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What is 'Coase Theorem '

Coase theorem is a legal and economic theory 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 are selected, regardless of how property rights are divided. Further, the Coase theorem asserts that when property rights are involved, parties naturally gravitate toward the most efficient and mutually beneficial outcome.

BREAKING DOWN 'Coase Theorem '

The Coase theorem states that where there is a conflict of property rights, the involved parties can bargain or negotiate terms that are more beneficial to both parties than the outcome of any assigned property rights. The theorem also asserts that in order for this to occur, bargaining must be costless; if there are costs associated with bargaining, such as those relating to meetings or enforcement, it affects the outcome. The Coase theorem shows that where property rights are concerned, involved parties do not necessarily consider how the property rights are granted if they can trade to produce a mutually advantageous outcome.

Coase Theorem and Compensation

Based on the bargaining that occurs during the application of the Coase Theorem, funds may be offered to compensate one party for the other's activities. For example, if a business is subject to a noise complaint initiated by neighboring households or other entities, the business may choose to offer financial compensation to the affected parties if that outcome is considered more favorable to the offending company than alternatives, such as making production changes to lower noise levels, shutting down operations or moving operations to another location.

In this instance, the neighbors of the business benefit from the financial compensation while the business avoids options that may result in higher costs. In order for the full intrinsic value of Coaseā€™s Theorem to apply, the outcome must be discussed and negotiated between the two parties without outside interference.

Additionally, a business may offer preemptive compensation to area residents who may be affected by a nuisance once operations begin. This allows the business to begin negotiations before the full nature of the issue is known, which may strengthen its bargaining position. In exchange for the advance compensation, potentially affected residents must agree to not pursue any legal complaints against the business due to the aforementioned nuisance.

Origins of the Coase Theorem

This theorem was developed by Ronald Coase when considering the regulation of radio frequencies. He posited that regulating frequencies were not required because stations with the most to gain by broadcasting on a particular frequency had an incentive to pay other broadcasters not to interfere.

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