Coase Theorem

Published Jun 25, 2023

Definition of Coase Theorem

The Coase Theorem is a proposition in economics that states that, under certain circumstances, private parties in a market will always reach an efficient outcome, regardless of the initial allocation of property rights. Coase’s thesis is significant as it establishes that in the absence of externalities such as market failures, parties involved will move to a Pareto efficient outcome despite transaction costs.

Example

To understand the Coase theorem, let’s consider the example of pollution. Company A produces a product that results in pollution affecting Company B’s operations. Traditionally, Company B would sue Company A for damages. However, according to the Coase theorem, if there are low transaction costs and defined property rights, the two companies can reach an agreement themselves.

Alternative outcomes could include Company A paying for the damage caused to Company B, or Company B paying Company A to reduce its pollution output. In either of these scenarios, the parties would reach the most achievable efficient outcome by transacting between themselves.

Why Coase Theorem Matters

The Coase Theorem posits that economically efficient outcomes do not require regulation nor enforcement of property rights. Instead, the theorem implies an optimal outcome will emerge based on voluntary exchange and the resolution of conflicting interests. The Coase Theorem highlights the significance of economic transactions in promoting Pareto optimal outcomes in open markets. Additionally, it serves as a key justification for government institutions and policymakers to facilitate transactional markets, ensuring property rights are legally defined and enforced, yet such a conclusion can only be achieved if transaction costs are low.