LAW AND ECONOMICS END TERM SUMMATIVE ASSESSMENT

COASE THEOREM AND CONTRACT LAW

Submitted to: Assistant professor Saksham Mishra

Submitted By: Husain Bohra

Enrolment No.- 20200401038
Section: A
Batch: 2020-25
TABLE OF CONTENTS
ABSTRACT ........................................................................................................................................... 3
INTRODUCTION................................................................................................................................. 3
COASE THEOREM ............................................................................................................................. 5
1.1 BRIEF HISTORY OF COASE THEOREM............................................................................. 6
1.2 CONDITIONS NECESSARY TO HOLD COASE THEOREM ............................................ 6
CONTRACT LAW IN RELATION TO ECONOMICS .................................................................... 7
COASE THEOREM AND CONTRACT LAW .................................................................................. 7
EXAMPLES OF HOW THE COASE THEOREM AND CONTRACT LAW HAVE BEEN
APPLIED IN THE CONTEXT OF EXTERNALITIES ................................................................... 9
CRITIQUES AND CHALLENGES TO THE COASE THEOREM AND ITS COMPATIBILITY
WITH CONTRACT LAW ................................................................................................................. 10
CONCLUSION ................................................................................................................................... 10
ABSTRACT

This Research paper considers an object which examines the way Coase Theorem meets
contract law in the world of law and economics. Economic thinking is based on transaction
costs and Coase theorem is one of such essential concepts, which determines optimal allocation
of resources. The assumption behind the Coase theorem and its application in contractual
relations. The Coase theory is used in different issues of contract law like contract formation,
breach, enforcement and many others. The paper also looks at some limitations of the Coase
theorem of the contract law such as limitation of knowledge and functions of the laws. To this
end, the author provides a number of case studies demonstrating the implementation of the
Coase theory in real life contract practice scenarios. The Coase theorem is also compared to
the breach contractual theory as well as relational contractual theory in this case. This
sophistication assists in understanding of the Coase theorem and contract law.1

INTRODUCTION

The known Coase theorem has drawn many researchers’ attention for several decades is
formulated by British economist Ronald Coase, which is important concept in the filed of law
and economics and examines how resources should be allocated efficiently when there are
externalities. In establishing ideal results, the theorem highlights the significance of transaction
costs and property rights. The significance of the Coase Theorem extends beyond economic
theory and may be found in other legal fields, such as contract law.

Contract law regulate the interpretation, formation and enforcement of agreements between the
parties It guarantees the security of contractual interactions and offers a framework for people
and corporations to trade. The Coase Theorem provides important insights into how contracts

1
Anthony T. Kronman and Richard A. posner, The Economics of Contract Law, Columbia Law Review
association, Inc., 867-877, 1980.
work and how best to allocate resources within them. It does this by emphasising the reduction
of transaction costs and the strengthening of property rights.2

This paper seeks to explore the relevance and practicality of the Coase theorem to contract law.
It is intended to explain the likely advantages, and downsides of using Coase theorem in
practice with regard to its theoretical premises, and ramifications on contracting relations.

For this reason, the paper is divided into various parts to allow for thorough assessment. The
first part explains what is Coase Theorem, and it gives definitions of relevant terms, as well as
transaction costs and why they matter along with their relationship with property rights. This
section provides a theoretical basis upon which other discussions are premised on. The next
part focuses on the overlap point between the Coase theorem and contract theory. It illustrates
how Coase Theorem could be used in understanding contract formation, enforcement and
breaching. The paper studies how transaction costs and property rights affect negotiations and
performance under contracts.

From the standpoint of contracts law, the third section offers a critical examination of the
shortcomings and objections to the Coase Theorem. This includes problems like insufficient
data, the presence of externalities, the requirement for legal frameworks, and judicial
intervention. The goal of this section is to provide a comprehensive analysis of how the Coase
theorem ought to be applied to a particular contract. Further it offers several case studies where
the Coase Theorem has been used in conjunction with an explanation of how it works in
contract law. These case studies employ the Coase Theorem to examine and resolve contract-
related problems.3

Through the presentation of several case studies, the fourth section shows how the Coase
theorem is effectively useful to contract law. The book's case studies provide concise examples
of how the Coase Theorem is used to analyse and resolve contract disputes.An article that
compares and contrasts the Coase theorem with other contract law ideas makes up the last
section. Furthermore, this study has wider ramifications for the area that contract law theories'
Coase theorem occupies.

2
Steven G. Medema and Richard O. Zerbe, Jr., The Coase Theorem, University of Washington, Graduate
School of Public Affairs,0730,1999.
3
Victor P. Goldberg, 5 The Coase Theorem and some puzzles on the tort/contract boundary, Kluwer Academic
Publishers,1998.
This paper examines the Coase Theorem's application to contract law in an effort to shed more
light on how it works. The paper will use a few chosen real-world examples to illustrate the
various benefits and drawbacks that result from utilising such a declaration in particular
contractual contexts. This paper aims to shed light on the applicability of Coase theorem in
contract law with regard to the underlying mechanisms of Coase Theorem. Nevertheless, this
type of assertion also tends to carry a number of pros and cons that will be discussed based on
a few actual business case studies.4

COASE THEOREM

Property rights are the subject of the Coase Theorem, a legal and economic theory that was
created at the time by economist Ronald Coase. It states that in an efficient input-output market
with zero transaction costs, an optimal course of action is chosen. Basically, this theory states
that there will always be an ideal result when properties are bargained among individuals or
organisations.

When competing property rights exist, the Coase Theorem is applicable. In an ideal
environment, the disputing parties should negotiate and ascertain the true worth of their
property in order to reach an optimal conclusion, according to the Coase Theorem. This only
occurs when the prerequisites—namely, the absence of transaction costs—that are often
assumed in the study of efficient and competitive markets are met. On the other hand, the data
must be symmetric, flawless, and free.5

According to the Coase Theorem, negotiations should be cost-free; if there are expenses
associated with them, such as those for meeting places and enforcement, they will affect the
results. The parties must have equal negotiating strength; neither may be in a position to control
the other so that the settlement's conclusion is not predetermined. In this instance, the Coase
Theorem suggests that, under some circumstances, the interested parties' consideration of
property rights is contingent upon future revenue or rent.

4
supra
5
Patrick W. Schmitz, The Coase Theorem, Private Information, and the Benefits of Not Assigning Property
Rights, Department of Law and Economics, Wirtschaftspolitische Abteilung, University of Bonn, Adenauerallee
24-42, D-53113 Bonn, Germany, 2001.
The Coase Theorem has been used historically to provide a theoretical framework that
challenges the necessity of laws governing disputed issues of property rights ownership and
settlements reached via privity. Ronald Coase first created it as an analytical tool for radio
frequency regulation. He said that since stations having a large stake in broadcasting
frequencies would compensate one another to avoid interfering, there was no need to regulate
frequencies.

1.1 BRIEF HISTORY OF COASE THEOREM

The widely held belief that private property was justified solely by scarcity was subverted by
Ronald Coase's revolutionary theories on property rights. After studying under Sir Arnold
Plant at the London School of Economics, Coase changed the emphasis of property rights from
scarcity to incentives. Coase was greatly influenced by Plant's theories, which emphasized the
economic system's capacity for self-regulation. Coase's LSE years sowed the seeds of his
famous Coase Theorem, which addresses societal costs. A major element was outlined by
Coase in 1959: resource utilization is determined by the highest bidder, regardless of the legal
assignment of property rights. The early opposition to this concept came from Chicago
economists like George Stigler, who opposed the Pigouvian method. Coase faced resistance,
but his perseverance and the conversations that followed helped him gain support and
ultimately shaped his seminal 19606 paper on the issue of social costs. Rather than impeding
Coase, the concerns of the Chicago economists served as a catalyst for the development of his
groundbreaking concepts.

1.2 CONDITIONS NECESSARY TO HOLD COASE THEOREM

In order to be applied in the context of contract law and the resolution of externalities, the
Coase Theorem is predicated on a number of premises. First of all, it presupposes the existence
of two entities—usually referred to as the polluter and the victim—engaged in an externality.
Second, in order for both parties to make educated judgements, it is believed that they are fully
aware of each other's utility functions or production capacities.7 The Coase Theorem also
presupposes the presence of competitive marketplaces with fairly balanced pricing that account
for costs and benefits. The theory also assumes that there are no transaction costs, which means

6
Victor P.goldberg,towards ann expanded theory of contract journal of economics issue, 1976, Vol. 10, No. 1
(Mar., 1976), pp. 45-61
7
Francesco parisi, Coase Theorem,Public choice, 115,2003
that parties can bargain freely without having to pay extra. It also presupposes the existence of
a free legal system, which would allow parties to settle disagreements without incurring any
expenses. The theorem takes into account both predicted utility-maximizing consumers and
profit-maximizing producers. It is envisaged that parties will come to mutually beneficial
agreements in the absence of transaction expenses, and that the distribution of wealth will have
no impact on the negotiations. It is crucial to understand that these presumptions could not
hold true in actual situations, and a number of variables could affect how the Coase Theorem
is used in contract law and how externalities are resolved.8

CONTRACT LAW IN RELATION TO ECONOMICS

A legal framework known as contract law governs the exchange process between parties in an
effort to maximize economic efficiency. Every agreement starts with the desire for both parties
to make money off of the bargain; the difference in the contractants' intensity of preference for
the things they are exchanging is the basis of the joint gain. To instil confidence in potential
contractants that their genuine promissory expectations would be met, the law should penalize
non-performance of contractual commitments. This will encourage people to engage in
negotiations. Furthermore, the law ought to promote contracting by strictly implementing each
agreement in line with the parties' intentions, especially when it comes to how the transaction's
inherent risks are divided. Reducing the "transaction costs9" that are usually incurred during
the bargaining process is contract law's second, independent purpose. Contract law can aid in
the promotion of economic efficiency by lowering these costs, simplifying the exchange of
goods and services, and motivating parties to enter into advantageous transactions.

COASE THEOREM AND CONTRACT LAW

Regardless of how property rights were first allocated, parties may always negotiate an
effective solution in the absence of transaction costs, according to the Coase Theorem. Put
another way, regardless of who originally owns the property rights, parties that are able to

8
Steven G.Medema,The coase theorem in environmental economics,New York university,2011
9
Herbert hovenkamp, Ronald Coase, university of lowa.
negotiate effectively will always be able to come to a decision that optimises their joint profits.
However, transaction costs are frequently prevalent in the real world, which can make it
challenging for parties to negotiate their way to an amicable agreement.

There is where the contract law comes in. A foundation for legislation provided by contract
law can save transaction costs and promote effective negotiation. Contract law can serve to
guarantee that parties are able to depend on the promises made by their counterparts by
enforcing contracts and offering remedies for violation. This can boost the parties' trust in the
negotiation process and lower the possibility of expensive disputes. Contract law may also
assist in lowering the costs of contract negotiation and writing by offering default norms and
standard forms, which can further promote effective bargaining. 10

Contract law and the Coase Theorem play complementary but distinct roles in promoting
efficient transactions. Contract law provides an essential framework that enables parties to
specify terms and deal with externalities during negotiations. Contract law offers means of
enforcement after agreements are made, encouraging responsibility and general effectiveness.
Furthermore, contract law is helpful in providing standardised contracts and effective dispute
resolution, as well as in reducing transaction expenses that may obstruct ideal results. It also
contributes to internalising externalities, making sure that all parties are held accountable for
their deeds. In actuality, these ideas frequently operate in concert. For example, a court may
take the Coase theorem into account when determining culpability for externalities while
simultaneously evaluating the various contract law remedies for reimbursing impacted parties.

The Coase Theorem has also affected how damages are determined in breach situations in
contract law. It is suggested for parties to examine the underlying economic concepts in their
negotiations and conflict resolution. As a result, resources may be allocated more effectively,
and damages may be fairly assessed to both recompense the harmed party and encourage
effective fulfilment of contractual duties.11

10
Frank j. tipler, coase theorem unifies normative and positive economics Tulane university new orleans,
louisinia 70118.
11
Louis Visscher, methodology of law and economics
EXAMPLES OF HOW THE COASE THEOREM AND CONTRACT LAW
HAVE BEEN APPLIED IN THE CONTEXT OF EXTERNALITIES

 THE FACTORY located near a residential area. It is producing air and water pollution
that is externality that is harming the residents of the locality. The Coase theorem
suggests that, with well-defined property rights, the factory owner and the affected
neighbour can negotiate an agreement. The factory owner may offer compensation or
invest in the pollution control measures to reduce the harm caused. By reaching the
agreement through bargain, both the parties can achieve an efficient allocation of
resources, balancing the factory’s production and to taking care of neighbour’s rights
by cleaning the environment.12
 One of the two next-door neighbours wakes up the other person throughout the night
by playing loud music. The loud music neighbour can agree to turn down the sound at
night, or the other neighbour can agree to wear earplugs, or both can agree on a
mutually beneficial solution if there are no transaction costs.
 A factory contaminating a neighbouring river, harming locals living downstream. If
there are no transaction costs, the inhabitants can bargain with the manufacturer to
lessen pollution, or the factory can bargain with the locals to make up for the harm
done.

The Coase Theorem indicates that, in both situations, the ultimate result is unaffected
by the original distribution of property rights (who gets to play loud music or
contaminate the river), provided that there are no transaction costs.13

12
Francesco parisi, coase Theorem, university of minnesta,7,2012
13
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CRITIQUES AND CHALLENGES TO THE COASE THEOREM AND ITS
COMPATIBILITY WITH CONTRACT LAW

In the Coase theorem it is assume that the transaction cost are low and property rights are well
defined but in real life situation it is not possible without government intervention when
transaction cost is high is difficult to negotiate and come to efficient outcome. Likewise, in the
situation where property rights are not well defined then it is difficult to determine who should
be responsible for the cost and benefits of the activity.14

Additionally, it is assumed that parties have proper information and are rational, but they don’t
have so it is difficult for them to negotiate and reach at efficient outcome. In relation to the
contract law the challenge is that we assume that the parties can negotiate and reach and
agreement without the need of contract law. But in reality, contract law paly very important
part in negotiating and enforcement of agreement between the parties.

Furthermore, it also assumes that parties have equal bargaining power it not trues in reality. In
situation where one party has more bargaining power then it is difficult to negotiate and it is
difficult to reach out at efficient outcome.

CONCLUSION

To sum up, this study examined how contract law and the Coase Theorem may be used to
allocate resources and settle disputes. The Coase Theorem provides a theoretical framework
for attaining efficient results in the presence of externalities by emphasising property rights,
bargaining, and the lack of transaction costs. We have observed situations when the Coase
Theorem has been successfully implemented through the analysis of examples, Contractual
agreements and discussions have been crucial in these circumstances in ensuring a more
effective resource allocation and balancing the interests of the parties.

It is imperative to acknowledge the constraints and difficulties linked to the pragmatic

implementation of the Coase Theorem. A number of variables can make negotiations more
difficult and prevent effective results from being achieved, including transaction costs,

14
Stephen craig pirrong, The efficient scope of private transactions -cost reducing institution:the successes and
failures of commodity exchanges, The journal of legal studiesm,24,1995
information gaps, power dynamics, and enforcement concerns. However, contract law and the
Coase Theorem continue to be useful instruments for resolving externalities, encouraging
dialogue, and advancing effective resource allocation. They give parties a framework to think
about property rights, solutions based on the market, and voluntary agreements as ways to settle
disagreements and come to win-win accords.

Future studies in this field might concentrate on figuring out how to get beyond the constraints
and roadblocks that sometimes stand in the way of applying contract law and the Coase
Theorem. Furthermore, research might examine how institutions, economic incentives, and
legal frameworks interact to improve the efficiency of resource allocation and negotiation in
practical contexts.

All things considered, contract law and the Coase Theorem provide helpful guidelines and
insights for settling conflicts, encouraging collaboration, and cultivating effective resource
allocation in a variety of situations. We can keep enhancing and improving our methods for
reaching just and equitable results in contractual agreements and externalities by
comprehending their theoretical underpinnings and evaluating their practical application.