Question

What is the Coase Theorem? What does this imply about the necessity of government corrections to markets that suffer from an externality problem? When will the theorem fail?

Answer 1

Coase Theorem tries to derive efficient allocation in the presence of externalities both positive and negative. The theorem states that irrespective of the initial state of the allocation, bargaining will lead to Pareto efficient allocation when the trade is done with negligible transportation costs.

It implies that government intervention can be minimized if the private players can bargain with each with less extra cost and reach to an efficient allocation beneficial to both.

Coase Theorem fails in the following scenarios:

- High Transaction costs: Generally the transaction costs of trade tend to be high in the real market conditions. In such situations, coase theorem would not work and the parties will not reach to an efficient allocation.

- Poorly defined property rights: If there are poorly defined property rights in the market, then the theorem would fail.

- The problem of Holdout: if the property rights are well defined, even then the theorem may fail due to hold out problem. For example, if a fishery firm has the property rights, then a steel firm cannot dump the waste into water without a fishery firm's permission.

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