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.

KEY TAKEAWAYS

 The Coase Theorem argues that under the right conditions parties to a dispute over
property rights will be able to negotiate an economically optimal solution, regardless
of the initial distribution of the property rights.
 The Coase Theorem offers a potentially useful way to think about how to best resolve
conflicts between competing businesses or other economic uses of limited resources.
 In order for the Coase Theorem to apply fully, the conditions of efficient, competitive
markets, and most importantly zero transaction costs, must occur.
 In the real world, it is rare that perfect economic conditions exist, making the Coase
Theorem better suited to explaining why inefficiencies exist as opposed to a way to
resolve disputes.

Coase Theorem

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.

In order 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 non-economic 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 neighbouring 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 neighbours 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 neighbours, 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 neighbours out of the revenue generated.

If the value of the business's output of making machines is less than the cost imposed on the
neighbours by the noise, then the efficient outcome is that the business will stop making
machines and the neighbours would compensate the business for doing so. In the real world,
however, neighbours 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 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.

What Is Pareto Efficiency?

Pareto efficiency, or Pareto optimality, is an economic state where resources cannot be reallocated to
make one individual better off without making at least one individual worse off. Pareto efficiency
implies that resources are allocated in the most economically efficient manner, but does not imply
equality or fairness. An economy is said to be in a Pareto optimum state when no economic changes
can make one individual better off without making at least one other individual worse off.

Pareto efficiency, named after the Italian economist and political scientist Vilfredo Pareto (1848-
1923), is a major pillar of welfare economics. Neoclassical economics, alongside the theoretical
construct of perfect competition, is used as a benchmark to judge the efficiency of real markets—
though neither perfectly efficient nor perfectly competitive markets occur outside of economic theory.

KEY TAKEAWAYS

 Pareto efficiency is when an economy has its resources and goods allocated to the maximum
level of efficiency, and no change can be made without making someone worse off.
 Pure Pareto efficiency exists only in theory, though the economy can move toward Pareto
efficiency.
 Alternative criteria for economic efficiency based on Pareto efficiency are often used to make
economic policy, as it is very difficult to make any change that will not make any one
individual worse off.

Pareto Efficiency

Understanding Pareto Efficiency

Hypothetically, if there were perfect competition and resources were used to maximum efficient
capacity, then everyone would be at their highest standard of living, or Pareto efficiency. Economists
Kenneth Arrow and Gerard Debreu demonstrated, theoretically, that under the assumption of perfect
competition and where all goods and services are tradable in competitive markets with
zero transaction costs, an economy will tend toward Pareto efficiency.

In any situation other than Pareto efficiency, some changes to the allocation of resources in an
economy can be made, such that at least one individual gains and no individuals lose from the change.
Only changes in allocation of resources that meet this condition are considered moves toward Pareto
efficiency. Such a change is called a Pareto improvement.

A Pareto improvement occurs when a change in allocation harms no one and helps at least one person,
given an initial allocation of goods for a set of persons. The theory suggests that Pareto improvements
will keep enhancing value to an economy until it achieves a Pareto equilibrium, where no more Pareto
improvements can be made. Conversely, when an economy is at Pareto efficiency, any change to the
allocation of resources will make at least one individual worse off.

Pareto Efficiency in Practice

In practice, it is almost impossible to take any social action, such as a change in economic policy,
without making at least one person worse off, which is why other criteria of economic efficiency have
found a wider use in economics.
These include the following:

 Buchanan unanimity criterion: under which a change is efficient if all members of society
unanimously consent to it.
 Kaldor-Hicks efficiency: under which a change is efficient if the gains to the winners of any
change in allocation outweigh the damage to the losers.
 Coase Theorem: which states that individuals can bargain over the gains and losses to reach
an economically efficient outcome under competitive markets with no transaction cost.

These alternative criteria for economic efficiency all to some extent relax the strict requirements of
pure Pareto efficiency in the pragmatic interest of real world policy and decision making.

Aside from applications in economics, the concept of Pareto improvements can be found in many
scientific fields, where trade-offs are simulated and studied to determine the number and type of
reallocation of resource variables necessary to achieve Pareto efficiency.

In the business world, factory managers may run Pareto improvement trials, in which they reallocate
labor resources to try to boost the productivity of assembly workers without, for example, decreasing
the productivity of the packing and shipping workers.