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.

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[edit] 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. Of course, the parties themselves would care who was granted the rights initially because this allocation would impact their wealth, but the end result of who broadcasts would not change because the parties would trade to the outcome that was overall most efficient. 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.

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..

[edit] Efficiency and Invariance

Because Ronald Coase himself did not originally intend to set forth any one particular theorem, it has largely been the effort of others who have developed the loose formulation of the Coase theorem. What Coase initially provided was fuel in the form of “counterintuitive insight” [1] that externalities necessarily involved more than a single party engaged in conflicting activities and must be treated as a reciprocal problem. His work explored the relationship between the parties and their conflicting activities and the role of assigned rights/liabilities. While the exact definition of the Coase theorem remains unsettled, there are two issues or claims within the theorem: the results will be efficient and the results in terms of resource allocation will be the same regardless of initial assignments of rights/liabilities.

[edit] Efficiency: the prevailing outcome will be efficient

This portion of the theorem is less controversial and rests on the assumption that the parties involved are rational self-interested actors who seek to maximize their returns from legal rights they possess.

[edit] Invariance: the same conflicting activity will prevail

The invariance claim of the theorem concludes that in the absence of transaction costs, the party engaging in the more valuable conflicting activity will buy the legal right from the other party engaged in conflicting activity. Thus, the ultimate outcome will be the same regardless of the initial assignment of rights with respect to both the rights-holder as well as the allocation of resources.

[edit] 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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.

[edit] 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."

A more recent criticism—by Andrew Halpin—of the Coase Theorem targeted towards the invariance thesis argues that Coase’s fundamental reasoning (and thus any version of the theorem) is flawed. Specifically, Halpin argues that Coase’s invariance thesis, or counterintuitive insight, does not hold up for two reasons. First, Halpin points out, obviously, that initial legal entitlements are in fact relevant where both conflicting activities have the same value, and thus, in the absence of surplus profit for either party, neither party will be able to buy out the other party’s activity and thus the legal entitlement will remain with the party initially enjoying the right. This observation is most likely not a flaw with Coase’s reasoning, however, but rather just an exception to Coase’s theorem.

Halpin’s second flaw in Coase’s invariance thesis is more profound. In Disproving the Coase Theorem, Halpin highlights Coase’s failure to allow for the role alternate activities may play in the parties’ decision making: at some point the parties will consider the possibility of abandoning the conflicting activity for a non-conflicting one or moving and continuing the activity on a non-conflicting site.

As Halpin discusses, the options available to the parties are not so limited: the rational actor facing a liability might realize that his or her gain is maximized not by buying the other party’s rights and continuing the same activity (the value of which becomes diminished by the cost of buying the right), but by pursuing an alternative activity altogether. Such an outcome may arise whenever the value of an alternate activity becomes greater than the value of the conflicting activity less the cost of the right to continue the activity in the face of liability. Halpin points out that in some cases, switching to a non-conflicting activity, or moving, might be more beneficial for a particular party than buying out his neighbor’s legal entitlement so that he may continue with his existing activity. In cases where the new activity has a higher value than the old activity minus the cost of purchasing his neighbor’s entitlements, the initial placement of the legal entailment will determine which activity prevails. If the actor holds the initial entitlement, he will continue with his old activity. If his neighbor holds the initial entitlement and the cost of a buyout is high enough that changing activities altogether is more valuable, the actor will not continue his old activity, but switch to a new activity. Halpin illustrates this reasoning with an example of a doctor working next to a noisy confectioner as in the case Sturges v. Bridgman. Halpin explains that in certain circumstances, the doctor may be better off moving the location of his surgery rather than buying the rights from his noisy neighbor, despite the fact that the doctor may value peace and quiet while operating more than the confectioner values his right to noise pollute. Thus, the allocation of the initial entitlement in this case will affect which activity eventually prevails, thereby disproving Coase’s invariance thesis. Thus, imposition of liability or initial assignment of rights is relevant to the continuation of conflicting activities.

Coase’s response to this criticism came in the form of economic rents—the “amount by which the value of each party’s activity is greater than the next most profitable activity in which he could be engaged.” Coase stated that the consideration of possible alternate activities is encompassed within the rational actor’s choice to engage in the conflicting activity, provided the chosen activity carries with it sufficient rents. Coase then proceeds with the same basic reasoning expanded by way of “expressing the values of both of the conflicting activities in rents, so that all the calculations occur beyond the reach of the value of alternate activities.”

Again Halpin finds error in Coase’s reasoning. Rents is not the only factor involved in the consideration of alternate activities. Rents is activity-specific; even if a party’s chosen activity has enough rents to cover the rents of the conflicting activity, the amount of profit potentially produced by the next-valuable activities on the same land needs to be considered as well. In other words, there may be many combinations of alternate activities that are also conflicting. Coase’s rents fails to recognize that the abandonment of one activity is not the same as the abandonment of all (potentially conflicting) alternate activities on the land. It would be most unlikely that the value of one activity would include enough rents and initial profit that it exceeds the total sum of all other activities on the neighboring land. The rational actor would most likely seek an alternate activity which is non-conflicting when he or she lacks the legal rights. Thus once again, Halpin arrives at a counter-invariance outcome where the imposition of legal rights/liability is relevant.

Having purported to disprove the invariance thesis, Halpin concludes that the efficiency element of the Coase Theorem must also fall away, as the possibility of switching activities altogether affects the total “pie” produced by neighboring lands. Thus, the initial placement of legal entitlements can also affect efficiency levels.

In addition to Halpin’s criticisms, there have been several traditional criticisms of the Coase theorem that have endured for decades. One such criticism centers around the difficulties in reaching efficient agreements in a bilateral monopoly situation. A bilateral monopoly is a situation in which there is only a single buyer and seller of a good. Although the Coase theorem proceeds as if there are no transaction costs, a bilateral monopoly may still prevent efficient bargaining. Specifically, bluffing by both of the parties regarding costs and benefits may lead to an inefficient bargain or cause no bargain to be reached at all. For example, in a situation in which there is an issue as to how many cows a rancher can let roam, both parties may bluff about the values and costs of roaming such that the farmer would agree to only let two cows graze when three would be efficient. Likewise, bluffing could prevent the parties from reaching any agreement at all.

Though the Coase theorem assumes no transaction costs, transaction costs may be completely unavoidable in particular situations, and the Coase theorem as an analytical tool may be far more valuable if transaction costs are recognized . In some situations, the transaction costs of gathering information or bringing parties together may be so substantial that any application of the Coase theorem will be futile. This is not so much a criticism of the elegance of the Coase theorem itself but there are certainly such high transaction cost situations in which the practical value of the Coase theorem is very limited. Guido Calabresi sought to expand the applicability of Coase’s insights by treating market transaction costs as a given and then analyzing the effects of decisions on efficiency. In proceeding with his analysis, Calabresi contends that “transaction costs, no less than existing technology, define what is currently achievable in any society-the Pareto frontier.” Just as it would not make sense to disregard technology and innovation, it would not make sense to disregard transaction costs because they are central in determining output, which in turn relates to efficiency. In sum, the Coase theorem may provide certain basic insights but its assumption of no transaction costs is so far removed from reality that this faulty assumption may prevent the theorem from having much practical significance.

[edit] 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]

[edit] 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).
  • Andrew Halpin, Disproving the Coase Theorem, 23 Econ. & Phil. 321 (2007).
  • 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).

[edit] External links