The Coase Theorem

1 January 2017

The Coase Theorem In “The Problem of Social Cost,” Ronald Coase introduced a different way of thinking about externalities, private property rights and government intervention. The student will briefly discuss how the Coase Theorem, as it would later become known, provides an alternative to government regulation and provision of services and the importance of private property in his theorem. In his book The Economics of Welfare, Arthur C.

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Pigou, a British economist, asserted that the existence of externalities, which are benefits conferred or costs imposed on others that are not taken into account by the person taking the action (innocent bystander? ), is sufficient justification for government intervention. He advocated subsidies for activities that created positive externalities and, when negative externalities existed, he advocated a tax on such activities to discourage them. (The Concise, n. d. ).

He asserted that when negative externalities are present, which indicated a divergence between private cost and social cost, the government had a role to tax and/or regulate activities that caused the externality to align the private cost with the social cost (Djerdingen, 2003, p. 2). He advocated that government regulation can enhance efficiency because it can correct imperfections, called “market failures” (McTeer, n. d. ). In contrast, Ronald Coase challenged the idea that the government had a role in taking action targeted at the person or persons who “caused” the externality.

He believed that government intervention did not necessarily lead to economic efficiency. In fact, it could lead to inefficiency and other/additional externalities. Unlike Pigou’s view of an assigning blame to the person(s) who caused the externality, for Coase, there was reciprocity of harm and that a tort results because, when a conflict arises over resources, all parties can harm each other. In his theorem, Coase states that, assuming no transaction costs, economic efficiency can result regardless of the initial placement of the property rights or legal liability.

In other words, the assignment of property rights does not appear to matter when the goal is economic efficiency. Coase explained that the rights to perform certain actions are what is being traded on the market, not the physical entities. Coase posits that when externalities exist, government inaction increased efficiency because there are “costs” that occur when the government takes action in response to “market failures” (Gjerdingen, n. d. ).

Coase advocated instead that the involved parties voluntarily bargain and negotiate a settlement, in essence internalizing an externality or bringing the social costs and private costs/benefits together (Haworth, n. d. ). If one assumes no transaction costs and no impediments to bargaining, the theorem posits that the terms of the negotiated settlement (allocation of resources) would be the same regardless of initial assignments of property rights because the party or parties with the higher economic gain would have the incentive to pay the party or parties of lesser economic gain (Friedman, n. . )

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