Coase Theorem

Coase Theorem and Externalities

Coase theorem and externalities are linked with a strong bond. Externalities are direct or indirect consequences of an action on peripheral agents. Externalities can be negative but also positive.

We can show the externalities with a graph as follows.

Fig. 1 - Marginal Benefits and Costs of an Externality

It is important to notice that the marginal benefit of an externality has a downward slope. On the contrary, the marginal cost of an externality has an upward slope.

Generally, to prevent negative externalities government can step in and introduce a law that will cover the benefits of both parties. For example, maybe the government can introduce a law that obligates the use of filters for the factory. As an effect, this will improve the environmental conditions. Another well-known solution is the Pigouvian taxes, introduced for the source of the negative externalities to bear the spillover costs.

However, what if the government stays passive about these externalities? Can both parties solve the problem of externalities? According to the suggestions of the Coase theorem, both parties can still solve this problem with bargaining strategies.

Coase Theorem Assumptions

Assumptions of the Coase theorem are inseparable from the theorem. Without the assumptions, the Coase theorem can not solve the problems regarding externalities. In a detailed manner, we can mention the assumptions as follows.

• Assumptions of the Coase theorem:
  • Perfect competition: the Coase theorem assumes perfect market conditions where bargaining occurs. This guarantees complete information for both sides.
  • Lack of bargaining or transaction costs: according to the Coase theorem, bargaining doesn’t have any additional costs than the already calculated ones. For example, there shouldn’t be a lawyer that causes additional costs to settle the bargaining between the two parties.
  • Rational agents: this is also a condition for perfect competition. Nonetheless, it is highly important for the Coase theorem and is therefore singled out. Agents must be rational and seek maximum utility.

Coase Theorem Significance

The significance of the Coase theorem comes from its main representation of it. One prominent failure of free market economics is externalities. Externalities are a problem that the invisible hand may not be able to solve. The government’s intervention may become necessary to prevent externalities or alter the costs of production. Consequently, this is a problem from the perspective of free market economics. Thus, the Coase theorem tries to solve the problems without the intervention of the government, backing up free market economics.

However, it is important to note how the assumptions of the Coase theorem can also be its limitations.

Let’s take a look at these assumptions and discuss why they are necessary. Let’s start with the transaction costs. We can imagine a scenario where your neighbor decides to learn how to play drums. Although she plays them during the day, you do not want to hear your neighbor’s drum practice. You say to yourself, “I would pay $200 a month for her to stop playing drums”. You decided to bring this offer to her, and lucky for you, she is not into drums, and a $200 fixed income seems like a good deal for her. But she is not sure if you will keep your promise. Therefore, she wants to make this an official agreement. Hiring a lawyer for both sides, approval of the papers, and even the papers themselves cost $1000 in total. In total, your cost increases by $1000. Now it seems like it is not a good deal for you. As you can see, transaction costs can prevent the Coase theorem.

Perfect information for both sides and perfect competition is another important assumption of the Coase theorem. Let us continue with the previous example. If you don’t know your neighbor’s benefit and she doesn’t know the cost of externality that she creates while playing drums, bargaining over a price can be extremely difficult, and surely you can’t decide on an effective bargaining point.

Finally, agents must be rational since, without this assumption, bargaining may not be possible. For example, in the previous scenario, if $200 is a reasonable amount for your neighbor and if it increases your neighbor’s total utility, she should act accordingly. Nonetheless, if she acts on irrational decisions, bargaining will fail to occur.

Coase Theorem Limitations

Limitations of the Coase theorem arise when the theorem meets with real life. There are three main problems in real life related to the theorem.

Coase Theorem Limitations: Cooperation

The first problem may arise when one or more parties can’t gather with individual incentives. For example, let’s assume that the noise your neighbor makes affects the whole neighborhood. The communication between multiple neighbors bargaining with one neighbor can be problematic. Gatherings, calculations of the costs, or making sure that everyone pays the same amount of money to that one neighbor to stop the noise. Since externalities generally affect multiple agents, cooperation may be extremely complex.

Coase Theorem Limitations: Transaction Costs

The second problem is the existence of transaction costs. Without any hesitation, we can say that transaction costs for bargaining in real life exist. Hiring a lawyer or even ordering documents is costly. Thus, this may increase the costs of the bargaining process, causing both sides to avoid bargaining from the beginning.

Coase Theorem Limitations: Differing Utilities

Finally, if both sides know the utility or the cost to the other side, then they may want to ask for greater compensation. For example, if you know that your neighbor gains $700 worth of utility from the porch, and your utility gain if the noise ceases is $900, you may offer $750 to your neighbor to cease the noise. However, even though both of your conditions are met, your neighbor may ask for more since they know that you are willing to pay more. The difference between your utility from ceasing the noise and your neighbor’s gain from the porch may cause disagreements.