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Coase theorem

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In law and economics, the Coase theorem, attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that when trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. Obstacles to bargaining are often sufficient to prevent this efficient outcome, leaving normative Coase theorem to prevail over positive Coase theorem.

This theorem, along with his 1937 paper on the nature of the firm which also emphasizes the role of transaction costs, earned Coase the 1991 Nobel Prize in Economics. The Coase theorem is an important basis for most modern economic analyses of government regulation, especially in the case of externalities. 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 literature on the Coase theorem and its various interpretations, proofs, and criticism has developed and continues to grow.

The Theory

What Coase originally proposed in 1959 in the context of the regulation of radio frequencies was that as long as property rights in these frequencies were well defined, it ultimately did not matter if adjacent radio stations would initially interfere with each other by broadcasting in the same frequency band. The station able to reap the higher economic gain of the two from broadcasting would in this case 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. Put differently, it would not matter whether one or the other 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.

Coase's main point, clarified in an article published in 1960 (Coase 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 mattered in the presence of side effects (externalities). In essence, the normative conclusion most often drawn from the Coase theorem is that the property rights should initially be assigned to the actors gaining the most utility from them. The problem in real life is that governments most often do not know ex ante the most valued use of a resource.

Another, more refined normative conclusion also often discussed in law and economics is that government should create institutions which minimize transaction costs, so as to allow misallocations of resources to be corrected for as cheaply as possible.

Application

The Coase theory provides the economic basis to the 'cap and trade' approaches to addressing climate change.

Criticism

The main criticism often targeted at the Coase theorem is to say that transaction costs are almost always too high for efficient bargaining to happen. For instance, economist James Meade argued that even in a simple case of a beekeeper's bees dusting a nearby farmer's crops, a coasean bargaining is inefficient.

However, such criticism often comes from economists such as Meade, who often analyze economic situations from a non-coasean, traditional neoclassical point of view, with exogenous transaction costs. However, coasean economic analysis, or new institutional economics also often looks at the dynamics of the institutions that create the transaction costs.

As it turns out, new institutional economists more sympathetic to Coase's point of view researched the empirical evidence, and found out Coasean agreements between beekeepers and nearby farmers had been common practice for nearly a century.

Another strain of criticism often points out other problems often associated with public goods which manifest in coasean bargainings. In many cases of externalities, the bargaining doesn't happen between two economic actors, but instead the parties might be a single large factory versus a thousand landowners nearby. In such situations, say the critics, not only do transaction costs rise extraordinarily high, but bargaining is hindered by basic prisoner's dilemma problems. For instance property rights might say the landowners must pay the factory to stop polluting, certain landowners might downplay the harm of pollution on them, trying to free ride on the other landowners' wallets.

There is also a Functionalist critique of the Coase Theorem.

Again, new institutional economics and coasean insights into the dynamics of institutions often taken exogenous in neoclassical analysis provides quite a different point of view into how public goods are created. As a counterexample against the neoclassical models' pessimistic views on public goods and collective action, Coase investigated the empirical evidence on lighthouses, perhaps the most common textbook example of a public good. In the article The Lighthouse in Economics, Coase pointed that "contrary to the belief of many economists, a lighthouse service can be provided by private enterprise... [Before the 20th century] The lighthouses were built, operated, financed and owned by private individuals, who could sell a lighthouse or dispose of it by bequest."

References

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