Coase Theorem

The Coase theorem is the proposition that, when property rights are clearly defined and the costs of negotiating are low enough, people affected by an externality will bargain their way to an efficient outcome, and that this outcome does not depend on which party the law initially favours. The initial assignment of rights decides who pays whom, but not how much of the harmful activity takes place.

The idea comes from the British-born economist Ronald Coase's 1960 article "The Problem of Social Cost", published in the Journal of Law and Economics. The label "Coase theorem" was coined by George Stigler a few years later. Coase received the Nobel Prize in economics in 1991, partly for this work. The theorem is a founding text of law and economics and offers an alternative to the tax-based approach to market failure associated with Arthur Pigou.

Suppose two neighbours share a wall. One plays the drums in the evening, and the other works night shifts and needs to sleep. If the rules say the drummer may play, the sleeper can offer to pay for soundproofing. If the rules say the sleeper has a right to quiet, the drummer can pay for soundproofing to be allowed to play. Either way, if soundproofing is the cheapest fix, it gets done.

What changes is who pays. Coase's point was that the neighbours, left to talk it over, can often find the sensible solution themselves, as long as it is clear who has the right to what and talking is not too costly.

Consider a factory whose smoke damages clothes at a neighbouring laundry, causing $300 a year in losses. The factory could fit a filter for $100 a year, or the laundry could install indoor dryers for $150 a year. The cheapest way to avoid the harm is the $100 filter.

• If the law gives the laundry a right to clean air, the factory must stop the damage. It fits the $100 filter rather than paying $300 in damages.
• If the law gives the factory the right to pollute, the laundry is better off paying the factory up to $150 (its next cheapest option) to fit the filter. Any payment between $100 and $150 leaves both better off, so the filter is again installed.

The total cost to society is $100 in both cases, which is the efficient result. Only the distribution differs: in the first case the factory bears the cost, in the second the laundry does. Coase illustrated the same logic with legal cases such as Sturges v Bridgman (1879), in which a doctor's consulting room was disturbed by a confectioner's machinery next door.

Coase himself stressed that the frictionless world of the theorem rarely exists. Transaction costs, meaning the costs of finding the other parties, negotiating, writing contracts and enforcing them, are often large, especially when thousands of people are affected, as with air pollution. When transaction costs are high, the initial assignment of rights and the design of the law matter a great deal, because bargaining will not undo a bad starting point. This insight, also developed in Coase's 1937 paper "The Nature of the Firm", led to the field of transaction-cost economics and to the theory of the firm.

• Emissions trading. Cap-and-trade systems create tradable rights to emit, letting firms that can cut pollution cheaply sell permits to those that cannot. The US Acid Rain Program under the 1990 Clean Air Act Amendments and the EU Emissions Trading System are built on this logic, as an alternative to a Pigouvian tax.
• Radio spectrum. In a 1959 paper Coase argued that the US should sell spectrum rights rather than allocate them administratively; spectrum auctions began in the US in 1994.
• Fisheries and water. Tradable catch quotas and water rights apply the same idea to the tragedy of the commons.
• Contract and tort law. Common-law judges and legal scholars use Coasean reasoning to ask which party could avoid a harm most cheaply.

• Large numbers. With many affected parties, the free-rider problem and holdouts make bargaining impractical, which is why pollution affecting a whole city rarely gets settled privately.
• Information. If one side knows its true costs and the other does not, asymmetric information can block a deal both would have welcomed.
• Wealth and fairness. The assignment of rights changes the distribution of wealth and can widen inequality, which some critics see as a central issue rather than a side detail.
• Behavioural evidence. Experiments by Daniel Kahneman, Jack Knetsch and Richard Thaler found an endowment effect: people demand more to give up a right than they would pay to acquire it, so the initial assignment can affect the final outcome, a finding from behavioural economics.
• Strategic behaviour. In two-party bargaining, each side may hold out for a larger share, so deals can fail even when gains exist, a problem studied in game theory.

Supporters reply that the theorem is best read not as a claim that bargaining always works but as a tool for identifying when it will not, and therefore where legal rules and public policy need to do the work.

• The Nobel Prize: Economic Sciences 1991