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