Coase Theorem

A Pollution Example

A simple example will illustrate the theorem's mechanisms in action. Consider a situation in which a factory discharges pollution into a stream, causing $1 million in damage to downstream landowners. The [Page 203]polluter can prevent the damage by installing a filtering device at the cost of $600,000, whereas downstream landowners could eliminate the damage at a cost of $300,000. Efficiency clearly dictates that the pollution be eliminated, since the damage is greater than the cost of abatement, and that the optimal way of abating the pollution is for the downstream landowners to undertake the abatement since they can do so at half the cost to the polluter.

Suppose that the landowners file suit against the factory, seeking an injunction against further emissions. Suppose further that the court grants the injunction, thereby assigning the downstream landowners the right to be free from pollution damage. The polluter can abate the pollution at a cost of $600,000. However, recognizing that the downstream landowners can abate the pollution at a cost of $300,000, the polluter will be willing to offer them any amount up to $600,000 to undertake the abatement. The landowners, in turn, will be willing to accept a payment in excess of $300,000 to do so. Thus, in the absence of transaction costs, they will strike a mutually beneficial bargain that results in the landowners undertaking the abatement.

If, on the other hand, the polluter is given the right to pollute, the downstream landowners, faced with a choice between $1 million in damages and abatement costs of $300,000, will chose to abate the pollution. Thus, regardless of the initial assignment of rights, the efficient result—abatement undertaken by downstream landowners—will occur. The distribution of the gains from this exchange may well differ across alternative assignments of rights, as the assignment of rights can affect the relative bargaining power of the two parties. In the above example, the polluter bears the entire $300,000 cost of abatement in the former case, while that cost is borne by the downstream landowners in the latter case.

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