18b. The Coase Theorem
Example:
 Lets Say a Steel Mill is producing smoke that is hurting the Laundry Business right next door to the steel
mill.
 Assume that the smoke only hurts the laundry and no other individual or business.
 Assume that the damage to the Laundry is $5 per ton of Steel produced.
So the dispute is taken to Court:
The judge has two possible decisions to make:
1) Steel Mill is Liable: Has to provide Clean Air to Laundry
2) Laundry is Liable: No right to clean air… smoke persists.
Possible Outcomes for whoever is Liable and Cost (in $ per ton of Steel produced)
Steel Mill is Liable
Laundry is Liable
1) Pay Laundry $5/ton
1) Suffer with Smoke $5/ton
2) Install Scrubber (air cleaner) $8/ton
2) Pay Steel Mill for Scrubber $8/ton
3) Steel Mill Moves $10/ton
3) Pay for Steel Mill to Move $10/ton
4) Pay Laundry to Move $20/ton
4) Laundry Moves $20/ton
Note:
 Either way, if smoke persists or not, the cost is the same. So the cheapest option is chosen… which has cost of
$5/ton.
 Conclusion: Judge Does not Matter.
 Definition of Coase Theorem: Liability Doesn’t Matter.
Real Life Scenario of Coase Theorem:
 You Have a Candy Maker Shop and Next to it A Doctor’s Office. (See Figure 18.b.1)
 The Law allows the Candy Maker to Build the Shop Right on the Property Line.
 The Doctor has his Office a couple of feet away from the Property Line.
 The Doctor decides to expand his business by building a New Office, which will allow him to see more
patients. The New Office is expanded to the property line.
 The New Office Will Generate an Additional $30k/year for the Doctor.
 However, he cannot use the office because there is too much noise coming from the Candy Maker who has
a machine right next to the location of the New Office.
 The Doctor can now only use the New Office for Storage, which is only worth $5k/year when used for
storage. Therefore, the Cost for the Doctor is $25k ($30k-$5k).
Property Line
Machine
New Office
CANDY MAKER
DOCTOR'S OFFICE
Figure 18.b.1
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
The Doctor and Candy Maker Settled this Dispute in Court. Whom do you think the Judge Favored?
The Judge went in favor of the Doctor and the Candy Maker Lost. The Candy Maker had to move his
Machine at a Cost of $10k/year.

The reasoning behind the Judges Decision:
o Let us say Joe Hillbilly has a lot in which he builds a home. His property is in the mountains in
the middle of nowhere and he has no neighbors. Therefore, he fires M16 Rifles in his back yard
and uses explosives.
o Then, a person buys a lot next to his property.
o Does Joe Hillbilly still have a right to fire off rifles and use explosives?
o The answer is No. Joe Hillbilly should not have been making noise beyond his property line in the
first place. There were no neighbors to complain about his disruptive noise before. However,
now that there is a neighbor, Joe Hillbilly has to stop the disruptive noise since the neighbor has
the right to complain.
o This same scenario applies to the Doctor and Candy Maker’s case. The Candy Maker is making
noise beyond his property line and as such must seize doing this.
o The Candy Maker was Liable and had to Move his Machine.
Further Analysis:
 The Coase Theory states that Liability Does Not Matter.
 You can flip a coin to see who is liable as cost will be the same anyways for both parties.
 It means that society does not need lawyers and judges in society.
 However, further analysis shows that cost is not the same.
Let us take the First Example of the Steel Mill versus Laundry Shop:

Note: Now assume that the damage to the Laundry is $10 per ton of Steel produced.
Possible Outcomes for whoever is Liable and Cost (in $ per ton of Steel produced)
Steel Mill is Liable
Laundry is Liable
1) Pay Laundry (Assume now $10/ton)
1) Suffer with Smoke $10/ton
2) Install Scrubber (air cleaner) $8/ton
2) Pay Steel Mill for Scrubber $8/ton→$12
3) Steel Mill Moves $10/ton
3) Pay for Steel Mill to Move $10/ton→$15
4) Pay Laundry to Move $20/ton
4) Laundry Moves $20/ton→$25



So now putting a Scrubber would be the cheapest solution at $8/ton.
However, now there is a difference in cost in putting in the scrubber.
o If the Steel Mill Simply puts in a Scrubber, the Cost is $8/ton.
o If the Laundry pays the Steel Mill for the Scrubber, the cost is $12/ton. The increase in price
comes from Negotiation Costs.
o The Negotiation Cost comes from the cost to argue. The steel mill owners will not simply put in a
scrubber willingly if the owners of the two companies are angry at each other. There will be a cost
in time to negotiate. It is easier for the Steel Mill to put in the scrubber than it is for the Laundry
to argue with the Steel Mill to put in the scrubber.
The Steel Mill has the lowest cost and is therefore liable. The Steel Mill is the Lowest Cost Avoider.
Examples of Lowest Cost Avoider:
Cars Driving To the Right
Car A
Car B


Car A hits Car B in an accident. Car A is liable for accident because he could have avoided the accident
more easily. It would be harder for Car B to avoid the accident because he has to drive looking forward.
Therefore, Car A is the Lowest Cost Avoider.
Another Example is Murder. The Murderer is the lowest cost avoider since he could have avoided the
murder more easily than the Victim could.
Summary of Coase Theorem:
1) Equal Avoidance Cost
 Liability does not matter.
2) Unequal Avoidance Costs
 Liability should fall on the least-cost avoider.
Chapter Summary Questions:
1) Coase Theorem States that “Liability Does Not Matter.” Explain this statement.
2) What are negotiation costs?
3) Who is the Lowest Cost Avoider in a murder, the victim or the murderer? Explain.
4) If there is unequal avoidance costs, the least cost avoider should be liable. True or False.
5) If an economy only has equal avoidance cost, would judges be necessary?
Chapter Summary Answers:
1) Liability Does Not Matter because cost is the same no matter which party is liable.
2) Negotiation costs are the costs associated with the cost to argue. In the case of the steel mill and laundry, it
is easier for the steel mill to put in scrubbers than it is for the laundry to argue with the steel mill to put in
the scrubber. The extra effort on the part of the laundry is the negotiation cost.
3) The murderer is the lowest cost avoider since it was easier for him to avoid the murder than it was for the
victim.
4) True
5) No, judges would not be necessary since liability does not matter, as cost would be the same anyways. The
flipping of a coin would decide liability.