and the
costly, difficult to process, emissions reductions will be implemented last. Curve FT1
has a downward and to the right orientation. As pollution emissions and externality
costs conjunctively increase, they inflict harm on the neighboring residents. Curve
OG depicts the marginal loss (externality cost) curve. The additional losses that occur
alongside emissions increase as pollution levels in a given area increase, so curve OG
proceeds up and to the right.
If there are no environmental regulations in place, the factory managers proceed
to maximize profits by expanding operations to T1 levels, in which case the loss cost

Marginal revenue Marginal cost curve

Marginal cost G

F Marginal benefit curve

E Local
Factory residents’
owner’s marginal
marginal cost
benefit
Local Factory
residents’ owner’s
marginal marginal
cost benefit
Operating
O T2 T0 T3 T1 time

FIGURE 3.3.1 Internalizing externalities through direct negotiations

80 3 Fundamental theories of environmental policy

burdens placed on surrounding residents is not absorbed as a cost to the factory (refer
to Chapter 3, Section 1). Thus, operating hours that maximize the social surplus lead
to the highest possible profits and eliminate the damages inflicted on local residents.
In other words, the socially optimal operating hours are, like the optimal environ-
mental tax found in Chapter 3, Section 3.2, T0 hours located at intersection E, where
the marginal benefit and marginal loss curves intersect. The social surplus here is the
area of ∆OEF, or, the difference between the factory managers’ profits (equivalent to
the area of figure OT0 EF) and the losses incurred by the local residents (equivalent to
the area of ∆OT0 E).
On the other hand, the social surplus at T1 hours is the difference between the fac-
tory managers’ profits (equivalent to ∆OT1F) and the losses incurred by local residents
(equivalent to ∆OT1G), or equivalent to duplicate ∆OET1, so they become ∆OEF −
∆EGT1. In this case, the local residents suffer enormous damages, which must be
reduced by ∆EGT1. Thus, if there are no regulations in place, the damages to society
equivalent to ∆EGT1 arise in comparison to those that come about during optimal
operating hours.
Now, assume that local residents have a right to enjoy a clean natural environ-
ment. If they exercise that right to their fullest ability, factory operating hours will be
forced to drop to the origin point O and emissions amounts will be zero. Accordingly,
in order for the factory to do production activity, the negotiation point starts from ori-
gin point O, and the residents must approve the operating hours. From this premise,
both parties begin negotiations, and if they can agree on compensation amounts for
the damages the factories place on the local environment and its residents, then oper-
ating hours can be increased. Since profits earned by the factory become equivalent
to OF as the damage inflicted on local residents is 0 when operating hours increase
from 0 to 1, the factory employs compensation to make up for the local residents’
losses. Next, when considering operating hours that increase to T2, the benefits to the
factory surpass the marginal losses of the local residents, providing further incentive
to increase operating hours.
In this way, the factory that increases compensation does not add on profits, when
at operating hours of T0, in other words, where the marginal benefit and marginal
losses are the same. For instance, considering the scenario when operating hours
are increased to T3 from T0, the marginal benefits to factory owners are below the
marginal losses to local residents, and there are no incentives to increase operating
hours. Thus, negotiations between both parties break down, resulting in a return to
point E. The area of ∆OT0E that represents the damage costs inflicted on residents is
exchanged by the amount paid by the factory to the residents, making T0 hours allow-
able. Thus, the remaining amounts equivalent to the area of ∆OEF after the factory
has paid compensation to the residents is retained as profit.

Scenario where factories have rights

Conversely, we can imagine scenarios where factories originally have rights. For
example, consider the scenario where a factory that has, for some time, been operating
 Fundamental theories of environmental policy 81

in the middle of the mountains where there had been absolutely no residential devel-
opment. Then, all of a sudden, the area around the factory is to become developed into
a residential area. In this case, the starting point of negotiations is point T1. At the start,
the factory earns profits equivalent to the area of ∆OT1F, and the residents incur losses
equivalent to the area of ∆ OT1G. In this case, residents have incentive to negotiate
with the factories to get them to decrease their operating hours to points below T1. The
reason for this is that marginal decreases in operating hours from T1 do not largely
decrease profits, but the local residents can avoid damages equivalent to GT1. Next, if
one were to consider a decrease in operating hours from T1 to the lesser T3, it is clear
that the marginal losses of the local residents surpass the marginal benefits of the fac-
tory owners, so there is an incentive to drop the operating hours. Through negotiations
of these aims, compared to the diminishing profits that the factory suffers as operating
hours are curtailed, they will be continued to the extent that the loss evasion amount
of the local residents is small. Therefore, the residents pay compensation to the factory
for its losses in marginal benefit in order to get them to cut back their operating hours.
Through this, the most efficient operating hours for society are realized.
The results of the above negotiations are that local residents pay an amount equiva-
lent to the area of ET0T1 in compensation. The terms of adopting this compensation
is that the factory agrees to curtail operating hours down to T0 levels. Even by doing
this, the factory gains profits equivalent to the area of ∆OT1F through compensation
increases in addition to profits equivalent to the area of space OT0EF when operating
hours decrease to T0 levels. Even if subsidies are paid out, the local residents’ losses go
down to an area equivalent to ∆EGT1 at T1 hours, so local residents’ economic condi-
tions improve. In other words, regardless of whether or not the environmental rights
belong to those harmed or the not, or whether or not the right to pollute are owned
by polluters, the operating hours that determine the final efficient redistribution of
resources do not change, and they become equal to T0.
Thinking about it like this, if the rights to possessing benefits and damages borne
out of environmental externalities are clearly determined at the outset, and regardless
of who has the rights, a local factory and residents can, through voluntary negotia-
tions, achieve a distribution of resources that is most efficient to society. This is the
essence of the Coase theorem.

Problems with the Coase theorem

However, in reality, there are many cases where parties with a vested interest cannot
smoothly solve externalities as depicted in the Coase theorem. Table 3.3.1 depicts a
number of issues inherent in Coase theorem assumptions.
The first issue is with regards to the influence attributed by changes in rights distri-
butions. If the distribution of rights changes, the most efficient resource distribution
for society becomes achievable based upon new marginal benefit and marginal loss
curves via methods that redistribute possession rights, and the resource distribution
is different than what was in place before the two curves changed. In reality, rights
distribution is considered to largely affect profit and income distributions among the
82 3 Fundamental theories of environmental policy

Table 3.3.1 Issues with the Coase theorem

Issue area Description

Impact on rights The Coase theorem presupposes that the marginal benefit curve
distribution of polluters and the marginal damage curve of victims do not
change based on changes in rights distributions.
Transaction costs The Coase theorem assumes that consensus is reached and
enforced without inconveniences during negotiations between
parties of vested interest.
Imperfect information When there is imperfect information regarding the marginal
benefits and damages of those involved in negotiations,
efficient negotiations are not possible.

polluters and victims related to the externalities. For example, when neighboring resi-
dents possess rights to the environment and could potentially increase their income
(via compensation) through negotiations, it is possible for the marginal losses curve
to go up. In this case, in addition to income increases, the local residents demand
improved environmental quality. In contrast, real incomes for factories decrease
due to compensation payouts to neighboring residents. Because of these real income
decreases, it is possible for the marginal benefits of the polluters to decrease as well.
Thus, the intersection of the two curves changes, and as a result of negotiations, the
actual hours of operation do not amount to the T0 depicted on the graph.
The second issue is the size of transaction costs. In order for the Coase theorem
to be valid, related parties must be able to easily negotiate. However, in reality, one
could imagine a plethora of scenarios where transaction costs would be quite high.
For example, the organization that possesses pertinent rights could have challenges
with regulations. There would be no issue there were only one local resident and one
factory manager. However, if there are many constituents, everyone’s rights must be
determined ahead of time, and all of the stakeholders related to such regulation must
be recognized.
For example, during negotiations, where someone serves as a proxy for those who
live nearby, it is difficult to specify who that person stands for. Furthermore, for peo-
ple who are separated by a significant distance from the factory, it is difficult to spec-
ify the losses that they incur. As we learned in Chapter 2, Section 2.3, environmental
problems and the losses that they generate are, like public goods in nature, difficult
to articulate along the lines of price. For instance, one could speculate the degree
to which health damages are incurred from air pollution, but it is difficult to specu-
late the monetary price for emotional unpleasantness. Furthermore, in dense factory
zones, how the responsibility for pollution control should be allocated becomes an
issue. In this way, when there are many entities involved in negotiations, they become
difficult to carry out.
In other words, overseeing and managing who acquires what rights and to what
degree and from whom through negotiations is difficult to determine. Because of this,
in order to carry out negotiations, transaction costs arise. Moreover, to the degree that
 Fundamental theories of environmental policy 83

there are many people involved in the negotiations, the free-rider problem in which a
person or people choose not to participate in negotiations because someone else will
accept responsibility for more than what they are accountable for could arise. And of
course, there is also the possibility of the worst-case scenario in which negotiations
do not occur at all. In other words, if negotiation costs are quite large, then voluntary
negotiations alone do not produce efficient resource distribution.
The third issue is the problem of imperfect information. For example, when local resi-
dents are recognized as possessing the rights to the environment, they will declare that
the losses that they incur are large and work to draw out as much compensation money
as possible from factories. It is not difficult to imagine that each party would operate
strategically to realize resource distributions that are comparatively favorable to them,
so negotiations would not conclude smoothly, and large transaction costs would arise.
Even Coase himself was not aiming to indicate that externalities could be inter-
nalized through the voluntary negotiations depicted in the theorem. The aim of the
Coase theorem was not to encourage unilateral engagements, but to use negotiations
to address free riding and other issues that arise not from oneself, but from the inap-
propriate behavior of others. Overall, the theorem incites efficient resource distribu-
tions and highlights the importance of the existence of transaction costs.
There are many transaction costs, including costs of specifying parties with vested
interests, costs of making space for negotiations among relevant parties, the income
foregone by residents upon participating in negotiations, and the necessary time costs
of strategic negotiations. Here, it is essential to think about the various benefits and
transaction costs as efficient resource distribution is put into place and residents’ util-
ity increases after negotiations. In this case, transaction costs for negotiations are enor-
mous, so transaction costs of negotiations can be thought of as larger than the benefits.
This could also be called a condition in which not performing transactions would be
efficient. Thus, when negotiations among relevant persons do not lead to the inter-
nalization of externalities, it could become necessary for the government or justice
departments to intervene.

Issues regarding environmental rights and

resource distributions
With the Coase theorem, when relevant parties can negotiate resource distribution
without incurring costs, the achieved pollution levels will be optimal and the same
regardless of whether or not the victims possess rights to the environment or polluters
possess rights to pollute. In other words, regardless of who possesses rights, negotia-
tions solve problems, and social benefits are maximized. Accordingly, looking at this
from the perspective of efficient resource use in society, environmental organizations
and nature preservation activity have no persuasive power in their emphasis that they
possess environmental rights.
However, deciding rights possession has a great impact on the distribution issue
with regards to which subsidies are received. Here, as an example of a pollution prob-
lem, consider the Japanese pollution trial where the business that caused the pollution