Coase theorem


The Coase theorem postulates the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem is significant because, if true, it would be possible for private individuals to make choices that can solve the problem of market externalities. The theorem states that if the provision of a good or service results in an externality and trade in that good or service is possible, then bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property. A key condition for this outcome is that there are sufficiently low transaction costs in the bargaining and exchange process. This 'theorem' is commonly attributed to Nobel Prize laureate Ronald Coase.
In practice, numerous complications, including imperfect information and poorly defined property rights, can prevent this optimal Coasean bargaining solution. In his 1960 paper, Coase specified the ideal conditions under which the theorem could hold and then also argued that real-world transaction costs are rarely low enough to allow for efficient bargaining. Hence, the theorem is almost always inapplicable to economic reality but is a useful tool in predicting possible economic outcomes.
The Coase theorem is considered an important basis for most modern economic analyses of government regulation, especially in the case of externalities, and it has been used by jurists and legal scholars to analyze and resolve legal disputes. George Stigler summarized the resolution of the externality problem in the absence of transaction costs in a 1966 economics textbook in terms of private and social cost, and for the first time called it a "theorem". Since the 1960s, a voluminous amount of literature on the Coase theorem and its various interpretations, proofs, and criticism has developed and continues to grow.

The theorem

Coase developed his theorem when considering the regulation of radio frequencies. Competing radio stations could use the same frequencies and would therefore interfere with each other's broadcasts. The problem faced by regulators was how to eliminate interference and allocate frequencies to radio stations efficiently. What Coase proposed in 1959 was that as long as property rights in these frequencies were well defined, it ultimately did not matter if adjacent radio stations interfered with each other by broadcasting in the same frequency band. Furthermore, it did not matter to whom the property rights were granted. His reasoning was that the station able to reap the higher economic gain from broadcasting would have an incentive to pay the other station not to interfere.
In the absence of transaction costs, both stations would strike a mutually advantageous deal. It would not matter which station had the initial right to broadcast; eventually, the right to broadcast would end up with the party that was able to put it to the most highly valued use. Of course, the parties themselves would care who was granted the rights initially because this allocation would impact their wealth, but the result of who broadcasts would not change because the parties would trade to the outcome that was overall most efficient. This counterintuitive insight—that the initial imposition of legal entitlement is irrelevant because the parties will eventually reach the same result—is Coase's invariance thesis.
Coase's main point, clarified in his article "The Problem of Social Cost", published in 1960 and cited when he was awarded the Nobel Prize in 1991, was that transaction costs, however, could not be neglected, and therefore, the initial allocation of property rights often mattered. As a result, one normative conclusion sometimes drawn from the Coase theorem is that liability should initially be assigned to the actors for whom the costs of avoiding the externality problem are the lowest. The problem in real life is that nobody knows ex ante the most valued use of a resource, and also that there exist costs involving the reallocation of resources by government. Another, more refined, normative conclusion also often discussed in law and economics is that government should create institutions that minimize transaction costs, so as to allow misallocations of resources to be corrected as cheaply as possible.
  1. In the case of zero transaction costs, no matter how the rights are initially allocated, negotiations between the parties will lead to the Pareto optimal allocation of resources;
  2. In the case of non-zero transaction costs, different rights allocation definitions will lead to different resource allocations;
  3. Because of the existence of transaction costs, different rights definitions and allocations will bring about resource allocation with different benefits. Therefore, the establishment of the property rights system is the basis for optimizing resource allocation.
When faced with an externality, the same efficient outcome can be reached without any government intervention as long as the following assumptions hold:
  1. Property rights must be clearly defined.
  2. There must be little to no transactions costs.
  3. There must be few affected parties.
  4. There must be no wealth effects. The efficient solution will be the same, regardless of who gets the initial property rights.
The Coase theorem shows that the essence of the market is not price, but property rights. As long as there are property rights, people will naturally "negotiate" a reasonable price.

Efficiency and invariance

Because Ronald Coase did not originally intend to set forth any one particular theorem, it has largely been the effort of others who have developed the loose formulation of the Coase theorem. What Coase initially provided was fuel in the form of "counterintuitive insight" that externalities necessarily involved more than a single party engaged in conflicting activities and must be treated as a reciprocal problem. His work explored the relationship between the parties and their conflicting activities and the role of assigned rights/liabilities. While the exact definition of the Coase theorem remains unsettled, there are two issues or claims within the theorem: the results will be efficient and the results in terms of resource allocation will be the same regardless of initial assignments of rights/liabilities.

Efficiency version: aside from transaction costs, the prevailing outcome will be efficient

The zero transaction cost condition is taken to mean that there are no impediments to bargaining. Since any inefficient allocation leaves unexploited contractual opportunities, the allocation cannot be a contractual equilibrium.

Invariance version: aside from transaction costs, the same efficient outcome will prevail

This version fits the legal cases cited by Coase. If it is more efficient to prevent cattle trampling a farmer's fields by fencing in the farm, rather than fencing in the cattle, the outcome of bargaining will be the fence around the farmer's fields, regardless of whether victim rights or unrestricted grazing-rights prevail. Subsequent authors have shown that this version of the theorem is not generally true, however. Changing liability placement changes wealth distribution, which in turn affects demand and prices.

Equivalence version

In his UCLA dissertation and in subsequent work, Steven N. S. Cheung coined an extension of the Coase theorem: aside from transaction costs, all institutional forms are capable of achieving the same efficient allocation. Contracts, extended markets, and corrective taxation are equally capable of internalizing an externality. To be logically correct, some restrictive assumptions are needed. First, spillover effects must be bilateral. This applies to the cases that Coase investigated. Cattle trample a farmer's fields; a building blocks sunlight to a neighbor's swimming pool; a confectioner disturbs a dentist's patients etc. In each case the source of the externality is matched with a particular victim. It does not apply to pollution generally, since there are typically multiple victims. Equivalence also requires that each institution has equivalent property rights. Victim rights in contract law correspond to victim entitlements in extended markets and to the polluter pays principle in taxation.
Notwithstanding these restrictive assumptions, the equivalence version helps to underscore the Pigouvian fallacies that motivated Coase. Pigouvian taxation is revealed as not the only way to internalize an externality. Market and contractual institutions should also be considered, as well as corrective subsidies. The equivalence theorem also is a springboard for Coase's primary achievement—providing the pillars for the New Institutional Economics. First, the Coasean maximum-value solution becomes a benchmark by which institutions can be compared. And the institutional equivalence result establishes the motive for comparative institutional analysis and suggests the means by which institutions can be compared. The equivalency result also underlies Coase's proposition that the boundaries of the firm are chosen to minimize transaction costs. Aside from the "marketing costs" of using outside suppliers and the agency costs of central direction inside the firm, whether to put Fisher Body inside or outside of General Motors would have been a matter of indifference.

Application in United States contract and tort law

The Coase theorem has been used by jurists and legal scholars in the analysis and resolution of disputes involving both contract law and tort law.
In contract law, the Coase theorem is often used as a method to evaluate the relative power of the parties during the negotiation and acceptance of a traditional or classical bargained-for contract.
In modern tort law, application of economic analysis to assign liability for damages was popularized by Judge Learned Hand of the Second Circuit Court of Appeals in his decision, United States v. Carroll Towing Co. 159 F.2d 169. Judge Hand's holding resolved simply that liability could be determined by applying the formula of, where is the burden of adequate protection against foreseeable damages, is the probability of damage occurring and is the gravity of the resulting injury. This decision flung open the doors of economic analysis in tort cases, thanks in no small part to Judge Hand's popularity among legal scholars.
In resultant scholarship using economic models of analysis, prominently including the Coase theorem, theoretical models demonstrated that, when transaction costs are minimized or nonexistent, the legal appropriation of liability diminishes in importance or disappears completely. In other words, parties will arrive at an economically efficient solution that may ignore the legal framework in place.