Coase Theorem

11 Key excerpts on "Coase Theorem"

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  The Hesitant Hand

  Taming Self-Interest in the History of Economic Ideas

  • Steven G. Medema(Author)
  • 2009(Publication Date)
  • Princeton University Press

    (Publisher)

  it is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximizes the value of production) is independent of the legal position if the pricing system is assumed to work without cost. (Coase 1960: 8)

  The Coase Theorem has been stated in several different ways, often with slight, but not necessarily unimportant, variations. Two of the classics are George Stigler’s (1966: 113) statement that “under perfect competition private and social costs will be equal”—the first naming of the Coase Theorem in print—and A. Mitchell Polinsky’s (1974: 1665) assertion that “[i]f transaction costs are zero, the structure of the law does not matter because efficiency will result in any case.”44 A statement that closely follows the spirit of Coase can be worded this way: If rights are fully specified and transaction costs are zero, parties to a dispute will bargain to an efficient and invariant outcome regardless of the initial specification of legal rights. This statement of the theorem contains two explicit assumptions and two assertions regarding the results.

  Let us begin with the results, which can best be understood as two theses regarding outcomes. The first is the efficiency thesis , which states that the outcome of the bargaining process will be efficient, regardless of who is initially assigned the right. The concept of efficiency underlying the Coase Theorem is Paretian—the exhaustion of all potential gains from trade45 —and much of the recent analysis by economists attempting to assess the validity of the theorem employs the Paretian notion of efficiency. Coase himself used the concept of efficiency in multiple ways in his analysis (maximizing the value of production and minimizing costs, in particular), while, within contemporary economic analysis of law, wealth maximization and cost minimization are the most frequently employed variants of the efficiency concept. The second of the implied results is the invariance thesis: The outcome of the bargaining process—the allocation of rights and resources (although not necessarily the distribution of income)—will be the same , regardless of who is initially assigned the right. That is, while the efficiency thesis contends that the final allocation of resources consequent to any particular assignment of rights will lie on the contract curve, the invariance thesis says that the final allocation will lie on the same point

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  Public Finance in Theory and Practice Second edition

  • Holley H. Ulbrich, Holley Ulbrich(Authors)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  In recent decades, much attention has been given to identifying existing mechanisms for correcting externalities as well as devising new techniques. They include:

  • assignment of property rights (the Coase Theorem);
  • tax incentives and vouchers;
  • educational/informational programs to encourage or discourage certain types of production;
  • the development of markets in permits for emissions;
  • shifting production to a lower level of government or a nonprofit provider.

  Property Rights and the Coase Theorem

  The Coase Theorem, developed by Nobel prize winner Ronald Coase, suggests that some externality problems could be resolved through assignment of property rights. Specifically, this theorem says that, where small numbers of participants are involved, property rights can be assigned to one of the parties for a contested resource (such as the use of a lake or waterway), and subsequent negotiations will result in the socially optimal use of the resource. This outcome is independent of which of the two parties is given the property right, although the distributional effects can be an important consideration (Coase 1960).

  For example, suppose that an industrial firm and a group of nature lovers are interested in using a small lake, the former for discharging wastes, the latter for swimming, boating, and fishing. These two uses are not compatible. Which is the best and highest use of the lake? If it is assumed that both parties have enough resources to express their effective demand, then the lake should be used by the party who is willing to pay the highest price for the use of the lake. Suppose that the industrial firm is assigned the right to use the lake as it sees fit. The group of nature lovers could make the firm an offer to restrict its effluent below a certain level that would make the lake still usable for recreation. If the cost of disposing of its effluent in another way was less than the amount offered by the nature lovers, the industrial firm would agree, and the lake would be used for fishing, boating, and swimming.

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  Football Economics and Policy

  • S. Szymanski(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  However, if an allocation of property rights exists for which the core is empty – that is, there is no equilibrium bargain that is efficient – then the Coase Theorem fails. Aivazian and Callen provide a simple example of just such a case. While theoretical objections abound, it is perhaps more important to understand whether the implications of the Coase Theorem are really relevant for economic policy. In other words, we need to understand whether, in a world where property rights are well defined and bargain- ing is not too costly, the outcomes of bargaining are plausibly close to efficiency. The team sports literature has been widely cited as an example of a situation where the Coase Theorem is put to a practical test. III The Coase Theorem in the sports literature One common characteristic of team sports as they developed on both sides of the Atlantic has been the desire of the owners of teams belong- ing to professional leagues to control the market for players, in particular to establish monopsony rights. Thus the Reserve Clause of baseball (see, e.g. Quirk and Fort, 1992, for an explanation) functioned in much the same way as the retain-and-transfer system of English soccer (see, e.g. Sloane, 1969). 1 This inevitably led to challenges in the courts by 206 Football Economics and Policy the players claiming the right to move freely between employers. Simon Rottenberg’s celebrated (1956) article examined this issue and presented the team owner’s rationale: the defense most commonly heard is that the reserve rule is neces- sary to assure an equal distribution of playing talent among opposing teams; that a more or less equal distribution of talent is necessary if there is to be uncertainty of outcome; and that uncertainty of out- come is necessary if the consumer is to be willing to pay admission to the game.

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  Fundamental Principles of Law and Economics

  • Alan Devlin(Author)
  • 2014(Publication Date)
  • Taylor & Francis

    (Publisher)

  In the real world, of course, transaction costs are never zero, so the facile conclusion that government policy should limit itself to creating and enforcing property rights will not always or even generally hold true. This does not mean that the Coase Theorem, and by extension, the role of property rights in alienating scarce resources, have no application to public policy. First, the fact that transaction costs are positive does not mean that the Coase Theorem will fail. When the private benefits of reaching agreement exceed the negotiating costs, efficient bargaining should occur. It is, therefore, no surprise that contracts (both formal and informal) abound. Each one represents the Coase Theorem in action.

  Private actors’ ability to negotiate reallocations of resource assignments is indispensable to an efficient economy. To facilitate this process, the only absolute requirement is that government give legal force to property rights. The principal benefit of this phenomenon is that markets can ameliorate mistaken property allocations, which is apt to be a common occurrence given the government’s inferior access to the information necessary to identify the highest-value allocations of entitlements. When private entities undo such mistakes, economists often refer to the ensuing arrangements as “private-ordering solutions”.

  Yet, impediments to voluntary exchange are ubiquitous. These transaction costs have a number of undesirable effects. In the first place, they foreclose some efficient reallocations of entitlements. This is apt to occur when the expense of negotiating an agreement exceeds the aggregate gain that the stakeholders would realise from reaching a bargain. Perhaps less obviously, transaction costs diminish the magnitude of the social value that even successful contracts generate.

  Ultimately, where bargaining costs are so severe that no contracting can take place, initial property assignments are final. In these cases, unless the government allocates entitlements to their highest-value uses in the first instance, inefficiency will ensue.

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  The Ideas of Ronald H. Coase

  Market failure and planning by contract for sustainable development

  • Lawrence W. C Lai(Author)
  • 2011(Publication Date)
  • Taylor & Francis

    (Publisher)

  Part II , this work is an original attempt to outline a much-wanted research project by (a) examining the inner logic of the theorem; (b) deriving propositions on the basis of the mischief of the theorem – that is, to deal with positive transaction costs in reality; and (c) taking stock and interpreting existing planning works that touch on Coasian transaction cost concepts, giving an example of how the derived propositions can be applied to organise empirically refutable planning research hypotheses.

  6.2 The internal logic of the Coase Theorem

  The Coase Theorem is often mistaken to be the same as libertarian economics in which no role for town planning is allowed. That is neither the intention of Coase nor the logic of the Coase Theorem, as particularly explained in Chapters 1 and 3 and the such works as Webster and Lai (2003). The Coase Theorem, if properly understood, is indeed extremely versatile and fruitful for planning policy and research.

  The actual formulation of the Coase Theorem, to recall our discussions in Chapters 2 and 3 , was deduced by Nobel laureate George J. Stigler (1966, 1987) from fellow laureate Coase’s paper ‘The Problem of Social Cost’ (1960), which was an article written with a view to rejecting Pigou’s (1932) concept of externality as a reason for state intervention in the market.

  Stigler’s formulation had two variants, which may be described as the ‘invariant theorem’ and the ‘optimality theorem’ (Cheung 1990). The invariant theorem reads: ‘given zero transaction cost and clearly defined property rights, the assignment of rights and liabilities would not affect resource allocation.’ In other words, ‘given zero transaction cost and clearly defined property rights, resource allocation would be identical irrespective of (and thus ‘invariant’ to) the pattern of rights and liabilities, or the way in which they are assigned.’2

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  Economics of the Law

  A Primer

  • Wolfgang Weigel(Author)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  The discussion about the Coase Theorem is almost unmanageable. To illustrate, the entry ‘externalities and the Coase Theorem’ in the Bibliography of Law and Economics contains 140 contributions. Therefore, an exhaustive appreciation is an impossible task. While there was (and still is) much praise for Ronald Coase culminating in the opinion that he initiated the emergence of a new paradigm there has always also been fierce criticism. Let us conclude the presentation with three examples of objections.

  First, does the theorem neglect important insights from microeconomic theory? The argument runs as follows: according to the theorem, the allocation emerging from bargaining is independent of the initial assignment of property rights. However, in the case of a negative externality between neighbouring households the negotiation cannot be independent of purchasing power. Thus the preferences of either side can be effectuated better the higher the initial endowment with purchasing power, which will be reflected in the willingness to pay or the claim for compensation. Consequently, it is true that the results of bargaining are efficient, but the results will vary according to difference in initial conditions!

  Second, the theorem is logically flawed! This argument runs as follows. The logic of the theorem is the following: in a case transaction costs are zero (A), it follows that the initial assignment of property rights does not affect the efficiency in resource allocation (B). So the logic is ‘B follows from A’. But B can have two different meanings here, that is to say (1) every assignment of property rights gives rise to an efficient allocation of resources, where efficiency requires some initial assignment of property rights and (2) resources are admitted to efficient use independently of some assignment of property rights. But only either (1) or (2) can hold, so there is an inherent logical contradiction contained in Coase’s analysis. Although his findings contain much truth, they cannot obtain as a ‘theorem’.

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  The Economics of Transaction Costs

  Theory, Methods and Application

  • P. Rao(Author)
  • 2002(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Limitations of the Coasean propositions Some of the important limitations of the Coase Theorem (or, equiva- lently, the Coasean propositions) arise from behavioural and structural problems of economic activities and the incidence of externalities. The following is a summary of various critical assessments of the Coasean propositions (including the so-called Coase Theorem); these are given below not only to provide a broad list of objections to the validity of the propositions, but also to raise awareness in respect of multiple facets of economic analysis relevant in this and other contexts of TCE. But for the significance of the Coasean contributions, this wider debate (and in the process, enriching economic thought as a positive externality) could not possibly have surfaced. In the behavioural dimension, people are more displeased with a loss than pleased with an equivalent gain, suggesting the feature of loss aversion in behavioural aspects (Thaler, 1992). An application of `loss aversion criteria' suggests that the Coase Theorem could not hold when the allocation of the legal entitlements influences the outcome, as those individuals who are `initially allocated an entitlement are likely to value it more than those without the legal entitlement' (Sunstein, 1999, p. 132). A legal entitlement creates an endowment effect (Thaler, 1991): a greater valuation of a right or resource stemming from the mere fact of endowment. As a consequence of the endowment effect, the initial allocation of rights has an effect on the final outcome of negotiations in any bargain. The allocation of resources contemplated by the theorem is not neu- tral with respect to legal rights and their enforcement, as Samuels (1992, p. 79) stated: `allocation is specific to the underlying rights structure which gives rise to it'.

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  Price Theory and Applications

  • Steven Landsburg(Author)
  • 2013(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  However, although the allocation of resources has changed, it is still efficient (that is, Pareto-optimal). Rock fans are happier, classical music lovers are less happy, but social welfare is still being maximized given the new wealth distribution. This is an example of what we will call the weak Coase Theorem: Weak Coase Theorem: In the absence of transactions costs, the assignment of property rights does not affect the efficiency of resource allocation (though it might cause resources to be diverted from one efficient allocation to another). The weak Coase Theorem is always true. The strong Coase Theorem is true when-ever the reallocation of property rights does not change people ’ s wealth enough to have significant effects on market demand curves. (In other words, the redistribution of income that results from the change in property rights should have negligible income effects.) 11 He also discovered that, contrary to a widespread assertion in economic literature, apples produce almost no honey. Therefore, he extended his investigation to include many other plants. EXTERNAL COSTS AND BENEFITS 429 Copyright 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Notice that changes in the assets of firms do not affect the validity of the strong Coase Theorem. Only changes in the assets of individuals are relevant, because indi-viduals are the source of demand curves. For the strong Coase Theorem to fail, there must be large changes in the wealth of enough individuals to make a significant dif-ference in the relevant market.

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  Philosophy of Economics

  A Contemporary Introduction

  • Julian Reiss(Author)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  Now suppose that the “polluter” is not facing one “victim” but many. The “polluter” might be a company using a dirty industry and the “victims” the entire population of the region affected by by-products of the production process. Given the affected population is large, it is likely that the most efficient solution requires the firm to install emission controls. But if the firm has the right to pollute, the individuals living in the affected area face a collective-action problem analogous to contributing to a public good. Everyone has an incentive to free ride, and it is unlikely that the public good—clean air in this case—will be produced. The converse is true when people in the region have the right to live pollution-free. The firm could offer compensation, but since each individual has a veto right, everyone has an incentive to use his or her bargaining power to extract more money and negotiations will break down.

  Coase regards these adverse incentive structures as creating transaction costs. In the absence of transaction costs, efficient solutions can be found, and the allocation of property rights does not matter. With transaction costs, the free market is unlikely to supply efficient solutions, and the allocation of property rights matters a great deal. In the last example, the firm using a dirty production process will produce an inefficiently high amount of pollution unless the affected individuals are able to solve the collective-action problem if it has the right to pollute; if people have the right to clean air, an inefficiently low amount of pollution will be produced.

  The discussion of the Coase Theorem nicely illustrates how different kinds of market imperfections interrelate. More importantly, it makes plain that it is not normally possible to ignore moral considerations when one thinks about how best to organize or regulate production processes. In the next subsection I will look at some of the relevant considerations.

  The Moral Limits of Coase's Theorem

  Coase's essay is titled “The Problem of Social Cost.” Let us focus on the idealized case in which there are no transaction costs first. The “social costs” Coase considers are measured exclusively in terms of efficiency. As we saw in the previous chapter, an allocation is Pareto-efficient if and only if there is no alternative allocation that makes at least one individual better of without making at least one individual worse of. “Better of” and “worse of” are understood in terms of (actual) preference satisfaction. An individual is thus regarded to be better of in social state S' than in the status quo S if and only if that individual prefers S' to S

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  The Rhetoric of Economics

  • Deirdre N. McCloskey(Author)
  • 1998(Publication Date)
  • University of Wisconsin Press

    (Publisher)

  In fact, as Coase argued also in the 1937 article, transaction costs put our world far away from the blackboard optimum. But I have given up hope of persuading any other economist of this interpretation, since the only economist who shares it is R. H. Coase (Coase 1988a, pp. 15, 174), and we know how unpersuasive he has been. Coase's chief contribution to economics has been to remind economists, as he does when com- plaining about Kaldor assuming "all relevant prices" are known, "but this is clearly not true of the real world" (Coase 1937, p. 38n. 18). The misunderstanding of the Coase Theo- rem arises from economists thinking that Coase is trying, like them, to flee the world. 89 The Lawyerly Rhetoric of Coase's "The Nature of the Firm" to be larger: (a.) the less the costs of organzing" and so forth. The "other things being equal," "therefore," and "tend" are careful and conven- tional boilerplate in the contract between reader and economic Scien- tist. When claiming the ethos of Scientist the young Coase was espe- cially fond of "tend to," the phrase becoming virtual anaphora on p. 46 (Coase 1937), repeated in all six of the complete sentences on the page and once in the footnotes. Such a treatise-rhetoric was popular in economics at the time. Like- wise Coase indulged in outlining, anticipation, and summary, the curse of modern prose, borrowed from the Germanic textbooks of an earlier age: phrases like "The point has been made in the previous paragraph" (Coase 1937, p. 44); "The problem which has been investigated in the pre- vious section" (p. 47); "This point is further discussed below" (p. SIn. 41); and "The factors mentioned above" (p. 53) litter the essay.

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  Thinking About Law

  Perspectives on the history, philosophy and sociology of law

  • Rosemary Hunter, Richard Ingleby, Richard Johnstone(Authors)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  transaction costs the initial assignment of a property right will not affect the ultimate use of the property. Transaction costs include all the costs incidental to the transaction, such as the time and resources consumed in gaining information, identifying and getting together the other parties to a negotiation, and enforcing the bargain. Assuming transaction costs are zero, property rights will be transferred to those who value them the highest or, in opportunity cost terms, are prepared to pay the most for them.

  For example,22 assume that if a factory pollutes a river each of the five residential landowners downstream will suffer $500 damage. The pollution can be minimised by the factory owner spending $250 on filtering equipment or by each residential landowner purchasing a water purifier for $80 each. The Coase Theorem argues that it does not matter whether the relevant legal rule protects the residential landowner’s right to clean water or gives the factory owner licence to pollute. The most efficient solution is for the factory to install the filtering equipment—it is cheaper than the other solutions. If pollution is illegal, the factory will pay $250 for equipment rather than $500 damages to each of the landowners. If there is no rule outlawing pollution the landowners will club together to pay the factory $250, which is less than the total cost of each installing a water purifier. If, however, there are transaction costs of $60 for each residential landowner and the rule prohibits water pollution, the factory owner will still install the equipment for $250. But if the rule allows water pollution, it is cheaper for each landowner to purchase a water purifier, because of the transaction costs involved in their seeking to have the factory owner install the filtering equipment. Hence the transaction costs prevent the efficient solution being implemented irrespective of the legal rule. To achieve the efficient solution in a world of transaction costs the legal rule would need to prohibit pollution.23

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