In law and economics, the Coase theorem 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 an efficient outcome regardless
of the initial allocation of property. In practice, obstacles to bargaining or
poorly defined property rights can prevent Coasian bargaining. This
"theorem" is commonly attributed to Nobel Prize laureate Ronald Coase during
his tenure at the University of Chicago. However, Coase himself stated that the
theorem was based on perhaps four pages of his 1960 paper "The Problem of Social
Cost", and that the "Coase theorem" is not about his work at all.
This 1960 paper, along with his 1937 paper on the nature of the firm, 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 have demonstrated the
importance of the perfect information assumption and shown using game theory
that inefficient outcomes are to be expected when this assumption is not
met. 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. 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. Version 1: A clear delineation of
private property rights is an essential prelude to market transactions.
Version 2: As long as private property rights are well defined under zero
transaction cost, exchange will eliminate divergence and lead to
efficient use of resources or highest valued use of resources.
Version 3: The allocation of resources is invariant to the assignment of
private property rights under zero transaction cost and zero income effect.
Efficiency and invariance Because Ronald Coase himself 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. These wealth effects may be small, however.
Equivalence version In his UCLA dissertation and in
subsequent work, Steven N. S. Cheung 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. The equivalency result also underlies Coase's 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.
Application in United States contract and tort law
The Coase Theorem has been used by jurists and legal scholars in the
analysis and resolution of disputes involving both contract law and tort
law. In contract law, Coase is often used as
a method to evaluate the relative power of the parties during the negotiation
and acceptance of a traditional or classical bargained-for contract.
In modern tort law, application of economic analysis to assign liability
for damages was popularized by Judge Learned Hand of Second Circuit Court of
Appeals in his decision, United States v. Carroll Towing Co. 159 F.2d 169.
Judge Hand's holding resolved simply that liability could be determined by
applying the formula of B