Question

1. Using an example of your choice, explain how, despite the Coase Theorum, the allocation of rights can:

1. Affect the distribution of income and
2. Affect market demand for different products

Answer 1

THE COASE THEOREM

Coase's exposition about property rights and their relevance to externality problems is so significant that it has come to be known as the Coase Theorem .This theorem states that proper assignment of property rights to any good,even if externality are present ,will allow bargaining between the affected parties such that an efficient soloution can be obtained ,no matter which party holds the right.Two important underlying assumptions of this theory are noteworthy:

1. Transactions are costless.

2. Damages are accessible and measurable.

To illustrate the Coase Theorem,let's revisit our market model of refined petroleum to see how the assignment of property rights and bargaining can restore efficiency.We impose the assumptions given above and test the theory's prediction by examining the outcome under two different assignments of rights to some hypothetical river.One is that private individuals hold the rights to theriver for recreational use and the other is that refineries hold the rights to release toxic chemicals into the river.

COASE THEOREM

Assignment of property rights,even in the presence of externalities ,will allow bargaining such that an efficient solution can be obtained.

Limitations of the Coase Theorem

Coase's model yields a powerful result and one that underscores the importance of property rights to the market process,regardless of who is assigned those rights.However ,as was stated at the outset ,the model's prediction of an efficient outcome depends on two very limiting assumptions:that transactions are costless and that damages are accessible and measurable.Thus,for the theory to hold in practice ,at minimum,it must be the case that few individuals are involved on each side of the market.

The reality of the refinery market and ,in fact ,of most markets is that there are many affected parties on both sides of the market .Nontrivial costs would be associated with trying to reach a consensus about the bargaining terms within each group even before negotiations could begin.Undoubtedly,legal counsel would be necessary ,adding still more to the transaction costs.Then there is the difficulty of identifying the sources of the damage and assigning a value to that damage.As more parties get involved ,the task becomes increasingly difficult.

The Coase Theorem and Wealth Effects

Another important clause in the coase theorem concerns wealth effects.Bargaining outcome creates wealth for the owner of the property right.If one is endowed with the right that has value ,she is considered rich and in the absence of the right she may be deemed as being poor.There is another spin to the wealth effects argument .For example that if the victim has right to clean air and he receives compensation by selling that right,then this might increase his demand for clean air.Similarly if polluter has the right to pollute,then any money he makes from the bribes to reduce pollution may end up increasing his demand for emissions.Similar to the transactions cost case,the final outcome depends on the initial allocation of property rights.Because the demand for a good depends on income,the existence of the wealth effects would generate differences in the final bargain ,depending upon hoe rights were initially allocated.

Further ,generation of income selling the property right might entire others to want to take advantage as well.With free entry in market ,the assignment of property rights to the firms may induce other polluting firms to enter the market in a lookout for some gains from bargaining .Similarily ,if the property rights are assigned to the victim,then creating wealth through bargaining and sale of property rights might entice new victims to enter the market .The simple version of Coase Theorem assume away entry-by both new firms and new victims .Thus in the presence of transaction costs,it is of importance to know where rights are initially vested . So when rights are initially established by the legal system,it is important to vest rights in those parties that have greatest willingness to pay for those rights.One cannot completely depend on trade to redistribute rights to pollute. Attention should also be paid to reducing the transaction cost associated with trading rights to pollute.