Coase theorem

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In law and economics, the Coase theorem, attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that when trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasian bargaining.

This theorem, along with his 1937 paper on the nature of the firm which also emphasizes the role of transaction costs, earned Coase the 1991 Nobel Prize in Economics. The Coase theorem is an important basis for most modern economic analyses of government regulation, especially in the case of externalities. George Stigler summarized the resolution of the externality problem in the absence of transaction costs in a 1966 economics textbook in terms of private and social cost, and for the first time called it a "theorem". Since the 1960s, a voluminous literature on the Coase theorem and its various interpretations, proofs, and criticism has developed and continues to grow.

1 The theory
2 Application in United States contract and tort law
3 Criticism
4 Evolutions
5 References
6 External links

The theory

Coase developed his theory when considering the regulation of radio frequencies. competing radio stations could use the same frequencies and would therefore interfere with each others' broadcasts. The problem faced by regulators was how to eliminate interference and allocate frequencies to radio stations efficiently. What Coase proposed in 1959 was that as long as property rights in these frequencies were well defined, it ultimately did not matter if adjacent radio stations interfered with each other by broadcasting in the same frequency band. Furthermore, it did not matter to whom the property rights were granted. His reasoning was that the station able to reap the higher economic gain from broadcasting would have an incentive to pay the other station not to interfere. In the absence of transaction costs, both stations would strike a mutually advantageous deal. It would not matter whether one or the other station had the initial right to broadcast; eventually, the right to broadcast would end up with the party that was able to put it to the most highly valued use.

Coase's main point, clarified in his article 'The Problem of Social Cost', published in 1960 and cited when he was awarded the Nobel Prize in 1991, was that transaction costs, however, could not be neglected, and therefore, the initial allocation of property rights often mattered. As a result, one normative conclusion sometimes drawn from the Coase theorem is that property rights should initially be assigned to the actors gaining the most utility from them. The problem in real life is that nobody knows ex ante the most valued use of a resource and also, that there exists costs involving the reallocation of resources by government. Another, more refined normative conclusion also often discussed in law and economics is that government should create institutions which minimize transaction costs, so as to allow misallocations of resources to be corrected as cheaply as possible.

Application in United States contract and tort law

The Coase Theorem has been used by jurists and legal scholars in the analysis and resolution of disputes involving both contract law and tort law.

In contract law, Coase is often used as a method to evaluate the relative power of the parties during the negotiation and acceptance of a traditional or classical bargained-for contract.

In modern tort law, application of economic analysis to assign liability for damages was popularized by Judge Learned Hand of Second Circuit Court of Appeals in his decision, United States v. Carroll Towing Co. 159 F.2d 169 (2d. Cir. 1947). Judge Hand's holding resolved simply that liability could be determined by applying the formula of B < PL, where B = the burden (economic or otherwise) of adequate protection against foreseeable damages, P = the probability of damage (or loss) occurring and L = the gravity of the resulting injury (loss). 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.

In resultant scholarship using economic models of analysis, prominently including the Coase theorem, theoretical models demonstrated that, when transaction costs are minimized or nonexistent, the legal appropriation of liability diminishes in importance or disappears completely. In other words, parties will arrive at an economically efficient solution that may ignore the legal framework in place.

For example, two property owners own land on a mountain-side. Property Owner #1's land is upstream from Owner #2 and there is significant, damaging run-off from Owner #1's land to Owner #2's land. Four scenarios are considered:

If a cause of action exists (i.e. #2 could sue #1 for damages and win) and the property damage equals $100 while the cost of building a wall to stop the run-off equals $50, the wall will probably exist. Owner #1 will build the wall, or pay Owner #2 between $1 and $50 to tolerate the run-off.
If a cause of action exists and the damage equals $50 while the cost of a wall is $100, the wall will not exist. Owner #2 may sue, win the case and the court will order Owner #1 to pay #2 $50. This is cheaper than actually building the wall. Courts rarely order persons to do or not do actions: they prefer monetary awards.
If a cause of action does not exist, and the damage equals $100 while the cost of the wall equals $50, the wall will exist. Even though #2 cannot win the lawsuit, he or she will still pay #1 some amount between $51 and $99 to build the wall.
If a cause of action does not exist, and the damage equals $50 while the wall will cost $100, the wall will not exist. #2 cannot win the lawsuit and the economic realities of trying to get the wall built are prohibitive.

The Coase theorem considers all four of these outcomes logical because the economic incentives will be stronger than legal incentives. Pure or traditional legal analysis will expect that the wall will exist in both scenarios where #2 has a cause of action and that the wall will never exist if #2 has no cause of action.

Criticism

The main criticism often targeted at the Coase theorem is to say that transaction costs are almost always too high for efficient bargaining to happen. For instance, economist James Meade argued that even in a simple case of a beekeeper's bees dusting a nearby farmer's crops, a coasean bargaining is inefficient. Ronald Coase himself asserts that it would be unrealistic to assume there were no costs in the conduction of market transactions, and that these costs are "often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost." (Coase, 1960 - first paragraph of section V.) On the other hand this isn't really a criticism, since the theorem considers only those situations in which there are no transaction costs. (At least, this is how Coase described the theorem during a 1997 interview. [1])

Another strain of criticism often points out other problems often associated with public goods which manifest in coasean bargainings. In many cases of externalities, the bargaining doesn't happen between two economic factors, but instead the parties might be a single large factory versus a thousand landowners nearby. In such situations, say the critics, not only do transaction costs rise extraordinarily high, but bargaining is hindered by basic prisoner's dilemma problems. For instance property rights might say the landowners must pay the factory to stop polluting, certain landowners might downplay the harm of pollution on them, trying to free ride on the other landowners' wallets.

There is also a Functionalist critique of the Coase Theorem.

Again, new institutional economics and coasean insights into the dynamics of institutions often taken exogenous in neoclassical analysis provides quite a different point of view into how public goods are created. As a counterexample against the neoclassical models' pessimistic views on public goods and collective action, Coase investigated the empirical evidence on lighthouses, perhaps the most common textbook example of a public good. In the article The Lighthouse in Economics, Coase pointed that "contrary to the belief of many economists, a lighthouse service can be provided by private enterprise... [Before the 20th century] The lighthouses were built, operated, financed and owned by private individuals, who could sell a lighthouse or dispose of it by bequest."

Evolutions

A way of stating the Coase's theorem is: “there must be a balance between the costs of the transactions that a company must pay and the opportunity to make everything in house”.^{[citation needed]} This is one of the reasons why, in the past, companies used to grow more and more: it was better to make something in house since the cost of the transaction to buy it was high. In the internet era, Coase's theorem became even more up to date, but under a slightly different version. The concept is the same, but the way of reading it is the opposite. We could say: "the size of a company will decrease until the cost of doing something inside the company will be lower than doing it outside". In other words, since in the internet era the cost of the transactions became very small, as a consequence, the size of the companies is decreasing. An example of this phenomenon is the increasing pace of the outsourcing and off-shoring businesses.^{[citation needed]}

References

Brown, J. "Toward an Economic Theory of Liability." Journal of Legal Studies. 2:323 (1973).
Coase, Ronald H. "The Problem of Social Cost." Journal of Law and Economics. 3 (1960).
Conway v. O'Brien, 111 F.2d 611 (2d Cir. 1940).
Gjerdingen, D. "The Coase Theorem and the Psychology of Common-Law Thought." Southern California Law Review. 56:711 (1983).
Gilles, S. "The Invisible Hand Formula." 80 Virginia L. Rev. 1015 (1994).
Harris, Seth D. "Coase's Paradox and the Inefficiency of Permanent Strike Replacements." Washington University Law Quarterly. 80:1185 (Winter 2002).
Posner, Richard. "A Theory of Negligence." Journal of Legal Studies. 1:29 (1972).
United States v. Carroll Towing Co., 159 F.2d 169.
Wright, R. "Hand, Posner, and the Myth of the Hand Formula." Theoretical Inquires in Law. 4:145 (2003).