Illustrate, using numerical values, how the Coase theorem might apply in a world without transaction costs...

Illustrate, using numerical values, how the Coase theorem might apply in a world without transaction costs and Coasean bargaining possible. And state a reason that such a result might not obtain in the real world, and please provide an example. In such case, what could and should the legal system do?

Please explain in detail.

Expert Solution

Coase theorem suggests that if there is a property right defined over a particular resource, then bargaining can result in an efficient outcome. Take for example, a railroad that damages the crop grown by the farmer when it generates sparks as and when it travels along the agricultural field. The loss in the form of damaged crops is worth $3,000 to the farmer. If the railroad install equipment that stops the sparking, it will cost around $4,000.

A farmer has property rights defined and assigned over the agricultural field, the railroad has to compensate the farmer for the loss it is causing in the form of damaging the crops. Otherwise it has to install the equipment. Railroad observes that it is profitable to compensate the farmer by giving him $3,000 and acquiring the right to generate Sparks. Railroad will save $1,000 from this bargain. If the property rights are defined and assigned to the railroad, then the farmer will have to bargain with the railroad in order to persuade it not to damage to the crops. Now the maximum that the farmer can pay is $3,000 so that the railroad install the new equipment. In this case the bargain will fail because the railroad will have to bear a cost of $4,000 to install the equipment while it will be receiving only $3,000 from farmer. Therefore the bargain failed to establish equilibrium in the market.

So we observe that there should be zero transaction cost and a bargaining power present between the two parties besides the proper assignment of property rights. These conditions are necessary for coase theorem to work. In absence of these conditions, the legal system would have to ensure assignment of property rights and elimination of transaction cost for the market to behave efficiently.

Rahul Sunny answered 1 year ago

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