Coase Theorem: What It Means in Economics and Law, With Examples

What Is the Coase Theorem?

The Coase Theorem is a legal and economic theory developed by economist Ronald Coase regarding property rights, which states that where there are complete competitive markets with no transaction costs and an efficient set of inputs and outputs, an optimal decision will be selected.

It basically asserts that bargaining between individuals or groups related to property rights will lead to an optimal and efficient outcome, no matter what that outcome is.

Understanding the Coase Theorem

The Coase Theorem is applied when there are conflicting property rights. The Coase Theorem states that under ideal economic conditions, where there is a conflict of property rights, the involved parties can bargain or negotiate terms that will accurately reflect the full costs and underlying values of the property rights at issue, resulting in the most efficient outcome.

For this to occur, the conditions conventionally assumed in the analysis of efficient, competitive markets must be in place, particularly the absence of transaction costs. The information must be free, perfect, and symmetrical.

One of the tenets of the Coase Theorem is that bargaining must be costless; if there are costs associated with bargaining, such as those relating to meetings or enforcement, it affects the outcome. Neither party can possess market power relative to the other so that bargaining power between the parties can be equal enough that it does not influence the outcome of the settlement.

The Coase Theorem shows that where property rights are concerned, involved parties do not necessarily consider how the property rights are divided up if these conditions apply and that they care only about current and future income and rent without regard to issues such as personal sentiment, social equity, or other noneconomic factors.

The Coase Theorem has been widely viewed as an argument against the legislative or regulatory intervention of conflicts over property rights and privately negotiated settlements thereof. It was originally developed by Ronald Coase when considering the regulation of radio frequencies. He posited that regulating frequencies was not required because stations with the most to gain by broadcasting on a particular frequency had an incentive to pay other broadcasters not to interfere.

Example of the Coase Theorem

The Coase Theorem is applied to situations where the economic activities of one party impose a cost on or damage to the property of another party. Based on the bargaining that occurs during the process, funds may either be offered to compensate one party for the other’s activities or to pay the party whose activity inflicts the damages in order to stop that activity.

For example, if a business that produces machines in a factory is subject to a noise complaint initiated by neighboring households who can hear the loud noises of machines being made, the Coase Theorem would lead to two possible settlements.

The business may choose to offer financial compensation to the affected parties in order to be allowed to continue producing the noise, or the business might refrain from producing the noise if the neighbors can be induced to pay the business to do so, in order to compensate the business for additional costs or lost revenue associated with stopping the noise. The latter would not actually occur, so the result would be the business continuing operations with no exchange of money.

If the market value produced by the activity that is making the noise exceeds the market value of the damage that the noise causes to the neighbors, then the efficient market outcome to the dispute is that the business will continue making machines. The business can continue to produce the noise and compensate the neighbors out of the revenue generated.

If the value of the business’s output of making machines is less than the cost imposed on the neighbors by the noise, then the efficient outcome is that the business will stop making machines and the neighbors would compensate the business for doing so. In the real world, however, neighbors would not pay a business to stop making machines because the cost of doing so is higher than the value they place on the absence of the noise.

Can the Coase Theorem Be Applied in the Real World?

In order for the Coase Theorem to apply, conditions for efficient competitive markets around the disputed property must occur. If not, an efficient solution is unlikely to be reached.

These assumptions—zero transaction (bargaining) costs, perfect information, no market power differences, and efficient markets for all related goods and production factors—are obviously a high hurdle to pass in the real world where transaction costs are ubiquitous, information is never perfect, market power is the norm, and most markets for final goods and production factors do not meet the requirements for perfect competitive efficiency.

Because the conditions necessary for the Coase Theorem to apply in real-world disputes over the distribution of property rights virtually never occur outside of idealized economic models, some question its relevance to applied questions of law and economics.

Recognizing these real-world difficulties with applying the Coase Theorem, some economists view the theorem not as a prescription for how disputes ought to be resolved, but as an explanation for why so many apparently inefficient outcomes to economic disputes can be found in the real world.

The Bottom Line

The Coase Theorem is a legal and economic theory regarding property rights. It states that where there are complete competitive markets with no transaction costs and an efficient set of inputs and outputs, an optimal decision will be selected. It was developed by economist Ronald Coase.