Question

Explain using an example how the Coase Theorem states that by properly assigning property rights will result in an efficient outcome (HINT: I highly recommend that you use a diagram to help explain your answer). What are the two assumptions needed for the Coase theorem to hold?

Answer 1

Meaning: Coase Theorem as given by Sir Ronald Coase states that the parties involved in an economic activity can bargain and reach an efficient outcome without the cost factor involved and by properly assigning property rights.

Example:Consider two parties say a factory and fishermen. Suppose the factory has the property right to dump effluent into the river.

Let us say initially, the profits of both parties are:

Fishermen 's profit=$100

Factory' s profit=$500

As per the rationale of Coase THEOREM, that is, "bargaining without cost" (being installation of a filter by the factory and treatment plant by the fishermen ) resulting in lesser effluent greater output maximizing the joint profit of the factory and the fishermen .By installing a treatment plant, the fishermen can increase their profits to $200. Joint profit without cooperation will be $500+$200=$700.Moreover,the fishermen are willing to pay the factory up to $300 to install a filter-the difference between the $500 profit with a filter and the $200 profit without cooperation. Because the factory loses only $200 in profit by installing a filter, it will be willing to do so because it is more than compensated for its loss without cooperation. In this case, the gain to both parties by cooperating is equal to $100 :the $300 gain to the fishermen less the $200 cost of a filter. Suppose the ffactory and the fishermen agree to split this gain equally by having the fishermen pay the factory $250 to install the filter. This bargaining solution achieves the efficient outcome. Without cooperation, the fishermen earn the profit of $200 and the factory $500. With cooperation, the profit of both increases by $50. Now suppose the fishermen are given the property rights to clean water, which requires the factory to install the filter. The factory earns a profit of $300 and the fishermen $500. Because neither party can be made better off by bargaining, having the factory install the filter is efficient. Hence, proper assignment of property rights will result in an efficient outcome. Following table helps to understand the example in a better way.

NO COOPERATION	RIGHT TO DUMP ($)	RIGHT TO CLEAN WATER ($)
Profit of factory	500	300
Profit of fishermen	200	500
COOPERATION
Profit of factory	550	300
Profit of fishermen	250	500

Assumptions to Coase Theorem:1) Parties bargain without the cost factor involved.

2)Mutual advantage and economic efficiency is the main target.