Coase theorem

 The Coase Theorem is applied when there are conflicting

property rights. The Coase Theorem states that under ideal
economic conditions, where there is a conflict of property rights,
the involved parties can bargain or negotiate terms that will
accurately reflect the full costs and underlying values of
the property rights at issue, resulting in the most efficient
outcome.

 For this to occur, the conditions conventionally assumed in the

analysis of efficient, competitive markets must be in place,
particularly in the absence of transaction costs. The information
must be free, perfect, and symmetrical.

 The Coase Theorem offers a potentially useful way to think

about how to best resolve conflicts between competing
businesses or other economic uses of limited resources.
 For the Coase Theorem to apply fully, the conditions of
efficient, competitive markets, and most importantly zero
transaction costs, must occur.
 In the real world, perfect economic conditions rarely exist,
making the Coase Theorem better suited to explaining why
inefficiencies exist as opposed to a way to resolve disputes.

Understanding the Coase theorem.

 Adam Smith’s fundamental theorem of the Invisible Hand
would fail when resource ownership is defined in such a way
that individuals could not take account of the full benefits or
costs of their actions. This will happen not because the costs or
benefits are not real.
 Instead, in this situation, the costs and benefits would be treated
as incidental or external. A technical term used to describe this
situation is an externality.
 Formally, we define externalities as conditions arising when the
actions of some individuals have direct (negative or positive)
effects on the welfare or utility of other individuals, none of
whom have direct control over that activity. In other words,
 externalities are incidental benefits or costs to others for whom
they are not specifically intended.
 Environmental resources are externality-ridden because they
lack clearly defined property rights.
 Once this is acknowledged, any effort to internalize (remedy)
environmental externalities requires an effective scheme for
assigning property rights.
 This captures the essence of the property rights approach. More
specifically, the approach requires that property rights should be
assigned to one of the parties involved in an environmental
dispute.
 According to Coase (1960), the assignment of property rights
could be completely arbitrary and this would not affect the
outcome of the environmental problem under consideration.
 For example, in the case of environmental pollution, the Coasian
approach suggests that the optimal level of pollution can be
achieved by an arbitrary assignment of property rights to either
the polluter(s) or the polluter(s).
 This proposition that the assignment of property rights to a
specific party does not affect the optimal level of pollution is the
core concept of what is widely known as the Coase theorem.
 To demonstrate the essence of this theorem simply, we shall
use the two familiar firms, the paper mill, and the fish
hatchery.
 An example is represented by a fish hatchery plant that has to
bear the clean-up costs for wastes discharged by a paper mill
located upstream.
 The externality arises from the fact that the owners of the
hatchery plant do not have the legal right to stop the operators of
the paper mill from dumping their industrial wastes in the river.
For that matter, since the river is viewed as common property,
no one can be excluded from using it.
 Non-exclusiveness resulted from the fact that the ownership of
the resource under consideration (the river) was not clearly
defined - that is, it is common property.
 To demonstrate how this problem can be remedied using a
property rights approach, let us start by assuming that the
legal rights to the use of the river belong to the hatchery.
 Given this, the hatchery, if it wishes, could completely deny the
paper mill access to the river. That is, the paper mill would not
be permitted to use the river to discharge its waste.
 In Figure 1, this situation is represented by the origin O, where
the amount of waste emitted into the river from the paper mill is
zero.
 This means that the paper mill has to find an alternative way of
disposing the waste from its current operation - a total of 200
units

Figure 1

 when the waste discharged by the paper mill is less than We

(110 units), we observe that the MCC (the incremental cost of
clean-up for the paper mill using other means than the river) is
greater than the MDC – the incremental damage cost to the
hatchery.
 For example, as shown in Figure (1) for the 70th unit of the
waste that is emitted into the river, the marginal damage cost to
the hatchery is $20. However, to achieve this same result, the
cost to the paper mill is $50. Note that this $50 is the marginal
 control cost of treating (cleaning) the 130th unit of waste (200 -
70).
 Thus, given this situation, the paper mill will have an incentive
to offer a financial bribe to the fish hatchery for the right to use
the river for discharging its industrial waste.
 For example, as shown in Figure (1), to discharge the 70th unit
of waste the paper mill will be willing to pay the hatchery a fee
of between $20 and $50. This should be acceptable to both
parties
 For the hatchery, a payment exceeding $20 more than
compensates for the damage caused to its fish operation from
the dumping of the 70th unit of waste into the river.
 Similarly, this situation should also be advantageous to the
paper mill because the cost of using alternative technology to
dispose of the 70th unit (i.e., to clean up the 130th unit) of waste
to this firm is at least $50.
 In general, then, these two firms will be in a position to engage
in a mutually beneficial transaction provided that, at the point
where the negotiation is taking place, MCC=MDC.
 Furthermore, the negotiation between these two parties ceases
when for the last unit of waste discharged by the paper mill,
MCC =MDC. This is indeed the condition for the optimal level
of pollution. In Figure (1), this is attained at We, or 110 units of
emission.
 The Coase theorem goes beyond the mere recognition of
optimality. It also states that this optimal outcome is completely
independent of the two parties who have rights to the river.
 To demonstrate this, let us now consider the case where the
paper mill has exclusive legal rights to the use of the river.
Under these circumstances the paper mill, if it wishes, can
dispose of all its waste into the river.
 If this strategy is followed, then as shown in Figure (1), the
paper mill will discharge a total of 200 units of waste into the
river.
 However, this company is not limited to this option only. As
shown in Figure (1), for each unit between 110 and 200 units of
waste discharged, the MDC is greater than the MCC.
 This situation will allow the fish hatchery and the paper mill to
engage in a mutually beneficial transaction.
 To see this, let us focus on what happens when the emission is at
140 units. When this unit of waste is discharged, the MDC to the
fish hatchery is $45, but the cost to the paper mill of treating this
same unit is $15.
 Note that the $15 is the marginal cost to the paper mill for
controlling the 60th unit of emission (200-140). Thus, when the
emission level is at 140 units the MDC is greater than the MCC.
 Given this, the hatchery will have an incentive to offer a
financial bribe to the paper mill of anywhere between $15 and
$45 to withhold this unit of waste. It is easy to see that the paper
mill will most likely take this offer seriously since the cost of
controlling the 60th unit of waste (200-140) is only $15.
 Thus, to the extent that the offer of the hatchery exceeds $15,
the paper mill will abide by the wishes of the hatchery. A
similar situation prevails for all the units where the MDC
exceeds the MCC, i.e., between 200 and 110 units.
 Thus, the optimal level of pollution is again reached at We or
110 units, where MDC =MCC. This result verifies the validity
of the Coase theorem.
 In the 1960s, for most economists, the Coase theorem was an
exciting and appealing revelation.
 The profound implication of this theorem has been that
pollution problems can be resolved by an arbitrary assignment
of property rights.
 What is appealing about this is that it reduces the role of public
regulators to a mere assignment of enforceable ownership rights.
Once this is done, as discussed above, the optimal level of
pollution is attained through voluntary negotiation of private
parties-which is consistent with the spirit of the private market.
Weakness of Coasian theorem.

Despite its appeal, however, the Coasian approach has several

weaknesses.

1. First, in our example above, the source of the pollution as well

as the parties involved in the dispute are easily identifiable.
However, in many real-world situations, the sources of the
pollution are likely to be multifaceted and their impacts quite
diffuse. In addition, environmental disputes normally involve
several parties.
2. In a typical real-world situation, then, the cost of negotiation and
enforcement – the transaction cost (the monetary outlays for
specifying, defining, and enforcing property rights) – could be
quite high.
 The high transaction cost could distort the outcome of
an environmental dispute in a rather significant manner.
In such a situation, a resolution reached using the
property rights approach might be far removed from
what is considered to be socially optimal.
 The above consideration would be even more serious
when pollution problems (such as acid rain, global
warming, and ozone depletion) transcend national
boundaries, involve irreversible changes and
considerable uncertainty, and call for a coordinated and
multifaceted response by a large number of nations that
are involved.
3. A property rights approach, especially its Coasian variation,
seems to support the ethos that ‘the end justifies the means.
 As is evident from the above discussion, in this approach
the focus is singularly placed on attaining an optimal
outcome.
 Whether the optimal outcome is attained by assigning
property rights to the polluters or assigning them to the
pollutes is considered entirely irrelevant.
  This seems to be counter to what appears to be the
conventional wisdom – ‘the polluter-pays principle.
4. According to the Coase theorem, the optimal level of pollution
can be achieved irrespective of which party was given the initial
property rights, the polluters or the polluters. However, what the
theorem does not address is the impact the initial assignment of
property rights has on income distribution.

Conclusion
 Under the property rights approach the sole responsibility of the
public authorities is to assign property rights to one of the
parties involved in an environmental dispute.
 Once these steps have been taken, at least theoretically it is
presumed that the interaction of the relevant parties involved in
the dispute will lead to an efficient outcome. In this sense, then,
both liability laws and property rights exemplify a decentralized
approach to pollution control.
 While this may be appealing in some professional circles,
especially among economists, the fact remains that the above
two approaches are of limited use in a real-world situation.
 This is because modern environmental problems are generally
widespread in their scope, varying in their ecological impacts,
and involve a large number of people with varying
socioeconomic circumstances.
 For this reason, one of the most widely used methods of
regulating environmental damages has been based on direct
regulation – a centralized form of pollution control.

Previous year question of UGC NET

1. “Under some conditions, it makes no difference to
efficiency whether the polluter has right to pollute or
the victim has right to clean air” this statement is
related to the work of:
a) G. Hardin
b) R. Coase
c) N. Kaldor
 d) Julian simon
Correct option: R Coase