Coase Theorem
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Ronald Coase, Nobel Prize winning
economist, born 1910, still living!
1937: “The Nature of the Firm”
1960: “The Problem of Social Cost”
Theorem: No problems of social cost would
arise in a world where:
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There is perfect competition
There is complete information
Transactions are costless
Rancher vs. farmer
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Rancher’s cattle stray onto farmer’s land and
damage the crops. What to do?
Six possible solutions
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Put up a fence
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Allow cattle to stray and do damage
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paid for by rancher
paid for by farmer
rancher reimburses farmer for damage
farmer absorbs cost of damage
Rancher stops raising cattle
Farmer stops growing crops
Assumptions
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Numbers (chosen by Coase)
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Damage done by cattle: $90
Fence costs $110
Farmer loses $100 if he doesn’t raise crops
Rancher loses $200 if he doesn’t raise cattle
Two entitlement scenarios
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Farmer is entitled to raise his crops without
damage
Rancher is entitled to raise his cattle irrespective
of damage
Case 1: Farmer is entitled to
raise his crops without damage
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Rancher has to decide what to do
Possible strategies for rancher:
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(1) Allow cattle to roam, pay $90 damages to
farmer
(2) Put up fence, pay $110
(3) Pay farmer $100 not to raise crops
(4) Stop raising cattle, absorb $200 loss
Case 2: rancher is entitled to let
his cattle roam free
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Farmer must decide what to do
Possible strategies for farmer
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(1) Allow cattle to roam, absorb damage: $90
(2) Put up fence: $110
(3) Don’t plant crops, forgo $100 income
(4) Pay rancher not to raise cattle: $200
Conclusion
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Same outcome irrespective of who holds the
legal entitlement
No need of government involvement
(prosecutors, courts) under stated
assumptions:
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There is perfect competition
There is complete information
Transactions are costless
Is justice served? Perhaps not, but total
costs (“social costs”) are minimized
Implications of assumption of
zero transaction costs
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Courts costs are a form of transaction costs
and would not exist. Courts might not even
exist.
Police would not exist
Implications of assumption of
perfect information
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No disputes about entitlements could arise
All contracts would perfectly anticipate all
contingencies
Torts could not happen
What good is the Coase Theorem with
such drastic assumptions?
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It is a counterfactual situation invented just to
clarify the real, factual world
Real world: transacting is always costly, but
reducing transaction costs gets us closer to
efficient outcomes. Law is needed.
Transaction costs can be introduced into the
analysis (Table 4.2)
Coase vs. Pigou
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Example (Friedman)
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Steel mill does $200,000 annual damage to
neighboring property
Steel mill could stop pollution at a cost of
$100,000
Neighbor could shift land use from summer
resort to growing timber at a cost of $50,000
Coase solution
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First possibility: steel mill owner has the right to
pollute.
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Continues to pollute
Neighbor shifts to timber
Cost: $50,000
Coase vs. Pigou
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Coase solution, continued
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Second possibility: neighbor has the right to be
free of pollution.
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Steel owner continues to pollute
Pays neighbor to shift from resort to timber
Cost: $50,000
Pigou solution:
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Government collects a fine equal to the damage
done, $200,000
Steel mill stops polluting, $100,000 damage
eliminated
Net cost $100,000
Coase theorem conclusions
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In the imaginary world of zero transaction
costs
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Negative externality problems are jointly caused
Parties will find the least-cost solution by
negotiation
No formal law is needed, nor any government
action
The final result is the same irrespective of the
initial distribution of property rights
In the real world of positive transaction costs
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Law does matter
We can move toward least-cost solutions
Pollution mitigation
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Suppose three factories emit pollutants in
various quantities and they have varying
mitigation costs
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Factory A emits 15,000 units per month, cleanup
cost $1 per unit
Factory B emits 30,000 units per month, cleanup
cost $2 per unit
Factory C emits 45,000 units per month, cleanup
cost $3 per unit
First approach: EPA prohibits emissions
exceeding 15,000 units per month
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Factory A does nothing
Factory B spends (30,000-15,000)x2 = $30,000
Factory C spends (45,000-15,000)x3 = $90,000
Total cost $120,000, total benefit 45,000 units
Pollution mitigation
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Second solution: EPA requires each factory
to cut its emissions in half
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Factory A: 7,500 units x $1 = $7,500
Factory B: 15,000 units x $2 = $30,000
Factory C: 22,500 units x $3 = $67,500
Total cost $105,000, total benefit 45,000 units
Third solution: EPA requires each factory to
cut its emissions by 15,000 units
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Factory A: 15,000 units x $1 = $15,000
Factory B: 15,000 units x $2 = $30,000
Factory C: 15,000 units x $3 = $45,000
Total cost $90,000, total benefit 45,000 units
Pollution mitigation
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Fourth solution: EPA requires each factory to
cut its emissions in half
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Factory A: 7,500 units x $1 = $7,500
Factory B: 15,000 units x $2 = $30,000
Factory C: 22,500 units x $3 = $67,500
Total cost $105,000, total benefit 45,000 units
Fifth solution: Pigovian tax
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Impose $2.01 unit tax on all factories
Factory A will eliminate all its pollution, cost
$15,000, benefit 15,000 units
Factory B will eliminate all its pollution, cost
$60,000, benefit 30,000 units
Factory C will continue polluting
Total cost $75,000, total benefit 45,000 units
Total benefit to EPA: $90,450
Pollution mitigation
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Sixth solution (Coase): EPA mandates total
pollution reduction, allows factories to trade
pollution rights
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EPA orders factory C to reduce total emissions
by 45,000 units or pay $2.01 fine for each unit by
which they fall short
Factory C is the high-cost avoider of pollution
Factory C will offer factory A $15,000 (plus $100
for their trouble) to eliminate its emissions
Factory C will then offer factory B $60,000 (plus
$100 for their trouble) to eliminate its 30,000
units
Factory C continues polluting
Total cost $75,200 vs. $135,000 to cleanup