Coase Theorem

Have you ever had a disturbing neighbor? Maybe a neighbor with unending constructions? This may be unfortunate for most of us. But how can we overcome this situation? Well, in the case of externalities, governments can be helpful in preventing these situations even before they occur, or they can intervene during the time that they are happening. But can we solve these problems without government intervention? According to the Coase theorem, indeed, we can! If you are also interested in these solutions, we advise you to keep reading!

Coase Theorem Coase Theorem

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Table of contents

    Coase Theorem Meaning

    The meaning behind the Coase theorem is heavily related to externalities. Proposed by the Nobel Prize laureate Ronald Coase, the theorem argues that if the government doesn’t intervene in the case of externalities, the problem can still be solved between the parties. According to Ronald Coase, these solutions may be extremely effective.

    The Coase theorem suggests that problems related to externalities can be solved without any government intervention if both parties are willing to bargain in a market with perfect competition conditions, irrelevant to their rights at the beginning.

    We have covered the solutions for externalities provided by the government in detail, don’t hesitate to check it out!

    - Externalities;

    - Externalities and Public Policy.

    Coase Theorem and Externalities

    Coase theorem and externalities are linked with a strong bond. Externalities are direct or indirect consequences of an action on peripheral agents. Externalities can be negative but also positive.

    The most well-known example of a negative externality is the story of the factory and the town. Imagine a factory that disturbs the ecological balance. Due to this ecological imbalance, citizens of the town can not grow crops and keep fishing. This induces a rather negative impact on the citizens of the town.

    On the other hand, externalities can be positive. For example, if someone stops smoking, this decision will also affect the people around them. They will no longer smell cigarettes or continuously be passive smokers. This is a positive externality.

    We can show the externalities with a graph as follows.

    Coase Theorem Graph showing the marginal benefits and costs of an externality StudySmarterFig. 1 - Marginal Benefits and Costs of an Externality

    It is important to notice that the marginal benefit of an externality has a downward slope. On the contrary, the marginal cost of an externality has an upward slope.

    Generally, to prevent negative externalities government can step in and introduce a law that will cover the benefits of both parties. For example, maybe the government can introduce a law that obligates the use of filters for the factory. As an effect, this will improve the environmental conditions. Another well-known solution is the Pigouvian taxes, introduced for the source of the negative externalities to bear the spillover costs.

    However, what if the government stays passive about these externalities? Can both parties solve the problem of externalities? According to the suggestions of the Coase theorem, both parties can still solve this problem with bargaining strategies.

    Imagine your neighbor decided to renew her porch. She hired workers from a construction company, and they began the process. In spite of that, this is an important week for you since you have an exam at the end of the week, and you need a silent environment to study.

    The Coase theorem suggests that you can bargain with your neighbor to prevent this. Let’s assume that your neighbor says she can postpone the construction or completely abandon the project if you pay her. This porch gives her the same utility with $700. Since this exam is pretty important for you, the negative utility or the cost of the noise and construction is equal to $800. If you are willing to pay $700, you can bargain with your neighbor to prevent this. If you give her $700, she will stop the construction, and you can study for your exam in peace!

    Coase Theorem Assumptions

    Assumptions of the Coase theorem are inseparable from the theorem. Without the assumptions, the Coase theorem can not solve the problems regarding externalities. In a detailed manner, we can mention the assumptions as follows.

    • Assumptions of the Coase theorem:
      • Perfect competition: the Coase theorem assumes perfect market conditions where bargaining occurs. This guarantees complete information for both sides.
      • Lack of bargaining or transaction costs: according to the Coase theorem, bargaining doesn’t have any additional costs than the already calculated ones. For example, there shouldn’t be a lawyer that causes additional costs to settle the bargaining between the two parties.
      • Rational agents: this is also a condition for perfect competition. Nonetheless, it is highly important for the Coase theorem and is therefore singled out. Agents must be rational and seek maximum utility.

    Coase Theorem Significance

    The significance of the Coase theorem comes from its main representation of it. One prominent failure of free market economics is externalities. Externalities are a problem that the invisible hand may not be able to solve. The government’s intervention may become necessary to prevent externalities or alter the costs of production. Consequently, this is a problem from the perspective of free market economics. Thus, the Coase theorem tries to solve the problems without the intervention of the government, backing up free market economics.

    However, it is important to note how the assumptions of the Coase theorem can also be its limitations.

    Let’s take a look at these assumptions and discuss why they are necessary. Let’s start with the transaction costs. We can imagine a scenario where your neighbor decides to learn how to play drums. Although she plays them during the day, you do not want to hear your neighbor’s drum practice. You say to yourself, “I would pay $200 a month for her to stop playing drums”. You decided to bring this offer to her, and lucky for you, she is not into drums, and a $200 fixed income seems like a good deal for her. But she is not sure if you will keep your promise. Therefore, she wants to make this an official agreement. Hiring a lawyer for both sides, approval of the papers, and even the papers themselves cost $1000 in total. In total, your cost increases by $1000. Now it seems like it is not a good deal for you. As you can see, transaction costs can prevent the Coase theorem.

    Perfect information for both sides and perfect competition is another important assumption of the Coase theorem. Let us continue with the previous example. If you don’t know your neighbor’s benefit and she doesn’t know the cost of externality that she creates while playing drums, bargaining over a price can be extremely difficult, and surely you can’t decide on an effective bargaining point.

    Finally, agents must be rational since, without this assumption, bargaining may not be possible. For example, in the previous scenario, if $200 is a reasonable amount for your neighbor and if it increases your neighbor’s total utility, she should act accordingly. Nonetheless, if she acts on irrational decisions, bargaining will fail to occur.

    Coase Theorem Limitations

    Limitations of the Coase theorem arise when the theorem meets with real life. There are three main problems in real life related to the theorem.

    Coase Theorem Limitations: Cooperation

    The first problem may arise when one or more parties can’t gather with individual incentives. For example, let’s assume that the noise your neighbor makes affects the whole neighborhood. The communication between multiple neighbors bargaining with one neighbor can be problematic. Gatherings, calculations of the costs, or making sure that everyone pays the same amount of money to that one neighbor to stop the noise. Since externalities generally affect multiple agents, cooperation may be extremely complex.

    Coase Theorem Limitations: Transaction Costs

    The second problem is the existence of transaction costs. Without any hesitation, we can say that transaction costs for bargaining in real life exist. Hiring a lawyer or even ordering documents is costly. Thus, this may increase the costs of the bargaining process, causing both sides to avoid bargaining from the beginning.

    Coase Theorem Limitations: Differing Utilities

    Finally, if both sides know the utility or the cost to the other side, then they may want to ask for greater compensation. For example, if you know that your neighbor gains $700 worth of utility from the porch, and your utility gain if the noise ceases is $900, you may offer $750 to your neighbor to cease the noise. However, even though both of your conditions are met, your neighbor may ask for more since they know that you are willing to pay more. The difference between your utility from ceasing the noise and your neighbor’s gain from the porch may cause disagreements.

    Coase Theorem - Key takeaways

    • The Coase theorem suggests that without government intervention, externalities can be solved if there are no transaction costs.
    • The Coase theorem requires three fundamental conditions. First is for the information to be completely liquid between the two bargaining parties. Secondly, both parties should not have any transaction costs caused by the bargaining process. And finally, agents must be rational and seek to maximize their utility.
    • The Coase theorem has some limitations in the case where parties are too big to cooperate or if the value between the costs of the two parties is high. Furthermore, in real life, transaction costs exist in many bargaining scenarios.
    Frequently Asked Questions about Coase Theorem

    What is the Coase theorem in economics?

    The Coase theorem suggests that problems related to externalities can be solved without any government intervention if both parties are willing to bargain in a market with perfect competition conditions, irrelevant to their rights at the beginning.

    Does the Coase theorem work for positive externalities?

    Technically yes, Coase Theorem would work on positive externalities too. Nonetheless, when it comes to positive externalities, both sides would avoid bargaining until it has become a negative externality.

    Why is Coase theorem important in environmental economics?

    Environmental problems, especially when they are related to pollution due to production, are textbook examples of externalities. From time to time, government and its institutions may fail to respond to these situations. Therefore, the Coase Theorem may become an alternative approach to solving these problems.

    Does Coase theorem assume perfect competition?

    Yes. The Coase Theorem assumes perfect competition. This is the only way to make sure that both sides have the perfect knowledge about the other party. Furthermore, monopolistic firms may have power over the other party with respect to market conditions.

    What are the limitations of Coase theorem?

    Mainly three things will be the obstacles to the Coase Theorem. The first thing is the transaction or bargaining costs. In the real world, transaction costs exist. Hiring a  lawyer or even ordering new documents may be expensive. This may affect parties in a way that they will avoid the bargaining process in the beginning.  Another important limitation of the Coase Theorem is that parties may fail to act collectively within themselves. Even if every agent suffers from externalities, sometimes they can not act cooperatively. Finally, if the gap between one side’s utility and the other side’s cost is high, bargaining may fail.

    Why is the Coase Theorem not always applicable?

    The bargaining process in real life rarely meets the conditions of the Coase Theorem. Thus, the Coase Theorem fails to satisfy its promise due to a lack of perfect competition, perfect knowledge, rational agents, and zero transaction costs.

    Test your knowledge with multiple choice flashcards

    The Coase theorem is a private solution for the problem of externalities.

    Which one of the following suggests a solution for externalities without any government incentives?

    Noise from construction is an example of a negative externality for the neighborhood.


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