Theorem (1960) which states -- in opposition to Pigou's theory that "only governments, by means of taxes and subsidies, can "internalize" externalities in economic exchange or production -- that in a bilateral agreeement with externalities, the parties can "internalize" them through negotiation without external influence when one considers opportunity cost fully.

What this all means is that if person A is negatively affecting person B (said effect is an "externality", for example a rancher's cattle are eating the protective plants at the edge of a farmer's crops which degrade his outputs), then it is not necessary that the government step in and force the parties to act properly. Instead, when they examine the possible costs to them, they will be able to find an agreement which is more Pareto efficient ("Pareto efficient" implies that in a given allocation no individual can be improved in standing without injuring someone else's standing)

Here's an example to make it all clearer: the farmer would normally receive \$100/day/acre but receives only \$50/day/acre due to the cattle, while the rancher receives \$150/day/head without any negative influences from the farmer. Now, the government could step in and attempt to protect the protective plants which are a natural capital of sorts, but in general the outcome will still end up being inefficient (at least in the Pareto sense) However, if the farmer and the rancher talk, the farmer might suggest that the rancher take his cattle to the other end of the field which is not as important to the farmer. In doing so, the farmer's income increases to \$75/day/acre but in walking his cattle farther the rancher loses and afterward receives only \$130/day/head. What the farmer must do to make such a scheme attractive for the rancher is to offer to pay the difference. The farmer now receives: \$75 - \$20 = \$55 (\$20 is (the difference=\$150-\$130) or \$5 more, and the rancher receives the same amount (\$130 earned and \$20 provided by the farmer).1 All are happier.

The theorem holds true until the transactional costs become to high. For example the price of the lawyer to write up the agreement between the rancher and farmer is higher than the price earned. Or another example would be if Person A were a power plant or industry. In such cases, the transaction costs for an individual are simply too high to enter into agreement. In these cases, the government would need to step in and use incentives, taxes, or other such measures to balance the inequality.

1  I have no idea about farming and much less about ranching, so please no comments on how ridculously outlandish these incomes are.

The 'Coase Theorem' states that in the absence of transanction costs, imposition of a private property rule, regardless of who the private property rights is assigned to, will lead to the socially optimal outcome.

Transaction costs may include:
• Administrative and legal costs of negotiation between the parties.
• Strategic costs within a party of co-operation.
• Other third party costs.

To show that this is true, we look at a situation where a factory is polluting the environment which causes 5 neighbouring houses health problems.

Information -
• The factory causes damage worth \$200 dollars each to the 5 neighbours --> Total of \$1000.
• A filter is available for \$500 which would eliminate all the pollution emitted from the factory.
• The optimum social outcome is the installation of the screen because it minimises the cost to society of pollution.

Incidence A - Households have right to clean environment, factory must pay for all damages.
1. Factory pay for damages --> \$1000
2. Factory install filter --> \$500
3. Outcome: Factory install filter.

Incidence B - Factory has right to pollute, households bear all damages.
1. Households pay for healthcare --> \$1000
2. Households get together to buy filter --> \$500
3. Outcome: Household will pay to install filter for factory.

Therefore, both legal rules lead to the efficient outcome. That is to install the filter.
Note, however, the 'zero transaction costs' assumption is necessary for this to happen. If this assumption did not hold, the efficient outcome may, or may not be achieved. Eg. If the cost of negotiation is too high, then households cannot get together and pay for the filter.

Coase's theorem explains one way of solving market failure with regards to externalities. It states that the problem of externalities can be solved without outside intervention, if parties are allowed to bargain without cost. In order to understand what this means for the economy, it is necessary first to examine what externalities are, and furthermore, how and why Coase's theorem is a route to solving them.

An externality can be defined as the product of one party's action that affects another, such as noise, pollution, or research. Externalities can either be positive or negative in the way in which they affect others: the knock-on effect of technological research, for example, is a positive externality, as the new knowledge developed benefits the whole of society's quest for new technology. Air pollution is a negative externality as it affects the quality of life of the people who continuously breathe polluted air. Common to both examples is that the actor is not affected by the externality in the sense that the researcher recieves no added benefit for the knowledge contributed to society, and the polluter is not penalised for the negative effect that is being created. In this way, there is a difference to the cost or benefit to society as a whole of the action, and the cost or benefit to the private actor. The cost of polluting, for example, is higher for society as a whole, as many people suffer as a result of it. There is no market for pollution so the producer does not have to pay for it, hence the private cost being lower.

The situation in which externalities are not being taken into account is one in which the market is inefficient: it has failed to maximise benefit to buyers and sellers as it does not consider bystanders, whereas society does. It is therefore necessary to solve this inefficiency by dealing with the externality. This is done by changing the quantity of production. Naurally, as the free market does not consider externalities as they do not constitute part of that market, to change will not take place without some kind of incentive. These can be public - government orientated, or private. Public solutions tend to rely on either regulating output, such as a law on levels of pollution output; or using market-based policies - taxing and subsidising: placing a tax on pollution per unit would reduce pollution as the polluter now has to consider the value of pollution, so called "Pigovian taxes". This is similar to Coase's solution: that actors can come to an agreement between themselves to solve the externality. A polluter of a river which is regularly used downstream by anglers, for example, could be solved by the anglers paying the factory not to pollute the river, or alternately, the factory paying the anglers compensation for the pollution they produce.

The issue of who pays whom is decided by the "property rights" involved in the affair. These create the market for the exhange to take place: if the anglers own the river then the polluter owes them compensation for damaging their river. If the polluters own the river, then the anglers need to bribe them to stop polluting it so they can still use it. The negotiations would be redundent if neither party had any claim to a right over the river as the flow of money or otherwise could not be determined: this is often the situation in which government intervention is required to solve the externality, as clear property rights are required for Coase?s theorem to function properly. Of course it is possible that the externality would not be solved at all if the benefit of polluting the river was greater to the polluter than the value of what was offered by the anglers; however this would mean that polluting at that level is efficient. Coase's theorem has a second stumbling block when it comes to transaction costs. These are the costs of bargaining and making the agreement. It is necessary to have low transaction costs for the theorem to work, otherwise it is possible that the externality will not be resolved. High legal costs to resolve situation, costs of coordinating many parties - gathering many anglers together to bargain with the factory, for example; translation costs if the parties speak different languages and so on, all make it increasingly unlikely that the negotiations between actors actually take place.

It is thus demonstrated that Coase's theorem is not always appropriate to solve externalities: it can occur that property rights are not clearly defined in order for one party to bargain with another; or that the price of this bargaining itself is too high to make it worthwhile for the parties involved. In ideal conditions however, it is suitable for private parties to act in the way the theorem describes to solve the externality in the most efficient manner: moving the equilibrium of production or comsumption to the level most beneficial to society as a whole.

Recent findings in the nascent field of behavioral economics suggest that the Coase theorem does not accurately model how people act in certain conditions.

Underlying the Coase theorem is the assumption of perfect rationality from rational choice theory, the way standard economics expects individuals to make decisions when faced with uncertainty. Simply, this means people will get the most they can out of any situation. In practice, humans make decisions under conditions of bounded rationality, which means they don't always get the most they can. The Coase theorem, which depends on people getting all they can from an economic situation for its prediction of efficiency in any resource dispute between two parties with clearly defined property rights, falls right apart.

The Coase theorem is derived from two basic premises of standard economics. First, to an economist (and the individuals in their models), an out-of-pocket cost is no different from opportunity cost, and sunk costs are not considered in decision making. Second, resources tend to gravitate toward their most efficent use because market actors seize all profit opportunities. Together, these propositions give us the Coase theorem: given no wealth effects or transaction costs, the distribution of entitlements will not affect the eventual efficient distribution of resources between the parties.

However, if opportunity costs are undervalued when the actors make decisions, the Coase theorem's prediction that initial entitlements are irrelevant falls apart. Consider a farmer whose property abuts a rancher's land. The rancher's cow tramples the farmer's corn at a cost to the farmer of \$200 dollars per year. The cost to the rancher to prevent the trampling is \$300 per year. Coase's theorem would lead us to predict that, in the event of a lawsuit which clarified their property rights (which for our purposes costs nothing), regardless of who won, the cattle would still be allowed to trample the land. If the farmer won, the rancher would bribe him with \$200.000000001 a year for the right to trample. The farmer, exhibiting perfect rationality, would realize that it was \$.000000001 cheaper to accept the bribe than maintain untrampled crops and would act accordingly. Conversely, the farmer would not bribe if the rancher won, because he would have to offer \$300 to avoid a \$200 dollar cost. Therefore, the argument goes, both parties' pursuit of their own self-interest serendipitously corresponds with the most efficient use of resources from a societal point of view (minimizing the total costs for the same resource production).

However, if the farmer does not consider out-of-pocket and opportunity costs as equivalent, he might not accept the \$200 bribe. In fact, it might take a \$400 dollar bribe to get the farmer to allow trampling. This is too much for the rancher to pay, as it only costs him \$300 to prevent trampling. The end result is the rancher pays \$300 for a \$200 cost, yielding a net inefficiency of \$100. What is going on here? The farmer is behaving "irrationally", and underestimating the opportunity cost of failing to take a bribe. His actual cost for trampling is \$200, but he requires \$400 to allow the trampling at an opportunity cost of \$200. Nobody could behave so irrationally, you might scream. Research shows they do.

Behavioral economists have found, contrary to Coase predictions, in markets where the price of goods is not exogenously defined (as prices are in stock markets, e.g.) entitlements matter. People systematically overvalue rights and goods they possess, a phenomenon known as "the endowment effect". This makes the initial distribution of resources important because they tend to be "sticky", i.e. they affect future dealings. In contrast, the standard model of economics assumes bygones are bygones when people make choices. The end result is often an inefficient distribution of resources -- the cows in the above example are fenced.

One of many experiments that demonstrate the "endowment effect" was performed at Cornell university with 44 students in a law and economics class. 22 of them at random were given coffee mugs. The other half of the students were given \$6. The researchers then held a market for the mugs, eliciting from the mug-holders their lowest selling price, and from the mug-buyers their highest buying price and then clearing the market.

It is clear what the Coase theorem predicts in this situation. There are no transaction costs and no wealth effects, and the property rights are clearly defined. Therefore, the mugs should be redistributed efficiently, which means people who value them most end up with them (if a mug-holder values the mug more than average, he will not find a buyer; if a buyer values the mug more than average, he will find a seller.) Because the mugs were randomly distributed, we would expect that half would sell their mugs and half would not (as random distribution would lead about half of the people who value mugs more than average to get them).

However, people who were given mugs offered to sell them at prices which were, on average, twice as high as the average buying price from non-mug-holders. Instead of 50% of the mugs changing hands, only about 15% did. People overvaluing what they have (or undervaluing opportunity costs) has also been shown in many real-world cases. For example, in a survey of lawyers on nuisance cases, researchers found that not one of twenty cases involved any post-judgment bargaining, even when transaction costs were low and there were clearly existing, mutually-advantageous deals to be made. Tellingly, the lawyers also said that, even if the judgment had been reversed, the parties would still not negotiate. It appears that acrimony and/or the overvaluation of what one has compared to what one could get in a sale is preventing these parties from negotiating for the most efficient outcome. As the Coase theorem and standard economics is very influential to policymakers, especially concerning nuisance law, this finding is important because it suggests damages, even if relatively imprecise, might be a better approximation of efficiency between the parties than the injunction a Coasian would suggest (allowing parties to bargain between themselves). Because people are people and not prefectly rational utility-maximizers (gasp!), laissez-faire does not always lead to efficiency, even with clear property rights and without transaction costs.

Sources

Jolls et. al., A Behavioral Approach to Law and Economics, 50 Stan. L. Rev. 1471 (1998).

Kahneman et. al., Experimental Tests of the Endowment Effect and the Coase Theorem, 98 J. Pol. Econ. 1325 (1990).