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Chapter 10 Market Failures • 185bacteria to thrive, thereby increasing water quality. Downstream landownersbenefit from these positive externalities. Another example is the pollutionwe spew every time we drive a car, which decreases air quality andcontributes to global warming.Because the agent conducting the activity in question is not compensatedfor positive externalities and pays no compensation for negativeones, she does not take into account these costs or benefits in her decisionto pursue the activity. In the case of negative externalities, the agent carriesthe activity too far. With positive externalities, the agent engages intoo little of the activity. If the agent conducting the activity were to be appropriatelycompensated or charged, there would be no more externality;the activity would be carried out until marginal benefits equaled marginalcosts, not only for the agent conducting the activity but also for society.As in the case of public goods, economists have suggested that assigningproperty rights will eliminate the externality problem. If the laundryhas the right to clean air, then the coal utility will be forced to pay thelaundry service for dirtying its laundry. 23 Once compensation is paid, theexternality is gone. Alternatively, it would be possible to assign the rightto pollute to the coal utility. In this case, the laundry would have to paythe coal utility not to pollute. 24 In perhaps the most widely cited articleever written on externalities, Ronald Coase argued that under certain conditionsit doesn’t matter whether the utility is assigned the right to polluteor the laundry is assigned the right to clean air. 25 In either case, the negotiatedoutcome will lead to an identical amount of pollution, preciselyat the level where marginal costs of pollution to the laundry are just equalto the marginal benefits to the utility. The implication is that the externalityissue requires no government intervention aside from the assignmentand enforcement of property rights; market forces are perfectly capable ofsorting it out. This is known as the Coase theorem.A graphic analysis may help make this a bit clearer. Figure 10.2 showspollution on the x-axis and marginal costs and benefits on the y-axis. Thecoal-fired utility benefits from polluting, while this pollution imposescosts on the laundry service. There are several technologies available forThe Coase theorem states thatthe initial allocation of legalentitlements does not matterfrom an efficiency perspectiveas long as they can beexchanged in a perfectlycompetitive market. 2623 In reality, this will not necessarily lead to an efficient solution in a dynamic setting. For example,if the payment makes the laundry service profitable, another laundry may locate nearby,which would also be profitable with a subsidy from the utility. For fairly obvious reasons, it is inefficientif the promise of a subsidy from the utility attracts businesses that are otherwise harmedby the utility’s presence.24 In this case, we would have to look at installation of pollution reduction equipment as generatinga positive externality for which the laundry service must compensate the public utility.25 R. Coase, The Problem of Social Cost, Journal of Law and Economics 3:1–44 (October 1960).26 R. Cooter, “Coase Theorem.” In The New Palgrave: A Dictionary of Economics, New York:Macmillan, 1987, pp. 457–459.