Coase theorem

Named after the English-born American economist Ronald Harry Coase (1910 – ).

Coase theorem asserts that as long as there are well-defined property rights (and no transaction costs), externalities will not cause a breakdown in the allocation of resources.

Externalities being defined as the benefits or costs to a society of the process of consumption or production; for example, pollution, disease and spill-overs.

In law and economics, the Coase theorem (/ˈkoʊs/) describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are sufficiently low transaction costs, bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasean bargaining. This ‘theorem’ is commonly attributed to Nobel Memorial Prize in Economic Sciences winner Ronald Coase during his tenure at the London School of Economics, SUNY at Buffalo, University of Virginia, and University of Chicago.

This 1960 paper, along with his 1937 paper on the nature of the firm (which also emphasizes the role of transaction costs), earned Ronald Coase the 1991 Nobel Memorial Prize in Economic Sciences. In this 1960 paper, Coase argued that real-world transaction costs are rarely low enough to allow for efficient bargaining and hence the theorem is almost always inapplicable to economic reality. Since then, others[who?] have demonstrated the importance of the perfect information assumption and shown[citation needed] using game theory that inefficient outcomes are to be expected when this assumption is not met.

In his later writings, Coase expressed frustration that his theorem was often misunderstood. Although some have used Coase’s analysis to argue that because transaction costs are never zero it is always appropriate for a government to intervene and regulate, Coase believed that economists and politicians “tended to over-estimate the advantages which come from governmental regulation.” Some mistakenly understood the theorem to mean that markets would always achieve efficient results when transaction costs were low, when in reality his point was almost the exact opposite: because transaction costs are never zero, it cannot be assumed that any institutional arrangement will necessarily be efficient. Therefore, Coase argued that it is important to always compare alternative institutional arrangements to see which would come closest to “the unattainable ideal of the (mythical) world of zero transaction costs.”

Nevertheless, 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 analyse 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 end 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 avoiding the costs associated with the externality problem are the lowest.[clarification needed] 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.

When faced with an externality, the same efficient outcome can be reached without any government intervention as long as the following assumptions hold:

Property rights must be clearly defined
There must be little to no transactions costs
(Following 2.) There must be few affected parties (or else the transactions costs of organizing them gets to be too great).
There must be no wealth effects. The efficient solution will be the same, regardless of who gets the initial property rights.
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 (1969) 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 (according to their respective abilities to economize on transaction costs). The equivalency result also underlies Coase’s (1937) 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.

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