Coase theorem

In practice, numerous complications, including imperfect information and poorly defined property rights, can prevent this optimal Coasean bargaining solution.

In his 1960 paper,[1] Coase specified the ideal conditions under which the theorem could hold and then also argued that real-world transaction costs are rarely low enough to allow for efficient bargaining.

This counterintuitive insight—that the initial imposition of legal entitlement is irrelevant because the parties will eventually reach the same result—is Coase's invariance thesis.

As a result, one normative conclusion sometimes drawn from the Coase theorem is that liability should initially be assigned to the actors for whom avoiding the costs associated with the externality problem are the lowest.

Another, more refined, normative conclusion also often discussed in law and economics is that government should create institutions that minimize transaction costs, so as to allow misallocations of resources to be corrected as cheaply as possible.

When faced with an externality, the same efficient outcome can be reached without any government intervention as long as the following assumptions hold: The Coase Theorem shows that the essence of the market is not price, but property rights.

What Coase initially provided was fuel in the form of “counterintuitive insight”[4] that externalities necessarily involved more than a single party engaged in conflicting activities and must be treated as a reciprocal problem.

[5] In his UCLA dissertation and in subsequent work, Steven N. S. Cheung (1969) coined an extension of the Coase theorem: aside from transaction costs, all institutional forms are capable of achieving the same efficient allocation.

Cattle trample a farmer's fields; a building blocks sunlight to a neighbor's swimming pool; a confectioner disturbs a dentist's patients etc.

In modern tort law, application of economic analysis to assign liability for damages was popularized by Judge Learned Hand of the Second Circuit Court of Appeals in his decision, United States v. Carroll Towing Co. 159 F.2d 169 (2d.

This decision flung open the doors of economic analysis in tort cases, thanks in no small part to Judge Hand's popularity among legal scholars.

These solutions can occur because the positive external benefits are clearly identified and we assume that 1) transaction costs are low; 2) property rights are clearly defined.

Whilst the Coase Theorem remains largely theoretical, a real life example of Coasean bargaining in the negotiations between waterworks and farmers in Denmark was published in 2012.

[8] Some main takeaways from this application of the Coase Theorem were that, the farmers tried to receive over compensation by exploiting their information advantage, which in turn may have resulted in waterworks terminating negotiations.

"[9] What Coase actually argued is, that it is important to always compare alternative institutional arrangements to see which would come closest to "the unattainable ideal of the world of zero transaction costs.

So, a key criticism is that the theorem is almost always inapplicable in economic reality, because real-world transaction costs are rarely low enough to allow for efficient bargaining.

In such situations, say the critics, the transaction costs rise extraordinarily high due to the fundamental difficulties in bargaining with a large number of individuals.

Whether it is the awkwardness of the exchange or the fear of greatly under-valuing someone else's property rights, transaction costs can still be quite high even in the most basic interactions that could make use of the Coase Theorem.

In 2016, Ellingsen and Paltseva[18] modelled contract negotiation games and showed that the only way to avoid the free-rider problem in situations with multiple parties is to enforce mandatory participation such as through the use of court orders.

In 2009, in their seminal JEI article, Hahnel and Sheeran highlight several major misinterpretations and common assumptions, which when accounted for substantially reduce the applicability of Coase's theorem to real world policy and economic problems.

This typically yields a broad range of potential negotiated solutions, making it unlikely that the efficient outcome will be the one selected.

Rather, they are due to fundamental theoretical requirements of Coase's theorem (necessary conditions) that are typically grossly misunderstood, and that when not present systematically eliminate the ability of Coaseian approaches to obtain efficient outcomes—locking in inefficient ones.

Hahnel and Sheeran conclude that it is highly unlikely that conditions required for an efficient Coaseian solution will exist in any real-world economic situations.

[23] Unlike Hahnel and Sheeran, the economist Richard Thaler highlights the importance of behavioral economics in explaining the inability to effectively use the Coase Theorem in practice.

Thaler has also provided experimental evidence for the argument that initial allocations matter, put forth by Duncan Kennedy (as previously noted), among others.

However, when the students were trading property (mugs in this case) that were not directly equivalent to cash, proper Coasean bargaining did not occur as depicted in the adjacent diagram.

[26] This research stems from the common belief within Coasean perspectives that Pigouvian taxation creates distortions and therefore inefficiencies, instead of effectively resolving the problem in question.

In order to examine whether the hypothesis that Coasean bargaining in the presence of a Pigouvian tax is superior to a scenario without taxation, MacKenzie and Ohndorf had to make certain assumptions.

By creating a more realistic environment with how property rights are allocated, MacKenzie and Ohndorf observed that gains from Coasean exchange are reduced by a Pigouvian tax.

Therefore, in summary, MacKenzie and Ohndorf's research provides an economic argument in support of Pigouvian taxation in the case where there is the potential for negotiation.