 Hi, Professor Gerald Friedman, the University of Massachusetts. And we're here today to talk about externalities and the Coase theorem. Externalities occur when something you're doing has an effect on people who are not part of your transaction. For example, I drive my car, I produce pollution, people on the Pacific Island nation of Tuvalo lose their homes because of global warming due to my pollution. My dog gets trained, we teach him to bark, my neighbors object to the sound of his barking. They're not part of the transaction between me and the dog, but they're affected by it. That is an external effect. They're positive and they're negative externalities. If you don't like my dogs barking, that's a negative. If you're on the island of Tuvalo, the external effects of my driving a car are negative. On the other hand, we also have planted wildflowers on the side of our yard. We have a beautiful rose bush on the front, and we have lots and lots of daffodils. Our neighbors come by, they admire daffodils, they feel good. That's positive externalities. Should we care about externalities? Should we change our behavior because of externalities? Generally speaking, if we're talking about a negative externality, we should change our behavior. We want a change in behavior if the course of the externalities to other people, because their loss of their homes, because the noise of the dog barking, are so bad that they are greater than the benefits we get by ignoring the externalities. We could change for electric cars and help Tuvalo, or bicycle. We could teach our dog to bark softly, and then our neighbors wouldn't be disturbed. We could do those things, they would cost money and resources, but we want that to happen if the benefits to the people in Tuvalo or to my neighbors exceed the cost to me. On the other hand, if the externality is relatively minor effect, nobody really hears the dog barking and nobody cares, and is hard to fix, have you ever tried to train a dog to bark softly? That's a lot of work. If the externality has relatively small effects and is hard to fix, we don't want people to change. Now historically, we have treated externalities as something for government to take care of. So government should set rules, pass laws, regulations, telling people what they can and can't do. We have in my neighborhood, for example, rules about mowing your lawn so that other people don't have to see your unkempt grass, and rules about taking your trash containers in after they've been emptied by the sanitation people. We have rules about noise, so you can't have wild, loud parties after one in the morning. These rules are enforced by the police who will throw you in jail if you don't behave. You, on the other hand, will sue other police for harassment, and you will sue the town and demand the right to party hardy, and proclaim it a First Amendment constitutional right, et cetera. There we have the problem with laws. The political process is imperfect. It doesn't necessarily represent everybody. In my town, two-thirds of the people are students. They hardly ever turn out to vote in local elections, which are dominated by a few thousand old people. Political process is imperfect. Laws lead to litigation. Laws good for the lawyers, not good for normal people. So there are also these problems with the traditional approach to litigation to regulating externalities. Ronald Coase, professor of economics at the University of Chicago, came up with an alternative solution. He suggests that if we have clear property rights, so it's clear who has the right to do things, then just leave it to the market, and the people will work out their own solution, an efficient solution, without a need for government or lawyers or any of that stuff. For example, if my neighbors don't like my dogs barking, and I have a right to keep a dog and a right for him to bark, then they can come to me and offer me cash. They can pay me, and the dog all stops the dog from barking, if they pay me enough. Let's say they really, really hate the dog barking, and my dog doesn't really like to bark that much anyway, so I have to train him to bark. Well, okay, they can give me a few dollars, and I'll stop having the dog bark. It will work out. They'll be happy. I'll have a few dollars. I'll be happy. Easy. On the other hand, let's say they don't really care very much, and I really like to have my dog bark, they'll offer me no more than a few dollars. I'll say, nah, not worth it, and we'll continue to have barking. That's the efficient solution. Either way, as long as it's clear who has the right, it will work out. If they have the right to quiet, and I want my dog to bark, I'll offer them money. If it's worth enough to me, and not worth that much to them, I'll be able to offer them enough that they'll let the dog bark. Otherwise, the dog won't bark, and whatever is the efficient solution in terms of benefits exceeding costs, that will happen. That's COSES Theorem. It could be applied to your cater party. You want to have a wild party? Your neighbors don't like the idea? No problem. You pay them. If you have a right to party, they'll pay you. If their benefits exceed your costs, they'll be able to pay you enough that you won't party. If your costs exceed their benefits, at worst you'll be able to pay them enough that they'll let you party. And when you do, I hope you do it responsibly.