Coase theorem
In law and economics, the Coase theorem (/ˈkoʊs/) describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem is significant because, if true, the conclusion is that it is possible for private individuals to make choices that can solve the problem of market externalities. The theorem states that if the provision of a good or service results in an externality and trade in that good or service is possible, then bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property. A key condition for this outcome is that there are sufficiently low transaction costs in the bargaining and exchange process. This 'theorem' is commonly attributed to Nobel Prize laureate Ronald Coase (quotations noting that Coase's theorem is not a theorem in the strict mathematical sense).
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. Hence, the theorem is almost always inapplicable to economic reality but is a useful tool in predicting possible economic outcomes.
The Coase theorem is considered an important basis for most modern economic analyses of government regulation, especially in the case of externalities, and it has been used by jurists and legal scholars to analyze and resolve legal disputes. 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 amount of literature on the Coase theorem and its various interpretations, proofs, and criticism has developed and continues to grow.
Equivalence version[edit]
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. Contracts, extended markets, and corrective taxation are equally capable of internalizing an externality. To be logically correct, some restrictive assumptions are needed. First, spillover effects must be bilateral. This applies to the cases that Coase investigated. 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 each case the source of the externality is matched with a particular victim. It does not apply to pollution generally, since there are typically multiple victims. Equivalence also requires that each institution has equivalent property rights. Victim rights in contract law correspond to victim entitlements in extended markets and to the polluter pays principle in taxation.[6]
Notwithstanding these restrictive assumptions, the equivalence version helps to underscore the Pigouvian fallacies[7] that motivated Coase. Pigouvian taxation is revealed as not the only way to internalize an externality. Market and contractual institutions should also be considered, as well as corrective subsidies. The equivalence theorem also is a springboard for Coase's primary achievement—providing the pillars for the New Institutional Economics. First, the Coasean maximum-value solution becomes a benchmark by which institutions can be compared. And the institutional equivalence result establishes the motive for comparative institutional analysis and suggests the means by which institutions can be compared (according to their respective abilities to economize on transaction costs). The equivalency result also underlies Coase's (1937) proposition that the boundaries of the firm are chosen to minimize transaction costs. Aside from the "marketing costs" of using outside suppliers and the agency costs of central direction inside the firm, whether to put Fisher Body inside or outside of General Motors would have been a matter of indifference.
Application in United States contract and tort law[edit]
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, the Coase theorem 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 the 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 , where is the burden (economic or otherwise) of adequate protection against foreseeable damages, is the probability of damage (or loss) occurring and is 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.
Criticism[edit]
Criticisms of the theorem[edit]
In his later writings, Coase himself expressed frustration that his theorem was often misunderstood. Some mistakenly understood the theorem to mean that markets would always achieve efficient results when transaction costs were low, when in reality his point was almost the exact opposite: because transaction costs are never zero, it cannot be assumed that any institutional arrangement will necessarily be efficient. Others have argued that because transaction costs are never zero it is always appropriate for a government to intervene and regulate, though Coase believed that economists and politicians "tended to over-estimate the advantages which come from governmental regulation."[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."[10]
While most critics find fault with the applicability of the Coase Theorem, a critique of the theorem itself can be found in the 1981 work of the critical legal scholar Duncan Kennedy, who argues that the initial allocation always matters in reality.[11] This is because psychological studies indicate that asking prices often exceed offer prices, due to the so-called endowment effect. Essentially, a person who already has an entitlement is likely to request more to give it up than would a person who started off without the entitlement. The validity of this theoretical critique in practice is addressed in a later section.
An additional critique of the theorem comes from new institutional economist Steven N. S. Cheung who thinks that private property rights are institutions that arise to reduce transaction costs. The existence of private property rights implies that transaction costs are non-zero. If transaction costs are really zero, any property rights system will result in identical and efficient resource allocation, and the assumption of private property rights is not necessary. Therefore, zero transaction costs and private property rights cannot logically coexist.
Lastly, using a game-theoretic model, it has been argued that sometimes it is easier to reach an agreement if the initial property rights are unclear.[12]