Question

When can the Coase Theorem properly handle a situation where an externality exists? Provide an example.

In what types of situations can the Coase Theorem not properly handle an externality? How can they be addressed instead?

Answer 1

Below are the assumptions under which the Coase Theorem can handle the positive or the negative externality:

- Bargaining cost amongst the parties is low

- Owners of resources can identify the source of damages to their property and legally prevent damanges.

Under these assumption, the socially efficient solution will be achieved independently of who is assigned property rights, as long as someone is assigned those rights.

Example:

Let say Person A and Person B are two neighbors living next to each other. Person A has a plant of mangoes adjacent to Person B's home. The location of the mango tree is such that some part of mangoes fell into the Person B's home. Now, Person B enjoys the benefits in terms of getting mangoes for which he doesn't pay to Person A. This is the problem of Positive externality. Coase Theorem can help here. Some cost can be imposed by Person A on B for using the benefits of mangoes. Such kind of bargaining between A and B can eliminate the externality.

Coase Theorem is ineffective where the property rights are not well established. In the above example, if Person A would not have property rights of mango tree, then he cannot enforce person A to pay a price.

Coase Theorem also doesn't work when there are many parties involved in the transaction. Involvement of multiple parties would make it difficult to ascertain the transaction costs and to identity the property rights.

High Transaction cost is also a reason because of which Coase Theorem fails.

They can be addressed through following solutions:

- Mergers: By combining the involved parties, the damage done by one part will be taken into consideration by the second party.

- Social Conventions

- The imposition of Pigouvian tax and subsidy.

- Government Regulation

- Creation of Markets

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