Question

The Coase Theorem is a name often given to an argument that property rights or liability rules will generally be sufficient to manage what have conventionally been referred to as “external effects” (externalities) efficiently. Describe Coase’s argument, including the reciprocal nature of the problem as he outlined it, and the claim that outcomes will be independent of the allocation of rights/liabilities. Outline some of the limitations to the claim that private bargaining will achieve efficient outcomes.

Answer 1

· Given by the famous Nobel Prize Winner economist Ronald Coase, the “Coase Theorem” provides a market based solution to the externality created by pollution which is negative in nature. It provides a direction in order to deal with problem of tragedy of commons regarding common property resources such as environment.

· The theorem claims, property rights and intervention of governments are unnecessary if parties can negotiate without incurring any type of cost, to solve the problem of any negative externality. It states, if actions of party X harms party Y, then Y can create an incentive for party X in order to reduce its effect or fully stop its actions that creates harm. It assumes that the cost of bargaining between the two parties is excessively low or completely zero.

· Coase gave an example in which a doctor’s daily operations of handling his patients was getting disturbed by the noise of tools and machinery used by a confectioner operating in adjacent building.

- Considering the traditional legal view, the confectioner was liable for the harm to the doctor’s operations and it was supposed to be restrained. But according to Coase, this view did not considered the reciprocal nature of the problem, which was that in order to prevent the noise the confectioner is asked to stop his operations, he too would be harmed.

- As per the traditional view if the problem was taken to court then 2 scenarios could happen either the confectioner could have won or the doctor could have won. In any situation, weather to prevent noise or to keep continuing with the noise one of the party would be surely harmed.

- Coase recognized that the common interest of these two parties is to avoid the larger of these two unpleasant events. He focused on the point that if the confectioner or the doctor are able to negotiate with each other at zero costs, it will lead to the most efficient outcome regardless the confectioner was held liable for creating a negative externality.

- Caoase proposed a scenario, in which the two parties might settle the dispute after the court has taken its decision: (1) If the doctor won the case, then under a market settlement he would be willing to allow the confectioner to continue its operations but the confectioner had to pay the doctor a sum that exceeded the doctor’s total loss income in terms of the cost of moving his clinic or to install any sound abatement machine. (2) If the confectioner won the case, then under a market settlement the confectioner must be willing to receive a payment to stop using the noisy machine, but the sum payment must be greater than his loss of income in terms of cost he had to incur by either shutting down or to install a noise abatement machine.

- Thus the above 2 situations assumes, if the negation or bargaining costs between the two parties are zero, then the parties would achieve the most efficient outcome with the need of allocation of property rights or without intervention of any external authority.

· However the, above theorem would breakdown due to:

(1) Existence of unequal political or social power among the two parties in question.

(2) It would also breakdown if the transactions cost among the two parties are too high – Costs of Identifying damage, Costs of agreeing on damage, Cots of negotiating on settlement or Costs of enforcing payment

(3) If there is no ability to bargain then optimal allocation of resources cannot be done.