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In: Economics

Discuss whether and how the Coase mechanism (as proposed in the article below and as discussed...

Discuss whether and how the Coase mechanism (as proposed in the article below and as discussed in the lecture) can be useful in reality by providing one real-world example. [Word limit 300] [10 marks]
Coase, R. (1960). The Problem of Social Cost. The Journal of Law and Economics 3: 1-40

Solutions

Expert Solution

Coase Theorem is a legal and economic theory developed by economist Ronald Coase that affirms that where there are complete competitive markets with no transactions costs, an efficient set of inputs and outputs to and from production-optimal distribution will be selected, regardless of how property rights are divided.

  • The Coase Theorem argues that under the right conditions parties to a dispute over property rights will be able to negotiate an economically optimal solution, regardless of the initial distribution of the property rights.
  • The Coase Theorem offers a potentially useful way to think about how to best resolve conflicts between competing business or other economic uses of limited resources.
  • In order for the Coase Theorem to apply fully, the conditions of efficient, competitive markets, and most importantly zero transactions costs, must occur.

Real-world Example-

A business is subject to a noise complaint initiated by neighboring households, the Coase Theorem leads to two possible settlements. The business may choose to offer financial compensation to the affected parties in order to be allowed to continue producing the noise. Or the business might refrain from producing the noise if the neighbors can be induced to pay the business to do so, in order to compensate the business for additional costs or lost revenue associated with noise abatement.

If the full market value produced by the activity that is producing the noise exceeds the market value of the damage that the noise causes to the neighbors, then the efficient market outcome to the dispute is the former. The business can continue to produce the noise, and compensate the neighbors out of the revenue generated thereby, keeping any extra revenue in excess of the damages.

If the value of the business's additional output associated with the offending noise is less than the cost imposed on the neighbors by the noise, then the the efficient outcome is the latter. The neighbors can pay the business enough not to make the noise to compensate for the business's forgone revenue, but less than the value they place on the absence of the noise.

This Coase Theorem has been widely viewed as an argument against legislative or regulatory preemption of conflicts over property rights and privately negotiated settlements thereof.

The problem of social Cost-Coase argued that, except for transaction costs, not only could private deals between voluntary agents always accommodate market failures but that “government failures” (that is, those caused by government intervention) were as deleterious as market failures, if not more so.

In other words, transaction costs were central to the problem of social welfare, and markets were inherently more efficient than any social intervention devised by governments. Up to this point the accepted neoclassical welfare ECONOMICS had promoted perfect competition as the best of all possible economic worlds. This theoretical market structure comprised a world of many small firms whose product prices were determined by the sum of all their output decisions in relation to the independent demand of consumers. This perfect condition, however, depended on increasing returns to scale which allow firms to cut costs as their businesses expand.


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