Coase Theorem – Definition

Cite this article as:"Coase Theorem – Definition," in The Business Professor, updated December 4, 2019, last accessed October 26, 2020, https://thebusinessprofessor.com/lesson/coase-theorem-definition/.

Back toECONOMIC ANALYSIS & MONETARY POLICY

Coase Theorem Definition

The Coase Theorem is an economic theory that was developed by Ronald Coase. This theory posits that bargaining or negotiation between two parties will lead to an optimal point of allocating a property, regardless of which of the parties holds the property rights. The Coase theorem also maintains that if the rights to a property are clearly defined, an efficient outcome or allocation will be reached when the parties involved negotiating freely and when there are no transaction costs. According to this theorem, a property is eventually allocated to whoever values it most, regardless of who has initial ownership rights over the property.

A Little More on What is Coase’s Theorem

The presence of clear property rights and the absence of transaction costs are the two prevalent criteria in Coase’s Theorem. In Coase’s Theorem, the most favorable allocation of property results from effective negotiation or bargaining.

A good example is the case of a chef and a veterinary doctor lobbying for the same space to carry out their professional work. After considering the pros and cons of the office space, Coase’s theorem posits that space is allocated to whoever values it most. An optimal point of allocation occurs when both parties are able to engage in free negotiation without incurring any transaction costs. In this case, the right to ownership on the property does not matter, rather, the individual with a higher value for the property gets the claim or allocation.

It is important to know that the Coase’s Theorem is no longer applicable to transactions or negotiations that entail high costs.

References for Coase’s Theorem

http://www.businessdictionary.com/definition/Coase-s-theorem.html

https://www.investopedia.com/terms/c/coase-theorem.asp

https://en.wikipedia.org/wiki/Coase_theorem

Academic Research on Coase’s Theorem

The Prisoners’ Dilemma and Coase’s Theorem: A Case for Democracy in Less Developed Countries?, Lipton, M. (1985). Economy and democracy (pp. 49-109). Palgrave Macmillan, London. In a society, there are many cases like; a common resource freely usable, for example, grazing land. Every private herdowner, if short-run net income motivates, adds more herds on the common resource and increases it until additional private return to him (MPR – MPC) from his beasts expansion reduces to 0. But the grazing expansion by every herdowner declines the existing pastures for every grazier, thus their herds’ condition. Shortly, they face the ‘tragedy of the commons’. Every herder, in rationally making expansion of his private claim on grazing, may decline the overall value of other people’s cattle much more as compared to the increase in his own value.

Experimental tests of the endowment effect and the Coase theorem, Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1990). Journal of political Economy, 98(6), 1325-1348. Opposing to theoretical expectations, willingness measures to ‘accept’ largely surpass willingness measures to ‘pay’. This article contains many experiments which show that the endowment effect continues in market settings even, with learning opportunities. In an experiment, consumption objects, such as coffee mugs, are randomly provided with half the subjects. Then, the mugs markets are conducted. As per the prediction of Coase Theorem, almost half of the mugs trade. But, always, the observed volume is considerably less. When we conduct induced value tokens markets, we can observe the predicted volume. The results show that transaction costs cannot elaborate on the consumption goods understanding.

The Coase theorem: Some experimental tests, Hoffman, E., & Spitzer, M. L. (1982). The Journal of Law and Economics, 25(1), 73-98. In the Coase Theorem, Ronald examines the economic effects of liability principles for externalities, when the affected participants start bargaining with each other. A liability rule change leaves the decisions of the agents about production and consumption unchanged. It is an economically efficient framework on the basis of 2 agents, perfect knowledge, competitive markets, 0 transaction cost, no cost court system, no wealth effects, profit-maximizing producers, utility maximizing consumers, agents strike mutually beneficial bargains with no transaction cost. The results show that the Coase Theorem explores the impacts of weakening the assumptions of the model.

Information and the Coase theorem, Farrell, J. (1987). Journal of Economic Perspectives, 1(2), 113-129. The Coase Theorem is significant only if the efficient negotiation is there. The inefficiencies can be regarded as the bargaining imperfection but may be, it is of no use. This paper is based on the reasoned view of an economist. It focuses on the decentralization results and why these are interesting. It presents a mechanism for uncovering private data and states the centralization problem. We can view this theorem as a 2nd best result. The author investigates, are property rights more efficient as compared to some reasonable substitute? Does this theorem suggest an institution or considers institutions unnecessary?

Consumption theory, production theory, and ideology in the Coase theorem, Kelman, M. (1978). S. Cal. L. Rev., 52, 669. The Coase Theorem is a very important legal economic proposition for gaining currency since when the early utilitarians specified the maximum individual satisfaction with the freedom to the consumer from the regulation of the conscious state. The Coase Theorem is, structure wise, simple. We can understand it with the help of a straightforward example. The entitlement problems create whenever 2 parties make interaction, for example, a manufacturer (denoted as P) pollutes a stream. The water consumers (denoted as U) downstream from him. Though water consumers have cleaned the water but for the manufacturer, the polluter polluted it without expensive abatement devices.

The Coase theorem and the empty core: a comment, Coase, R. H. (1981). The Journal of Law and Economics, 24(1), 183-187. This paper provides insights into the debate on the Coase Theorem and the empty core problem. Particularly, the author analyzes the role of transaction costs in this regard. Using the transaction cost structure of Aivazian & Collen, he presents a new type of “transaction Cost concerning the endless bargain. The argument is that under certain assumptions, though the analysis of Aivazian & Callen is true, it may support the Coase intuition about the relationship between the empty core and transaction costs in case of introduction to reputational concerns.

The “Coase Theorem”: A Reexamination—Comment, Jaffe, J. F. (1975). The Quarterly Journal of Economics, 89(4), 660-661. Generally, the economists accept the Coase Theorem as valid with respect to the law economic analysis and theory of externalities. However, the main controversy is that the Coase Theorem has many versions and it defines transaction costs in various ways. Understanding the transaction costs and the model of the competitive market shows that this theorem is not a part of the theory of standard market, so, is invalid. The transaction and information costs originating from market uncertainty resolve several controversies which arise from the Coase Theorem and following that the basic economic function of law is to uprise the transaction costs in bargaining situations.

The cost of Coase, Cooter, R. (1982). The cost of Coase. The Journal of Legal Studies, 11(1), 1-33. This research has been carried out to analyze the cost of Coase and examine the economic theory related to externalities and tradition of the common law about nuisance and torts brought by Ronald in 1960. The author suggests how the generalization should be made applicable, how the externalities can be corrected with the help of liability law, transferable property rights and taxes. Finally, the author highlights the Coase Theorem bargains.

The Coase Theorem, Cooter, R. D. (1989). In Allocation, Information and Markets (pp. 64-70). Palgrave Macmillan, London. The interesting fact is that Coase did not write the Coase Theorem. It was first developed with the help of a set of examples. When Coase judged it, he, in his original article, firmly refused to formulate broad generalizations. As a judge, for each of his paper’s interpretation, there is a reasonable alternative. Rather than arriving at a final answer, the author presents many conventional interpretations of this theorem. He explains them with the help of examples. After more than 20 years of discussion, the conventional interpretations prove to be insufficient.

Does voluntary participation undermine the Coase Theorem?, Dixit, A., & Olson, M. (2000). Journal of public economics, 76(3), 309-335.  This paper is about the Coase Theorem according to which, those voluntary agreements render efficient outcomes that have costless enforcement. The authors pass an argument that old theories could not explain the meaning of the word ‘voluntary’ in this statement. It needs a 2 stage game: a decision of non-cooperative participation following Coaseian bargaining just among those who are willing to participate. The authors explain it with the help of Public Goods Model and find results within the range of extremely inefficient to completely efficient. The efficient algorithm is, however, not robust to minor transaction cost, even. So, the authors are not sure about universal efficiency Coaseian claims. Lastly, they highlight a coercion type which restores efficiency.

The so-called Coase theorem, McCloskey, D. (1998). Eastern Economic Journal, 24(3), 367-371. In this paper, the author states that generally, a man cannot internalize an externality, efficiently, in the transaction costs presence by subsidizing or taxing whoever generates the positive or negative externalities. This is because generally it will not conclude with the right to the resource influenced going to one who values it. The Coase Theorem claims that the reason of desirability of Laissez Faire is not that in case of lower transaction costs, things sort out into place, but also in case of higher transaction costs, it becomes difficult for the government to get the right entitlements. So, people confuse on this ground, the same is with the laissez-faire economists.

Was this article helpful?