The Coase Theorem

Updated Jun 26, 2020

The Coase Theorem (named after the British economist Ronald Coase) is a famous theorem that addresses the question of how effectively private markets can deal with externalities. In essence, it states that private parties can solve the problem of externalities on their own, if they can bargain over the allocation of resources without cost.

Before we start, it is important to note that the Coase Theorem is a theoretical construct. In reality, bargaining always comes at a certain cost (e.g. opportunity costs). However, looking at the theorem will give you a better understanding of why the problem of externalities persists in reality. So let’s get started.

The Problem of Externalities

To understand the reasoning behind the Coase Theorem, we can look at a simple example. Let’s assume a friend of yours plays the piano. She has a piano at home and practices every day. Unfortunately, her neighbor does not like piano music at all. Therefore, your friend’s practicing bothers him. This is a classical example of a negative externality. Now, what should they do about this situation? Should your friend give up playing the piano because of the neighbor’s taste in music? Does he have to get used to her practicing? Or could they come to a compromise?

Weighing Costs and Benefits

From the perspective of society, those questions are difficult to answer just yet. We need some additional information first. So, let’s assume playing the piano is worth USD 100 to your friend. Her neighbor on the other hand values his peaceful silence at about USD 150. In this case, the neighbor can ask your friend to stop playing the piano and compensate her with USD 110 (or any amount between USD 100 and 150) instead. This way, both of them are happy. Your friend is happy because she is compensated adequately for the lack of playing and her neighbor is happy because he ensured his silence for less than he would have been willing to pay. Both parties are better off, so we have an efficient outcome.

At this point it is important to note that we also speak of an efficient outcome if no agreement can be reached. This would be the case for instance if the neighbor valued silence at USD 50 but playing the piano was still worth USD 100 to your friend. In that case, your friend would not accept any of the offers her neighbor would be willing to make. So the current situation is the best possible outcome for both parties, which is considered an efficient outcome.

Distribution of Rights

Until now, we have assumed that your friend has the initial right to play the piano whenever she wants. That’s why her neighbor has to compensate her if he wants her to stop playing. In that sense, he has to buy the “right to play the piano” from her. What if the neighbor had the initial right to enjoy silence instead? In that case, your friend would not be payed to stop playing. Instead she would have to pay the neighbor to be allowed to play in the first place. In other words, she would have to buy the “right to enjoy silence” from him.

As you can see, the initial distribution of rights has a significant effect on the distribution of wealth. If the two parties come to an agreement it will always be the initial owner of the rights who gets paid by the other party for giving up part of those rights. However, please note that the initial distribution of rights does not have any effect on the overall efficiency of the outcome in the end. It does not matter who pays whom, as long as both of them are happy in the end.

Bargaining at no Cost

According to the Coase Theorem, your friend and her neighbor can always bargain until they reach an efficient outcome. However, as mentioned above, this only holds true if we assume that there are no costs associated with bargaining. If we drop the assumption, we might end up with situations where no efficient outcome can be reached, because the costs of bargaining would be higher than its benefits.

To illustrate this, let’s assume your friend values playing the piano at USD 140. Her neighbor might be willing to pay her USD 150 if she stops playing the piano. In that scenario she wins USD 10. What if she could have used the time they spent bargaining to go to work and make USD 20 instead. In that case, she is better off not bargaining so the Coarse Theorem does not hold true anymore.

In a Nutshell

According to the Coase Theorem, private economic actors can solve the problem of externalities among themselves, assuming they can bargain without cost. Regardless of the initial distribution of rights, they can always reach an efficient outcome. However, the initial distribution of rights determines the distribution of wealth.