THE COASE THEOREM






Publication: Yale Economic Review
Author: Hashem, Nabeem
Date published: January 1, 2010

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HOW MIGHT A POLLUTING factory and a neighbor negatively affected by this pollution settle their differences? According to Ronald Coase, the solution is deceptively simple: negotiate.

Ronald Coase, an economist at the Universit)' of Chicago, proposed a groundbreaking yet highly counterintuitive idea in a 1960 paper that is now known as the "Coase Theorem." The theorem presented a radical idea: it said that if initial property rights are well defined and transaction costs are low, private bargaining will tend to produce socially efficient outcomes no matter where liability is assigned. That is, externalities can be settled by straightforward free market negotiations between parties!

This statement can be parsed by considering a simple example. Consider, as Coase did, the situation of a doctor and a confectioner both operating their businesses next door to each other. Suppose that the confectioner uses noisy equipment that disrupts the doctor's ability to care for his patients. Common sense might suggest that because the confectioner is causing the external disruption on the doctor's services, the law should dictate that the confectioner be held liable. But what if the confectioner had established his business long before the doctor, who was unaware of the noisy equipment, had moved in? Is the confectioner's noise still considered a negative externality'? Would it stiM make sense to force the confectioner to compensate the doctor? These considerations make the picture far from clear cut.

The Coase Theorem suggests a simple solution: no matter who is assigned liability, the doctor and the confectioner can come to a mutual agreement that will leave them both better off. To better understand this, now suppose that the doctor can move his business for $1000, and that the confectioner can buy quieter machinery for S500. If the law dictates that the confectioner is liable for the noise he makes, then the confectioner would, just spend the $500 to buy quiet machinery; otherwise, he would have to stop producing altogether. However, if the law says that the confectioner can make as much noise as he wants, the doctor still would not have to spend the full $1000 to move his business. Why? The doctor could simply pay the confectioner $500 to buy quieter machinery and eliminate its effects. In fact, he could compensate the confectioner with any value between $500 and $1000 in order to reduce noise and end up better off than paying the $1,000 fee to move.

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In this case, the doctor would be made better off since it would have cost him more money to move altogether, and the confectioner would be made better off since he can still continue his operation and received $500 or more out of the bargain. Both parties benefit from trade, and the efficiency of the system increases since both the doctor and confectioner can continue to produce output.

Of course, the Coase theorem is not always applicable: sometimes negotiating is so pricey that it is not feasible. But Professor Coase recognized these costs. In his 1937 article "The Nature of the Firm," Ronald Coase introduced the concept of transaction costsy i.e. costs to using the market. For example, convincing the confectioner to accept quieter equipment, finding this equipment, and then installing it requires both time and mone\'. Such costs can often make bilateral transactions implicitly more expensive than the value of the actual products or services involved. As a result, the theoretical outcome predicted by Coase is not always possible.

Nevertheless, one normative conclusion drawn from Coase's theorem is diat the government should work to reduce transaction costs so that private bargaining can achieve efficient outcomes. Even while recognizing that in most real world cases transaction costs are nonzero, Coase argued that there are ways to minimize these costs. For instance, excessive regulation and bureaucracy and poorly defined property rights laws iare often responsible for high transaction costs. Coase asserted that the government should not meddle in the complex process of adjudicating "fairness" and "liability"; rather, the government should try to assign property rights in a simple way that minimizes transaction costs, allowing collective bargaining to create the best outcome.

Although initially poorly received, substantial evidence eventually supported the theorem, and people began to realize its broad implications in law and government. The theorem caused many economists and legal scholars to reexamine a myriad of issues, such as divorce, and the theorem has been influential in shaping how many legal decisions are made. Coase eventually received the Nobel Prize for his work in 1991.

Coase's findings revolutionized contract and tort theory, suggesting that even the most complex problems sometimes have simple solutions.

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