COASE THEOREM

-AAKSHA SAJNANI
-MUSKAAN DARGAR
RONALD HARRY COASE
(1910 – 2013) WAS A BRITISH
ECONOMIST AND AUTHOR.
HE WAS THE PROFESSOR OF
ECONOMICS AT
THE UNIVERSITY OF
CHICAGO LAW SCHOOL. HE
RECEIVED THE NOBEL
MEMORIAL PRIZE IN
ECONOMIC SCIENCES IN 1991
FOR HIS ARTICLE ON “THE
NATURE OF THE FIRM”.
 Emergence of coase theory: Pigouvian
theory
Over the years, the problem of how to internalize of
external effects is dominated by Pigouvian theory. To
some extent, Coase theory is developed through the
criticisim of Pigouvian theory.
In a very simple way, Pigouvian solution prefer to use
government intervention to solve externality while
Coasean solution prefer to use market method to solve
externality.
 Cont.
Pigou believes that government should impose taxes and subsidies, the
externality problem could be internalized. And such policy is known as
Pigouvian solution, and the tax is called Pigouvian tax.
Pigovian solution has been widely used. In the field of infrastructure, the
policy is who invest who benefits; in the environmental protection, the
policy is who pollute who pay(a.k.a Polluter Pays Principle PPP).
Whereas according to Coase theorem, If the transaction cost is zero, no
matter how the initial definition of property rights is, optimal allocation
of resources can be achieved through market.
Coasian solution shows that even there is a market failure it doesn't
automatically means we should use government intervention.
 THE PROBLEM OF SOCIAL COST
(COASE THEOREM)
➢ The Coase Theorem addresses the question of how
effectively private markets can deal with externalities. In
essence, it states that private parties can solve the problem
of externalities on their own, if they can bargain over the
allocation of resources without cost.
➢ Theorem states that where there is a conflict of property
rights, the involved parties can bargain or negotiate terms
that are more beneficial to both parties than the outcome of
any assigned property rights.
 CONT.
➢ The theorem also asserts that in order for this to occur,
bargaining must be costless; if there are costs associated
with bargaining, such as those relating to meetings or
enforcement, it affects the outcome.
➢ With costless market transactions the decision of the court
concerning liability for damage would be without effect on
the allocation of resources.
 ASSUMPTIONS OF THEOREM

➢ Equal status of bargaining partners

➢ No transaction cost
➢ No income effect
➢ No government interference
 EXAMPLE-1

➢ If a factory pollutes the river, then fishermen are

affected.
➢ Their income is reduced or their health suffers this is
external cost of pollution.
➢ Lets suppose if factory has right to pollute- in such a
situation the fishermen needs to pay to the industry to
reduce pollution or may move to other place.
And if fishermen have right to clean river then the factory
owners needs to compensate the damage caused or can
move to other place and all of which is not economical.
Therefore according to coase this can be achieved through
bargaining by both the parties, without government
regulation.
 Coase shows that ‘least cost’ method can lead to
optimum solution.
 EQUILIBRIUM
➢ In this figure MD is Marginal environmental Damage. It
increases as pollution increases.
➢ Its cost is borne by the fishermen or other victims in terms
of income or health.
➢ MCA = Marginal Abatement Cost. If the firm has to
reduce pollution, it has to spend more on pollution control
measures.
➢ Optimum level of pollution is at X0, where MD=MCA
➢ But if actual pollution is X1 then MCA > MD. The firm
will bargain to reduce the pollution upto X0, paying
compensation to victims= ABE
➢ If actual pollution is X2 then the cost of damage to victim is
GX2.
➢ To make firm reduce pollution up to X0, cost to firm will be
EGH. Victims will pay this amount to firm to reduce
pollution to X0.
➢ Thus pollution level could be optimum through bargaining
by both the parties. Either victim should pay to polluters to
reduce pollution or polluters should pay to victims as
compensation.
 Case- Sturges vs. Bridgman, 11 Ch.D.852(1879)

In this case a confectioner used machinery at a location for

more than 30 years. A doctor than came to occupy
neighbouring premises. The confectioners machinery caused
the doctor no harm until 8 years after he built a consulting
room at the end of his garden right against the confectioners
kitchen it was then found that the noise and vibration caused
by the confectioners machinery made it difficult for the doctor
to use his consulting room.
Cont.
The doctor therefore bought a legal action to force the
confectioner to stop using his machinery. The court's decision
established that the doctor had the right to prevent the
confectioner from using his machinery.
But of course it would have been possible to modify the
arrangements envisaged in the legal ruling by the means of
bargain between the parties.
 LIMITATIONS

➢ Unequal bargaining power

➢ Transaction costs are not zero
THANK YOU