Coase Theorem

Updated on April 11, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Coase Theorem? 

Coase theorem states that one can assume an efficient and optimum output following the negotiations between two parties if the external transaction cost between two parties over any property dispute is absent. It shows that every property dispute can have an effective negotiation and the best outcome irrespective of its nature.

Coase Theorem

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Individuals and groups utilize the Coase theorem in formulating market-based and incentive-driven regulatory systems. Many countries followed this theorem to amicably resolve many international environmental problems, like global warming, under the Montreal Protocol. It also advocates for no government intervention in property disputes related to externalities.

Key Takeaways

  • Coase theorem deals with an efficient and optimum solution to a dispute between two parties by assigning property rights.
  • It assumes there won’t be any transaction cost, and contenders will have the equal marketing power and perfect information.
  • This theorem has certain limitations like impossible assumptions of equal bargaining power, zero cost of transactions, equal distribution of resources and incentives, and complete information to both parties.

Coase Theorem Explained

The Coase theorem is an economic and legal theory that addresses dispute resolution between two parties without any transaction cost. It ensures an optimum outcome for both parties, irrespective of its nature. Economist and author Ronald Coase, a British American, promulgated the theorem concerning property rights in 1960 in the field of institutional economics. The theorem tried to explain the impact of government on economic growth. Economists and researchers consider his works a pioneer in property rights and related transaction costs related to Coase theorem econ, for which he received the Nobel Prize for economics in 1991.

Coase theorem is a methodology of handling conflicting property rights or the lack of efficiency owing to externality through providing the property rights over the externality or external cost to one of the contenders so both the parties may negotiate to obtain the best efficient results. The method helps to obtain the best and true economic value by assigning the property rights to the contenders. For example, suppose any negative externality or external cost like air or water pollution by the polluter is present in a situation. In that case, one could only avoid it by allocating property rights so that one can negotiate amicably. 

The theorem assumes that transaction cost in the negotiation will be absent in competitive markets, both parties have complete information, and both have equal marketing power. In the absence of any of these, the theorem is not applicable. 

The greatest use of the theorem is in resolving international environmental disputes like global warming.

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Coase Theorem Graph

One can also explain the Coase theorem environmental economics using the Coase theorem graph as shown below. It shows the dispute between the polluter and the victim of pollution.

Coase Theorem Graph

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As per the above figure, one can observe that when there is a pollution dispute between the producer of the pollutant and the victim, then-

  • Pollutant gets a marginal benefit represented by line ABC.
  • The victim gets a marginal disbenefit, as shown by line OBD.
  • To reduce the pollution, victims will have to pay an amount equal to what the triangle ECB shows.
  • For the Pollutant to continue polluting, it must pay an amount equal to triangle OBE.

Thus, beneficiaries can see that the theorem helps in the amicable resolution of the pollution problem between the polluter and the victim. Moreover, it resolves in an efficient and optimum manner without caring about the nature of the outcome.

Example

As discussed here, the best way to understand the Coase theorem externalities is through the Coase theorem example

Let us assume that there is a factory located near a residential area. It may produce air and water pollution, termed an externality that may harm the residents of the locality.

The residents may find it difficult to live with such environmental pollution and face health hazards. They may fall ill with lung ailments and have to bear a huge health cost. In addition, it may prompt the residents to file a legal suit against the factory. If this happens, the property rights issue between the factory owner and the residents will crop up.

The property dispute may lead to legal or Coase theorem transaction costs for both parties if the court decides that the company can continue operations at the expense of the residents or that the residents have the right to a clean environment. Moreover, suppose the property dispute gets settled without cost between the factory owner and the residents. In that case, the Coase theorem property rights will be applicable, which hypothecates the same.

In short, it is a theorem that presumes that certain negative externalities can be solved within a prescribed condition using the issuance of property rights. For instance, a renter will always try to keep the rented premises safe, sound, and in good condition during his stay in the place. Renter will do so to avoid any penalty from the property owner and create a good reputation to have respect in society.

Limitations Of Coase Theorem

The following points discuss the limitations of the Coase Theorem:

  1. The unreal proposition of equal bargaining between two parties over property disputes makes the bargaining ineffective. As a result, the assumption of effective and efficient negotiation as required by the theorem fails.
  2. Another assumption of Coase theory assumes that transaction cost has to be zero, which is never always possible in the real world. So, it gets limited in the scope of application.
  3. Coase theory states that one equally distributes the income during negotiation over the disputed property. However, in practice, the party with the property ownership gets more of the income from the settlement of the property dispute.
  4. Finally, the Coase theory is limited by the lack of perfect information about both parties involved in a property dispute which hinders its widescale application to real-life situations.

Frequently Asked Questions (FAQs)

When does Coase theorem fail?

Coase theorem fails in cases involving bribery and unequal social and political power. One can stop a harmful action by bribing others, i.e., the bargaining cost is negligible. It may also fail in cases that include the endowment effects. Finally, it fails even if one does not consider its assumptions. For example, the transaction costs will not be absent in many cases.

How does the Coase theorem solve negative externalities?

The Coase theorem solves negative externalities by allocating rights to the property within a stipulated limit. Moreover, the contesting parties over the property can negotiate as per the externality cost instead of the price they would like to pay each other.

What is Coase theorem in economics?

The Coase theorem in economics states that if the conditions are absolute, then any property dispute between two claimants can contemplate such terms and conditions, which gives the best outcome covering the full cost value of the property.

What problems do the Coase theorem address?

The Coase theorem solves the property dispute between two parties arising from negative externalities. It assigns well-defined property rights.

This has been a guide to Coase Theorem and its definition. Here we explain the Coase Theorem using a graph and example and also discuss its limitations. You can learn more from the following articles –

Reader Interactions

Comments

  1. Gapi Joseph says

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  2. Mailess Phiri says

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