The Coase Theorem:

The Coase Theorem, formulated by economist Ronald Coase in his seminal

paper "The Problem of Social Cost" (1960), addresses the allocation of
resources and the mitigation of externalities in the presence of property rights.
The theorem asserts that under certain conditions, if property rights are well-
defined and transaction costs are low, then individuals can negotiate and reach
efficient outcomes regardless of the initial assignment of property rights.

Prof. R. Coase points out that if property rights are clearly defined, the affected
parties will adopt policies to internalise the externality. In other words, if
property rights and liability are properly defined and there are no transaction
costs, then people can be held responsible for any negative externalities they
impose on others and market transactions will produce an efficient outcome.

Coase explains property rights in two theorems:

First Theorem:

Assumptions:
The first theorem is based on the following assumptions:
1. It assumes that the number of contracting parties is very small.

2. The cost of negotiating by the interested parties is also small.

3. There are no transaction costs.

4. There are no income or wealth effects.

5. There is no government interference.

Let us take Coase’s famous example of only two parties—a cattle raiser and a
wheat producing farmer. They are operating on neighbourhood properties
without any fencing. The externality is the damage done by cattle roaming on
the unfenced land of the farmer. As the cattle raiser increases the size of the
herd, the damage to the farmer’s crop increases.

According to Coase, property rights should be properly defined and enforced.

First, the farmer has the right that his wheat be not destroyed. Therefore, the
cattle raiser will then be forced to pay damages to the farmer for the crop
destroyed.

These will be added to the marginal costs of the cattle- raiser who will reduce
the number of cattle to be raised to a manageable level. Second, if the law is that
the cattle raiser has no liability for damage done by his herd to the farmer’s
crop, it will now be advisable for the farmer to bribe the cattle raiser to keep his
herd to a minimum level.

The coase theorem is explained with the help of Figure 16.1.

Initially, the condition of raising cattle is Dc = (ARc = MRc). The marginal cost
of raising cattle curve MCc cuts the Dc curve at point Lx and the rancher would
raise OQ1 cattle per year. Therefore, the marginal social cost of wheat is
MSCw1 and a loss to wheat crop is OW 1. If a bribe equal to damage is added to
marginal cost (MCc + OW1) then the optimal solution will be at point L 2 where
(MCc + OW1) curve cuts the Dc curve, and the cattle number will restricted to
OQ2.

According to Coase, market failure due to property rights can be eliminated

through private bargaining among the affected parties. He points out that if
property rights are clearly defined and marketable and transaction costs are
zero, a perfectly competitive economy will allocate resources optimally even
under conditions of externalities.

By transaction costs he means costs of negotiating or enforcing a contract. The

existence of differential transaction costs creates opportunities for one person’s
choice to impact on others. It is property rights that direct and control these
choices.

Second Theorem:
On the other hand, if bargaining becomes costly, then property rights matter
significantly. In the words of Coase, “If bargaining is costly and information is
imperfect, then liability rules help to achieve optimality and the party that has
the least costly way of dealing with the harmful effects of an externality should
be made responsible for paying the costs associated with the externality.” Thus
the second theorem of Coase provides a natural link between economics and
law, offering an efficiency rationale for deciding externality liability rules.

Coase has related his second theorem to the problems caused by the sparks
emitted by coal and wood-power steam engines. The problem is that fires
sometimes caused by the sparks damage nearby agriculture fields. In the
absence of rules governing compensation for firm’s damages, it creates negative
externalities since rail companies have little incentive to prevent sparks.
On the other hand, rail companies may pay full compensation that may leave
property owners with little or no incentive to protect themselves. Is it better for
rail companies to take defensive measures or for farmers to take defensive
measures? Which is done, depends on whether farmers can sue for damages?

The problem of sparks can be solved in the following ways:

(a) Limit the amount of train traffic;

(b) Rail companies should install some type of spark- inhibiting device; or

(c) Farmers should plant their crops several yards further away from the railway
tracks.

There are some Pareto optimal rules that make someone better off without any
change in the welfare position of others. If a stable set of rules is maintained,
most parties stand to gain. Also, there are some efforts involved in coming to an
agreement with another party.

In certain cases, the cost of negotiating the agreement can be more than the
value of the rights to produce. A buyer must pay contractual cost as well as the
cost of the right to the resource use desired. It is not enough merely to know
who owns a particular resource. The example of conflict over airport noise can
be illustrated. Jet airplanes flying low to approach a runway create disutility for
nearby residents and lower the value of their property. The costs faced by the
airlines depends on the character of rights.

If the air space is owned by the airlines, it will be costly for the large number of
residents to organize a bid. But even where the residents have some rights, the
character of the right makes a difference. One alternative is for the residents to
have the right to an injunction, which means that the airlines must deal with
each individual homeowner and obtain permission to fly over. Thus a high
transaction cost is put on the airline which must deal with large numbers and
face the possibility of exhorbitant holdouts.

Significance of Theorems:
Many economists have explained the significance of Coase theorems:
1. Institutional Base:
S. Baker has pointed out many aspects of first Coase theorem which signify a
new area of economics. According to him, the Coase theorem tells us that in a
world with zero transaction costs and well defined property rights institutions
neither foster nor prevent allocative efficiency.

Of course, the importance of this observation rests on the reverse conclusion

that if transaction costs (information costs, bargaining costs, administrative
costs etc.) are significant as in the real world, institutions do matter. Hence,
different institutions will have different impacts on efficiency and distribution,
which, in turn, make comparative institutional analysis indispensable.

2. Need for Policy Measures:

The Coase theorems signify that well defined and marketable property rights
help in promoting economic efficiency. Further, the market mechanism can lead
to a Pareto optimality despite the presence of externalities because it is possible
to devise a private bargaining solution to remove the externalities.

Today, there is general agreement that assigning property rights clearly may
take care of some externality problems, particularly those concerning
environmental problems. They require more active government intervention.
Some forms of this intervention might include regulatory measures, financial
penalties, subsidization of corrective measures and creating a market for
externality.

3. Interdepence of Economics on Law:

According to J. Hirshleifer, given an assignment of proper rights and if there are
no transaction costs, the final outcome will be efficient. It implies that in
addition to removing artificial barriers to transaction costs, the law ought to
assign well defined property rights to all resources of economic value.
Moreover, a free market would redistribute initial legal ownership rights in
efficiency. It is only possible through judicial manner which would facilitate
such transfers.