7 Answer to Question 2 The Coase theorem, developed by economist Ronald Coase, posits that when property rights are clearly defined and trade is possible at low transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of these rights (McDougall, 2017, Week 2). Though the theorem is said to provide attractive solutions on how the private market can effectively deal with various externality problems, specifically environmentally related problems, this proposition will discuss the contextual issues that can arise with Coasian remedies. Ultimately, this paper will stipulate that the Coase theorem, like any other economic or policy theory has its limitations. Consequently, this paper will discuss the situations where the Coase theorem works well, and the situations where it does not.
In the end, alternatives to the dealing with these negative externalities will be demonstrated to also have legitimacy in the areas where the Coase theorem has its limitations. In order to better understand the Coase theorem, two interrelated economic concepts need to be defined and discussed; Market failures and externalities. These two concepts are vital to understanding Coase’s theory. Market failure refers to a situation which market forces lead to an outcome which specifies an unequal relationship between inputs and outputs (McDougall, 2017, Week 2). Specifically, in the situation, there exists another outcome where an individual may be made better off without making someone else worse off. Externalities are aftereffects of an economic activity, which are experienced by an unassociated third party. An externality can be positive or negative.
Certain externalities, namely negative externalities are identified as a prominent example of a market failure (McDougall, 2017, Week 2). A negative externality is a cost suffered by an unrelated third party as the result of a transaction between the first two parties (McDougall, 2017, Week 2). Coase, in his most influential work “The Problem of Social Cost” found that some production processes create negative externalities for other firms or individuals, and therefore used his views (now a theorem) as a tool to deal with such externalities, specifically environmental externalities (Coase, 1960, 1). For Coase, government intervention was not an optimal fix in these cases concerning environmental externalities. Rather, he found the free market to do a better job of dealing with such issues (Frank, 2011, 86).
In the work, Coase makes two main arguments that reflect his skepticism. Coase’s first argument was concerning property rights and the reciprocal nature of externalities (Frank, 2011, 87). Coase, argued that it did not matter which party was held liable for producing the externalities (ie. pollution). Therefore, what was important for Coase was deliberation between both parties.
Coase illustrated this concept through a cattle farmer analogy. In the analogy, the cattle farmer’s flock is wandering onto the fields of a near-by grain farmer (Coase, 1960, 2). In this case, if the farmer was liable then he would end up paying for the cost of a new fence. However, if the onus was found to be on grain planter, then he too may have to buy a fence. Consequently, the way the property rights are delegated makes little to no difference in a Coasian world the final result for all parties will be same because of the relative costs incurred by both parties. In the end, because the parties share an interest, they would have to compromise (Frank, 2011, 87-88). As a result the value of production for each will be maximized (Coase, 1960, 6). Secondly, Coase argued for negotiations to take place voluntarily, at zero or low transaction costs (Coase, 1960, 15-16).
Transaction costs in the context of externalities, include but are not limited to: the costs of finding who it is one wants to deal with, to inform people of what terms the deal will take place, to reach a bargain, and enforcing the bargain (Coase, 1960, 15) (Jones et al., 2000, 230). Coase, acknowledges in his own work, the many limitations with achieving negotiations at no cost (Frank, 2011, 91).
As a result, he opts for low cost negotiations as an alternative. Coase, at this point acknowledges the ability of firms, and even the government. He found that sometimes, transaction costs are minimized when firms have a role in the negotiation process. For one example, Coase identifies that:within the firm, individual bargains between the various cooperating factors of production are eliminated. In this case, the rearrangement of production takes places without the need of bargains between owners of the factors of production(Coase, 1960, 16). In recent scholarship, Coase’s theorem is referenced quite extensively in relation to environmental policy and environmental economics.
This is because the theorem, and its basic tenets provide a decently explained solution to current environmental externalities (ie. pollution), which has been affecting the global political economy today. Though Coase’s theorem has and continues to be cited by many economists today (Frank, 2011, 89), some may argue that the theory has limitations that become evident in praxis. There are several difficulties associated with the Coase theorem. Namely, there are a few issues with the delegation of property rights and transaction costs. To illustrate these issues we will consider the scenario of a steel firm and a fish farmer.
In this scenario, the steel firm dumps all of its trash into a river which negatively impacts the fish farmers fish. The negative externality, (ie. pollution) effects the river, the fish and those who wish to use the river (Jones et al., 2000, 229-230). Coase discussed property rights as if they are so easy to determine and delegate. In praxis, this is not usually the case. The pollution could involve a large number of people, and not just the steel firm. Therefore, back to the farmer and the steel firm, there could likely be many other people causing the polluted waters.
Additionally, the costs of negotiation and transactions may not be zero, and though Coase addresses this, his alternative of low costs may also not be feasible. The costs of transactions are many, even in the case of one polluter. For example, even organizing negotiation alone may result in high transaction costs. Asymmetric information may also be an issue in negotiation (McDougall, 2017, Week 2) even once it is organized. Specifically, if an individual has more or less information than the other (ex. farmer knows significant amounts more about the fertilizer, than the river user does not). The less informed user will to educate themselves on whatever they do not know. This does not by any chance mean that Coase’s theory does not work.
It is evident from the brief analysis of the theories shortcomings, the situations where the theorem works and is beneficial. For instance, this theory may work well under private law conditions (ie. environmental tort law), where there are only a few parties involved. Therefore, delegating property rights is more efficient, and solutions to these externalities have more of a chance of being achieved. Furthermore, in situations where transaction costs are too high, perhaps government intervention and regulation is needed in order to deal with these externalities. In other words, the Coasian notion of allowing the free market to solve negative externalities may sometimes not be sufficient enough. In these cases, taxing or regulating through public policy may be the only viable alternative to what Coase recommends.
In conclusion, though the theorem prescribes attractive solutions on how the private market can effectively deal with various externality problems, specifically environmentally related problems, those who are supporters of the Coase theorem must acknowledge its limitations and realize that government intervention is sometimes required in order to deal with negative externalities.