Coase Theorem

Conceptual Overview

Business firms and other economic agents often engage in activities that impose unintended harm on others. Traditionally, economists have assumed that this sort of “externality” causes a market failure that requires government intervention, usually in the form of a tax on the injurer, to restore efficiency. In 1960, however, economist Ronald Coase wrote a path-breaking article that challenged this conventional view of externalities, arguing, not that it was wrong, but that it was incomplete because it relied on certain implicit assumptions that obscured consideration of other possible remedies. These assumptions were, first, that there is a well-defined “cause” of the harm (that is, a clear injurer and victim); and second, that bargaining between the injurer and victim is impossible.

Coase challenged the first assumption by noting that there is no clear cause of externalities because everyone involved (both injurers and victims) is responsible for the harm. To use one of Coase's examples, when a rancher's cattle stray, they will only cause damage if there is a farmer growing crops on nearby land. In this sense, the harm is “reciprocal” in that both the rancher and the farmer must be present for it to occur. Based on this insight, Coase argued that taxing the rancher so that he fences in his herd is not the only way to internalize the externality, and it may not be the best way. Suppose, for example, that it is cheaper for the farmer to fence the cattle out. In that case, a better response might be for the government to do nothing so that the farmer, wishing to minimize his loss, erects the fence. The key point is that identifying the rancher as the sole cause of the harm obscures consideration of alternative solutions.

The second assumption, that bargaining between the parties to an externality is impossible, also affects the choice of a remedy. Suppose the parties can bargain costlessly. Then, regardless of what remedy the government imposes, they will be able to negotiate a different, and more efficient, solution whenever it is jointly advantageous. To illustrate, suppose the government initially imposes a tax on the rancher equal to the farmer's damage. If the rancher can avoid the damage at lowest cost by fencing his cattle in, he will do so and the outcome will be efficient. However, if it is less costly for the farmer to fence the cattle out, the farmer and rancher will negotiate a transaction whereby the rancher will agree to pay the farmer's cost of erecting the fencing. The general statement of this result, that the efficient resolution of an externality will be achieved regardless of the legal assignment of responsibility, provided that bargaining is possible, has become known as the Coase theorem.

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