Ronald Coase Theorem Examples | Coase Theorem Property rights  and Transaction Costs

What is Coase Theorem/Coasian Theorem?

The Coase theorem, first proposed in 1960 by economist Ronald H. Coase and commonly referred to as the Coase Theorem, results from an economic analysis that states that an externality can be made worse without government intervention if there are transaction costs between the parties involved.

While this theorem was originally developed regarding property rights concerning air pollution, it has been applied more generally to other situations involving externalities and property rights.

The Coase theorem has been at the center of many economic debates. It is a model that indicates how agents may voluntarily allocate resources irrespective of transaction costs. In other words, it states that an efficient allocation can be achieved without a central coordinator.

Coase Theorem Assumptions

Coase Theorem argues that when faced with an externality, the same efficient outcome can be reached without any government intervention as long as the following assumptions hold: requires that:

1. Property rights are well defined.
2. People act rationally
3. Transaction costs are minimal.
4. There must be no wealth effects. The efficient solution will be the same, regardless of who gets the initial property rights.

Coasian Bargaining

What is Coasian bargaining?

Coasian bargaining is based on the ideas of the significance of transaction costs and property rights for the economy’s institutional structure and functioning. Coase argues that well-defined property rights can overcome externalities’ problems because many environmental problems arise from poorly defined or a lack of property rights.

Assuming that the polluter holds property rights and that transaction costs are zero, the Coase theorem states that a polluter and a victim can reach a mutually beneficial bargain if the damage from pollution is more serious than the polluter’s net return from the sale of the good generating the pollution. In this case, a payment from the affected party to the polluter would reduce the pollution.

Coase Theorem Negative Externalities

The Coase theorem states that under certain conditions, private parties can bargain to reach an efficient solution to a problem of negative externalities. This is generally considered the starting point for analyzing environmental economics and has far-reaching implications in related fields.

We use it here to reference some other economic instruments that may be used to deal with externalities caused by market transactions.

Coase Theorem Property rights  and Transaction Costs

The Coase theorem results from economic theory state that an externality can be perfectly internalized by private negotiation and market transactions under certain conditions. Ronald H. Coase developed the theorem to explain how externalities could be taken into account in the economic analysis of law without government regulation through legal contracts.

The Coase theorem is an economic theory that says it doesn’t matter who owns a resource so long as property rights are well-defined. It states that parties can trade in ways to avoid externalities. This also implies that government intervention may be unnecessary if property rights are clearly defined because all other things equal, markets tend towards efficient outcomes.

The Coase Theorem point is that if there are no transaction costs, then as long as property rights are well defined and tradable, then for efficiency, it doesn’t matter who owns property rights initially. People will trade with each other until the individuals who value certain property the highest own that property.

However, even with zero transaction costs, which has initial property rights definitely matters for distribution; if I own a car that you value more, I will sell you the car and earn a profit, but it is just as efficient for you to own the car in the beginning and reap the entire surplus, leaving me with no wealth.

The Problem of Social Cost

The Coase theorem is a theory in economics that states that in a well-functioning market, an economic agent will be able to obtain all the necessary resources they need for production without having to engage in bargaining.

In other words, if the transaction costs are low enough, it doesn’t matter who owns what rights; they can always sell those rights and repurchase them at a minimal cost. Ronald Coase originally formulated (1910-2013) through his article “The Problem of Social Cost,” published on 19 December 1960.

Coase Theorem and Pigouvian Tax

Ronald Coase theorem finds that the Pigouvian externality control system is “faulty.” Coase claims that by developing a pollution market, companies can compete with each other, the government can achieve an acceptable level of pollution without causing excess market inefficiency.

In this way, companies will determine among themselves who can pollute the most and, in certain situations, firms would be able to sell their benefit permits, thereby increasing the economic incentive to pollute less and sell more permits to other firms.

• Related: Pigouvian Tax Example

Ronald Coase Theorem Examples/Real-life Examples of Coase Theorem

Wills family plant pear trees on their land adjacent to the Mathews family. The Mathew family has an external gain from the Wills family’s pear trees because they pick up the pears that fall on the ground on their side of the property line.

This is an externality since the Mathews family would not pay the Wills family to profit from harvesting falling pears. As a result, the Wills family plant too few pear trees.

In response, the Wills family can set up a net that prevents pears from dropping on the Mathew side of the property line, preventing externality. Alternatively, the Wills could put a cost on the Mathew family if they wanted to keep enjoying the pears from the pear trees.

Both sides will be better off if they consent to the second scenario, as the Mathew family will continue to enjoy pears, and the Wills family will be able to increase the production of pears.

Why Would the Coase Theorem Not Work?

In fact, there are a variety of reasons why the Coase Theorem cannot be applied, depending on the context. In some situations, the endowment effect could cause the negotiation phase’s valuations to rely on property rights’ initial allocation.

In other situations, agreements may not be necessary either based on the number of participants or based on social conventions.

Coase Theorem Graph/Diagram Explained

Limitations of Coase Theorem

• There are weaknesses to the theorem of the Coase. If the emissions impact several polluters or more than one party, the assignment of property rights will ultimately decide the degree of pollution. Take, for example, a waste disposal plant in a river.
• Besides, many environmental externalities are indirect, cumulative, and uncertain. The costs of enforcing or striking a Coasian bargain may be high. Again, as many externalities are intertemporal, future generations are not present in any bargain.
• Coasian bargaining does not eliminate the role of government in assigning initial property rights. This process will be subject to special interest group lobbying and rent-seeking.