QUALIFICATIONS TO

THE COASE THEOREM

Part 2 (Transaction costs)
Qualifications to Coase: transaction costs
• The Coase theorem implies that the initial allocation of
legal rights does not fix the final allocation of rights.
• This is not so if transaction costs are important.
• For example, if there are multiple landowners, and the
efficient outcome is for them to bribe the factory not to
pollute (in case legal rights rest with the factory), a free
riding problem can occur.
• Similarly, if the efficient outcome is for the factory to bribe
landowners to be allowed to pollute, a “monopoly holdout”
problem can occur.
Transaction costs
• Holdout can be a problem in other contexts, eg multiple
plots of land where a highway or development is being
built, multiple landowners next to an airport.
• Transaction costs are also associated with monitoring,
and enforcement.
• They can also occur in a bilateral monopoly where terms
of trade are not fixed.
• Bargaining may fail when valuations are imperfectly
known (Israeli daycare example).
Implications of transaction costs for law
• If these problems are serious, the initial allocation of legal
rights matters because it is harder to change it via the Coase
theorem.
• Eminent domain rules versus consent clauses.
• In general laws might seek to minimize transaction costs
associated with correcting the initial allocation of property
rights.
• Eg, a law that gives landowners rights to claim damages for
pollution, but not to stop pollution.
• Free riding (if controlling pollution is efficient) does not occur
since the rights are not with the factory.
• Holdout (if controlling pollution is inefficient) does not occur
since the factory does not need to bribe landowners to let it
pollute.
Other implications of the Coase theorem
for law
• Laws that seek to determine the least-cost avoider and assign
rights to the other party.
• Efficient but can change depending on different courts’
perception of who the least cost avoider is.
• Difficult if information on this is hard to obtain.
• General liability rules based on the tort of “coming to the
nuisance” are used to solve other externality problems, based
on the sequence in which parties act.
• It is easier for the second mover to avoid the externality. Eg, a
dentist who sets up a clinic next to a noisy confectioner’s and
then complains about the noise, is held liable. If the
confectioner built his shop next to an existing dentist’s clinic, he
would be held liable.
• These liability rules are not necessarily efficient.
• But they are easy to understand for defendants and require
less information.
Coase and Pigou: Legal Implications
• Suppose damage caused due to pollution < cost of pollution control.
• Suppose a Pigovian tax is imposed on the factory = the damage.
• The factory would pay the tax and continue to pollute.
• However, the landholders would not benefit from the Pigovian tax as it
is not paid to them.
• They would offer the factory an additional side payment < their
switching cost, as an incentive to stop polluting.
• If this side payment plus the Pigovian tax exceed the cost of pollution
control..
• The factory ends up controlling pollution.
• However this is inefficient!
• Legal implication: a tort law that directly awards damages to the
affected party works better than an administrative law that requires a
fine. The latter is like a Pigovian tax, but Coasian side payments
would also kick in, distorting incentives away from efficiency.