Coase Theorem
What is Coase Theorem?
The Coase theorem holds that if property rights are clear and bargaining is costless, private parties can negotiate to fix externalities efficiently.
It implies government intervention may be unnecessary when transaction costs are low and rights are well defined. The efficient outcome is reached regardless of who initially holds the rights. In practice, high bargaining costs and many affected parties limit its use.
Coase Theorem: a worked example
A tannery earns 9,000 dollars a month from a process that fouls a river, and the fishery downstream loses 14,000 dollars a month because of it. Stopping the process is efficient, since 14,000 exceeds 9,000. Give the fishery a legal right to clean water: the tannery would have to buy that right for at least 14,000 while gaining only 9,000, so it stops. Now give the tannery the right to discharge: the fishery offers a payment somewhere between 9,000 and 14,000, say 11,000, and the tannery accepts because 11,000 beats the 9,000 it earns by polluting. The process stops under either rule. What changes is money. Under the first rule the fishery avoids the whole 14,000 loss and pays nothing, while under the second it avoids that loss but hands over 11,000, ending 3,000 ahead rather than 14,000 ahead.
The mistake students make with coase theorem
Two readings go wrong fast. The first turns the theorem into a rule that the polluter must stop. Reverse the numbers so the tannery gains more than the fishery loses and the efficient outcome is that the discharge continues, with the fishery either compensated for it or simply unable to raise enough to buy it out. The second reading treats the result as proof that regulation is never needed. Costless bargaining is the assumption carrying the whole argument, and it fails when hundreds of households share the harm, when the polluter cannot be identified, or when every victim would rather free ride on somebody else's negotiation.
Coase Theorem questions
What does the Coase theorem actually claim?
The Coase theorem claims that when rights over a resource are clearly assigned and bargaining is costless, the parties will trade those rights until the efficient outcome is reached, no matter who held them at the start. An externality then survives only where the gain from causing it exceeds the harm it does. Law in that setting exists to define entitlements precisely rather than to dictate quantities, because private negotiation settles the quantity on its own.
Does it matter who receives the property right?
Efficiency does not depend on the assignment, but wealth does. Whoever holds the right either keeps the benefit outright or is paid to give it up, so the loser under one rule becomes the payer under the other. The assignment also affects whether bargaining happens at all, since a scattered group of victims usually finds it much harder to organize and finance a payment than a single firm finds it to write one cheque.
When does the Coase theorem break down?
Bargaining costs are the usual culprit. Many affected parties, difficulty proving who caused the harm, and an incentive to hold out for a larger share all make private negotiation fail. Poorly defined rights break it too, because if nobody legally owns the air above a city there is no entitlement to buy or sell. Those conditions describe most pollution problems, which is why taxes, tradable permits, or standards get used instead of private deals.
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