by In mainstream economic theory, institutions were long taken for granted. As the far-reaching consequences of institutional assumptions have become increasingly difficult to ignore, economists have, in recent times, made greater efforts to incorporate institutions into their models. This renewed interest in broadening economic theory to encompass economic and political institutions has centred on the analysis of property rights and transaction costs. Ronald Coase’s work has played a crucial role in this regard, and his research has provided significant insights not only in welfare economics but also in fields such as law, law and economics, and financial economics. The alternative solution to the problem of externalities known as the Coase theorem will be described below.
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In mainstream economic theory, institutions were long taken for granted. As the far-reaching consequences of institutional assumptions have become increasingly difficult to ignore, economists have, in recent times, made greater efforts to incorporate institutions into their models. This renewed interest in broadening economic theory to encompass economic and political institutions has centred on the analysis of property rights and transaction costs. Ronald Coase’s work has played a crucial role in this regard, and his research has provided significant insights not only in welfare economics but also in fields such as law, law and economics, and financial economics. The alternative solution to the problem of externalities known as the Coase theorem will be described below. Subsequently, theoretical and practical issues with its application to the analysis of public activities will be discussed.
In his now-classic article “The Problem of Social Cost” (Journal of Law and Economics, 1960), Coase aimed to demonstrate that economic models must incorporate positive transaction costs to be relevant. However, discussions have largely revolved around the so-called Coase theorem, which describes a world without transaction costs.
Let us follow Coase’s example and imagine a simple situation where two economic actors are engaged in two different economic activities, where one inflicts uncompensated costs on the other through harmful effects on their production, negative externalities. For example, suppose that farmer Adam and cattle rancher Beda conduct their activities on adjacent lands. Since there is no fence between the properties, Beda’s free-roaming cattle can damage Adam’s crops. The larger the cattle herd, the greater the total damage to the crops.
This situation is often interpreted as an example of market failure, characterized by a difference between private and societal costs/revenues.
The traditional way to solve the problems arising from this divergence is to make the party causing the harm pay (via a tax) an amount corresponding to the costs incurred by the harmed party. Alternatively, one can attempt to achieve an optimal production level by allowing both activities to continue but reorganizing production to take place within a single entity that regulates costs internally. Consequently, it is common to speak of internalizing external costs.
Another way to address the problems is to allow the parties to negotiate how the costs should be borne. This is Coase’s solution. Coase argues that — assuming the price system operates without any costs — the allocation of rights between Adam and Beda is irrelevant to resource allocation.
If Beda is liable for damages, she will include the compensation for damages in her cost calculations and will only increase her herd if the increased production value exceeds the additional costs associated with the increase. Perhaps Beda installs a fence, or she lets the animals roam freely and pays for the damaged crops. The choice depends on what is the most cost-effective option.
It may seem that Beda’s liability for damages could incentivize Adam to cultivate more on the adjacent lands (to gain a better negotiating position). However, according to Coase, the long-term effect is that Adam cultivates less by entering into an agreement with Beda not to cultivate the land. The terms of this agreement will, of course, depend on the skills and bargaining power of both actors. Regardless, the agreement is said to have no effect on resource allocation.
If, on the other hand, Adam is liable for damages, he must try to persuade Beda not to expand her herd, thus increasing the harmful effects. Even though Beda may have an incentive to expand her herd during negotiations and when making agreements to make Adam pay more, such manoeuvres would not affect the long-term equilibrium, which remains the same whether the cattle raiser is responsible or not responsible for the crop damaged by the cattle.
According to Coase, this demonstrates that the final outcome maximizing production value is independent of the allocation of rights if the price system is assumed to function without costs.
The core of market failure problems of the type that Coase discusses lies in the structure of property rights. However, the rights that Coase deals with are somewhat peculiar in some respects. Adam being liable for damages to Beda is equivalent to Adam having to pay Beda not to park her car in his garage. Such rights are rarely seen. Coase engages with them because he is uninterested in who causes the externality, an uninterest that is far from shared by the courts. It should also be noted that Coase only addresses external effects on relationships between producers. If Adam derives his income from corn sales or damages, and Beda derives her income from cattle sales and/or damages, it makes no difference. However, when considering external effects on relationships between producers and consumers, the situation becomes entirely different due to the presence of income and wealth effects. The reason is that the shapes of preference structures are assumed to be different for firms and individuals in a way that invalidates the assumption that the distribution of rights is irrelevant to production outcomes. An example will illustrate this central objection to Coase’s theorem.
A municipal property company wishes to build new housing. To acquire the land, they decide to clear a forest area that the citizens of the municipality use as a recreational area. If the rights to the area are granted to the property company and if the willingness to pay is high enough, negotiations between the property company and the residents of the municipality will take place to determine the exact use of the resource. A negotiated solution is assumed to be reached where, in exchange for a certain payment, half of the current area will be left untouched. The compensation goes to the company, which will use this income in a way that maximizes returns, just like in the case of Adam and Beda mentioned above. However, if the rights are transferred to the citizens, negotiations will once again begin, but it is not possible to a priori predict that the production outcome will be the same as in the case of profit-maximizing companies. This is because individuals’ preference structures are assumed to be such that changes in the overall consumption space affect what and how much an individual chooses to consume. As a result, it is not irrelevant to the production outcome who is allocated the rights. Avoiding payment for the right to use the recreational area may, for example, lead citizens to choose to use the entire area and thus forego the compensation from the property company because they now have a higher potential income than if they were liable for compensation. Furthermore, changes in the rights structure have effects on production in the rest of the economy, as transfers of resources between companies and individuals also result in changes in the demand for all other goods that an individual consumes.
However, Coase argues that the distribution of wealth, given that established rights exist, does not change if the distribution of rights is changed by choosing a different legal rule. Therefore, there are no demand effects to consider. But if liability changes, it will obviously affect the profitability of different activities, and the resulting imbalance will eventually lead to a reallocation of resources, wealth, and demand.
Efficiency is not an absolute but a relative concept. Change the environment, and efficiency changes with it. If not everyone voluntarily agrees to change existing rights, one can always use power to force others to accept new rights against their will. Coase’s argument rests on an unfounded assumption that well-defined property rights are more efficient and therefore more desirable than other forms of rights. Many critics argue that this is wrong. An efficient (Pareto-sanctioned) change is defined in economic literature only if a change in resource allocation results in no one being worse off and someone being better off. But in the choice between different rights structures, one cannot say that one is better than another. They are just different. In the choice between different rights structures, the concept of efficiency is simply not applicable. However, the concept of power is very much relevant.
Coase does not take into account asymmetries in negotiation power, wealth, and the ability to use available resources. Even if a change in the rule of liability will not lead to any change in the distribution of wealth, this gives no indication of the effects of the above-mentioned asymmetries on the conclusion and enforcement of contracts. The stronger party can make a better deal and transfer costs to the weaker party. Therefore, it is not enough to know the original resource distribution.
Markets and economic relationships are always part of a larger social context where norms, rules, and other institutions play a crucial role. Well-defined rights specify who can do what, to whom, and when. Rights give individuals and groups power. This also applies to the special rights we call property rights. Without such socially established and sanctioned rights, neither markets nor society exist.
Coase and his followers have analyzed the effects of these rights, but they have rarely asked where these rights come from and how they are established. This should be done because the establishment of rights involves power. And where power is present, there is always someone who wins and someone who loses. Most major conflicts in history are about how new rights emerge.
The crucial assumption in Coase’s argument is that the price system operates costlessly, or in other words, without transaction costs. These types of costs, which are the costs associated with the activities a market requires — contact, contract, and control — were analyzed by Coase in 1937 in the article “The Nature of the Firm.” They represent the costs for a firm to acquire relevant price information, negotiate and enter into contracts, and monitor contract compliance. While the concept itself may be relatively straightforward, it is much more challenging to apply it within the framework of a useful theory or to imagine precisely what a world without transaction costs would look like. This poses significant problems.
The Coase Theorem relies on the implicit assumption that actors have perfect information, which in most contexts is an unrealistic assumption. In cases involving externalities, it is common for actors to know their own costs but have limited information about the costs of others. Starting from this type of incomplete information, it can be shown that parties typically cannot reach efficient bargaining solutions, and the degree of efficiency depends on who is liable for damages and what negotiation procedure is used.
In Coase’s analysis, it is assumed that — if no transaction costs exist — all potential gains from trade are captured through bargaining in a market, leading to efficiency. The theorem itself does not state that the market mechanism is superior in all circumstances. Rather, what Coase emphasizes is that there is no prima facie reason for collective solutions in the style of Pigou and traditional welfare theory. Externalities do not necessarily indicate market failure. To evaluate the market’s efficiency in dealing with external effects, one must determine under what circumstances the market can be considered an effective way to allocate resources and when it is not. It is likely that when there are many parties involved in the externality relationship, internalization becomes a less viable solution due to the transaction costs outweighing the benefits. In such cases, market transactions will not take place because the losses exceed the gains.
So, the Coase Theorem implies that the market has a great potential to internalize externalities when there are few parties involved and competition prevails in the market. However, the problem is that these two conditions are incompatible in the context in which they are used here. Normally, a large number of actors are expected for a functioning market. But if there are many actors, as we have seen, transaction costs will become too high for the market to solve the externality problem. On the other hand, if there is no competition, there may be issues with unproductive behaviour in negotiation situations.
The difference between Coase and traditional welfare theory largely concerns how the status quo is described, not just the different proposed solutions to the problems. For Coase, the solution of traditional welfare theory, which usually involved using taxation to make social and private costs coincide, was merely replacing one externality with another. For Coase, the problem is symmetrical — granting rights to someone also means taking them away from someone else. It’s about a reallocation through taxation. The debate about these taxes revolves around whether they, in some sense, infringe on someone’s rights unfairly. In the world of traditional welfare theory, it is more or less obvious — even if never explicitly stated — that the one creating the externality (the polluter, emitter) should pay the social costs or refrain from the harmful activity altogether. Coase, on the other hand, always sees the externality situation as a logically symmetric relationship, which becomes especially clear in the Coase Theorem. This is a central point because it means consciously refraining from applying a historical perspective to the question. An externality requires at least two parties, and the question then becomes whose claim for damages should be prioritized. According to Coase, the solution of traditional welfare theory is arbitrary. It is also inefficient because, it is argued, a better solution could be negotiated in the market than through taxes. But is this market solution, which is assumed to minimize transaction costs in a given resource allocation problem, obvious when considering its effects on economic opportunities and distribution? The difference between traditional welfare theory and Coase becomes clearer when the problem is viewed as an issue of how externalities and distributional conflicts arise and evolve over time, rather than as an allocation problem to be solved in a static partial equilibrium situation.
Even though Coase never explicitly states that rights do not matter for income distribution, his focus on the resource allocation problem diverts attention away from distributional issues. Coase argues that the problem of the optimal distribution of income and wealth is partly a question of ethics but because he only deals with the problem of the optimal price system, he assumes that income and wealth distribution is optimal.
But the ethical choice cannot be avoided when proposing a policy measure in the real world. The Pareto principle does not exempt us from the necessity of this, even though Coase attempts to diminish the significance of this choice by focusing on resource allocation rather than income distribution.