Coase theorem: economic principles and applications

Coase Theorem is a concept developed by Nobel Prize winning economist, Ronald Coase. It revolves around the efficiency in the economic allocation of trade in externalities. The theorem states that if there are negligible transaction costs, then bargaining between conflicting parties will lead to an efficient outcome and allocation regardless of initial allocation of property rights, given that a trade in the externality is possible (Andrew & Schlafly, 2007). Externality is defined as the cost or benefit that arises as a result of an economic activity that may have an impact on an uninvolved third party (Evans, 2011). The uninvolved third party often doesn't choose to incur the cost or benefit, but is a part of the chain as a consequence of the nature of these circumstances. Property rights often relate to the determination of who owns a resource and how it is being used. In economics, property rights are viewed as having the attributes of an economic good. Thus, the rights to the proceeds of the output generated and the control over them is the matter at hand when discussing conflicting property rights.

The legality of the ownership of the resource matters when it comes to property rights. Private property, however, is both excludable and rival. The access, usage and management of private property are controlled by a group of legal owners (O' Driscoll & Hoskins, 2003). Transaction costs are the costs of being in business. The theorem concludes that if the transaction costs of an activity don't overwhelm the gains by it, even with the presence of externalities, social welfare can be maximized through the allocation of resources to their socially efficient uses by way of sale of the property rights. The theorem also suggests that a legal system to regulate externalities is futile without transaction costs.

However, Coase himself argued about the applicability of the theorem in reality due to transaction costs rarely being low enough. None the less, Coase theorem is considered an important economic model and is often used by jurists and regulators in order to resolve disputes and conflicts concerned with externalities. It a strong basis for the analyses of government regulation and how an externality can be internalized.

The theorem is easier to grasp by way of an example. Let us assume that a chemical plant is built next to a lake. Instead of installing a proper waste disposal system, the plant dumps its waste into the lake. The waste disposal equipment costs $1,500 to purchase and maintain per year. The chemical waste dumped in the lake kills the fish and other natural habitat thriving in it. As a result, fishermen who earn their livelihood based on the lake are affected. The presence of the chemical plant is a negative externality on the fishermen.

Coase theorem can aid in the resolution of the matter by way of bargaining between the owners of the chemical plant and the fishermen. According to Coase, the result of their bargains, after taking into consideration the transaction costs involved, will result in the most cost-efficient allocation of property rights of the lake. The matter can of course be taken up in front of a judge for resolution since neither the fishermen nor the chemical plant owns the property rights of the lake. Now, there are two ways in which the judges' decision can work. One is where the property rights of the lake are granted to the chemical plant, i.e. It can continue to dump chemical waste into the lake. It can be assumed that remaining in the market with a polluted lake will lead to a drop in the fishermen's profits by $3,000.

If we assume further that the owners of the plant would allow the fishermen to continue fishing in the lake, given that the profits of the chemical plant are not affected, the ball lands in the fishermen's court. The fishermen must decide whether to remain in the fishing market, and continue to lose $3,000 annually or to purchase the pollution controlling equipment themselves. As the cost of purchasing the equipment is far less than that of purchasing the pollution controlling equipment, the fishermen will opt to do so. The chemical plant owners, since have been allocated property rights to the lake, are not obliged to purchase the equipment. Another direction that the judges' decision can take is to allocate the property rights to the fishermen. If that is the case, then the chemical plant owners are faced with a choice instead. Either compensate the fishermen $3,000 per annum or to purchase the pollution control equipment worth $1,500. The most cost efficient choice for the chemical plant owners would be to purchase the pollution/waste control equipment themselves.