What is Coase Theorem?

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. Further, the Coase Theorem asserts that if conflict arises over property rights under these assumptions, then parties will tend to settle on the efficient set of inputs and output.

Key Takeaways

  • 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.

Coase Theorem

Understanding Coase Theorem

The Coase Theorem states that under ideal economic conditions, where there is a conflict of property rights, the involved parties can bargain or negotiate terms that will accurately reflect the full costs and underlying values of the property rights at issue. In order for this to occur, the conditions conventionally assumed in analysis of efficient, competitive markets must be in place, particularly the absence of transaction costs. Information must be free, perfect, and symmetrical. Bargaining must be costless; if there are costs associated with bargaining, such as those relating to meetings or enforcement, it affects the outcome. Neither party can posses market power relative to the other; bargaining power between the parties must be equal enough that it can not influence the outcome of the settlement. Markets for all final goods and productive factors economically related to the property at issue must be efficient so that the market prices of the property in question can be accurately ascertained. The Coase Theorem shows that, where property rights are concerned, involved parties do not necessarily consider how the property rights are divided up if these conditions apply and they care only about the division of flow of current and future incomes and rents without regard issues such as personal sentiment, social equity, or other non-economic factors.

Application of the Coase Theorem

The Coase Theorem is applied to situations where the economic activities of one party impose a cost on or damage the property of another party. Based on the bargaining that occurs during the application of the Coase Theorem, funds may either be offered to compensate one party for the other's activities or to pay the party who's activity inflicts the damages to forgo that activity.

For example, if 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. It was originally 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.

However, as stated above, in order Coaseā€™s Theorem to apply, conditions for efficient competitive markets around the disputed property must occur. If not, the efficient solution is unlikely to be reached. These assumptions: zero transaction (bargaining) costs, perfect information, no market power differences, and efficient markets for all related goods and productive factors, are obviously a high hurdle to pass in the real world, where transaction costs are ubiquitous, information is never perfect, market power is the norm, and most markets for final goods and productive factors do not meet the requirements for perfect competitive efficiency.

Because the conditions necessary for the Coase Theorem to apply in real world disputes over the distribution of property rights virtually never occur outside of idealized economic models, some question its relevance to applied questions of law and economics. Recognizing these real world difficulties with applying the Coase Theorem, some economists view the theorem not as a prescription for how disputes ought to be resolved, but as an explanation for why so many apparently inefficient outcomes to economic disputes can be found in the real world.