Coase Theorems on Property Rights: Meaning and Significance!

Meaning:

Prof. R. Coase points out that if property rights are clearly defined, the affected parties will
adopt policies to internalise the externality. In other words, if property rights and liability are
properly defined and there are no transaction costs, then people can be held responsible
for any negative externalities they impose on others and market transactions will produce
an efficient outcome.

Coase explains property rights in two theorems:

First Theorem:

Assumptions:

The first theorem is based on the following assumptions:

1. It assumes that the number of contracting parties is very small.

2. The cost of negotiating by the interested parties is also small.
3. There are no transaction costs.
4. There are no income or wealth effects.
5. There is no government interference.

Let us take Coase’s famous example of only two parties—a cattle raiser and a wheat
producing farmer. They are operating on neighbourhood properties without any fencing.
The externality is the damage done by cattle roaming on the unfenced land of the farmer.
As the cattle raiser increases the size of the herd, the damage to the farmer’s crop
increases.

According to Coase, property rights should be properly defined and enforced. First, the
farmer has the right that his wheat be not destroyed. Therefore, the cattle raiser will then be
forced to pay damages to the farmer for the crop destroyed.
These will be added to the marginal costs of the cattle- raiser who will reduce the number
of cattle to be raised to a manageable level. Second, if the law is that the cattle raiser has
no liability for damage done by his herd to the farmer’s crop, it will now be advisable for the
farmer to bribe the cattle raiser to keep his herd to a minimum level.

The coase theorem is explained with the help of Figure 16.1.

The Coase Theorem

Initially, the condition of raising cattle is Dc = (Arc = MRc). The marginal cost of raising
cattle curve MCc cuts the Dc curve at point Lx and the rancher would raise OQ1 cattle per
year. Therefore, the marginal social cost of wheat is MSCw1 and a loss to wheat crop is
OW1. If a bribe equal to damage is added to marginal cost (MCc + OW1) then the optimal
solution will be at point L2 where (MCc + OW1) curve cuts the Dc curve, and the cattle
number will restricted to OQ2.

According to Coase, market failure due to property rights can be eliminated through private
bargaining among the affected parties. He points out that if property rights are clearly
defined and marketable and transaction costs are zero, a perfectly competitive economy

will allocate resources optimally even under conditions of externalities.

By transaction costs he means costs of negotiating or enforcing a contract. The existence
of differential transaction costs creates opportunities for one person’s choice to impact on
others. It is property rights that direct and control these choices.

Second Theorem:

On the other hand, if bargaining becomes costly, then property rights matter significantly.
In the words of Coase, “If bargaining is costly and information is imperfect, then liability
rules help to achieve optimality and the party that has the least costly way of dealing with
the harmful effects of an externality should be made responsible for paying the costs
associated with the externality.” Thus the second theorem of Coase provides a natural link
between economics and law, offering an efficiency rationale for deciding externality liability
rules.

Coase has related his second theorem to the problems caused by the sparks emitted by
coal and wood-power steam engines. The problem is that fires sometimes caused by the
sparks damage nearby agriculture fields. In the absence of rules governing compensation
for firm’s damages, it creates negative externalities since rail companies have little
incentive to prevent sparks.

On the other hand, rail companies may pay full compensation that may leave property
owners with little or no incentive to protect themselves. Is it better for rail companies to
take defensive measures or for farmers to take defensive measures? Which is done,
depends on whether farmers can sue for damages?

The problem of sparks can be solved in the following ways:

(a) Limit the amount of train traffic;

(b) Rail companies should install some type of spark- inhibiting device; or

© Farmers should plant their crops several yards further away from the railway tracks.

There are some Pareto optimal rules that make someone better off without any change in
the welfare position of others. If a stable set of rules is maintained, most parties stand to
gain. Also, there are some efforts involved in coming to an agreement with another party.
In certain cases, the cost of negotiating the agreement can be more than the value of the
rights to produce. A buyer must pay contractual cost as well as the cost of the right to the
resource use desired. It is not enough merely to know who owns a particular resource. The
example of conflict over airport noise can be illustrated. Jet airplanes flying low to
approach a runway create disutility for nearby residents and lower the value of their
property. The costs faced by the airlines depends on the character of rights.

If the air space is owned by the airlines, it will be costly for the large number of residents to
organize a bid. But even where the residents have some rights, the character of the right
makes a difference. One alternative is for the residents to have the right to an injunction,
which means that the airlines must deal with each individual homeowner and obtain
permission to fly over. Thus a high transaction cost Is put on the airline which must deal
with large numbers and face the possibility of exhorbitant holdouts.

Significance of Theorems:

Many economists have explained the significance of Coase theorems:

1. Institutional Base:

S. Baker has pointed out many aspects of first Coase theorem which signify a new area of
economics. According to him, the Coase theorem tells us that in a world with zero
transaction costs and well defined property rights institutions neither foster nor prevent
allocative efficiency.

Of course, the importance of this observation rests on the reverse conclusion that if
transaction costs (information costs, bargaining costs, administrative costs etc.) are
significant as in the real world, institutions do matter. Hence, different institutions will have
different impacts on efficiency and distribution, which, in turn, make comparative
institutional analysis indispensable.

2. Need for Policy Measures:

The Coase theorems signify that well defined and marketable property rights help in
promoting economic efficiency. Further, the market mechanism can lead to a Pareto
optimality despite the presence of externalities because it is possible to devise a private
bargaining solution to remove the externalities.

Today, there is general agreement that assigning property rights clearly may take care of
some externality problems, particularly those concerning environmental problems. They
require more active government intervention. Some forms of this intervention might
include regulatory measures, financial penalties, subsidization of corrective measures and
creating a market for externality.

3. Interdepence of Economics on Law:

According to J. Hirshleifer, given an assignment of proper rights and if there are no

transaction costs, the final outcome will be efficient. It implies that in addition to removing
artificial barriers to transaction costs, the law ought to assign well defined property rights
to all resources of economic value. Moreover, a free market would redistribute initial legal
ownership rights in efficiency. It is only possible through judicial manner which would
facilitate such transfers.