The Coase Theorem Says That as Long as Property Rights Are Clearly Defined, Externalities Do Not Matter

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  • Topic: Ronald Coase, Externality, Transaction cost
  • Pages : 6 (2208 words )
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  • Published : January 25, 2007
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The ‘Coase Theorem' as it has become known, was propounded by Ronald Coase of the University of Chicago and deals with a hypothetical world of zero transaction costs. His aim in so doing was "not to describe what life would be like in such a world but to provide a simple setting in which to develop the analysis and, what was even more important, to make clear the fundamental role which transaction costs do, and should, play in the fashioning of the institutions which make up the economic system." A zero transaction cost world does of course have very peculiar properties, such that one of Coase's own conclusions was that, in such a world, the law does not matter. People would always be able to negotiate without cost to acquire, subdivide and combine rights whenever this would increase the value of production and so a legal framework is unnecessary. However, a world of zero transaction costs does not exist and Coase tried to use the argument to suggest the need to introduce positive transaction costs explicitly into economic analysis so that the real world could be better studied by economists. Whether he has been successful in this aim is debatable, however, what is certain is that many lawyers (particularly property lawyers) have applauded his analysis and ‘theorem' as it states that the law should determine the level of transaction costs and react accordingly. Instead of determining a legal outcome through causes and fairness, the Coase Theorem encourages legal analysis in terms of efficiency.

The Coase Theorem is best described with an example as Coase did in his original paper. A cattle rancher lives beside a crop farmer. The farmer grows corn on some of his land and leaves some uncultivated. The rancher runs cattle over all of her land. The boundary between the rancher and the farmer is clear but is unfenced and so from time to time, the cattle wander over the boundary and cause damage to the farmer's crops. There are a variety of ways of reducing the damage, such as building a fence, growing less corn or keeping fewer cattle, each of which is costly. Thus the rancher and the farmer could bargain with each other to achieve an equitable outcome or the law could intervene and assign liability for the damages. If the latter option is taken, there are two rules which the law could adopt: Firstly, the farmer is responsible for keeping the cattle off his property, and he must pay for the damages when they get in. Secondly, the rancher is responsible for keeping the cattle on her property and so she must pay for the damage when they get out.

Under the first rule, the farmer would not be able to claim from his neighbour for the damage and so he would either have to grow less corn or fence his fields. Under the second rule, the rancher would have to build a fence around her property, and if the cattle escape again, she would be liable for the damage. Obviously, the erection and maintenance of a fence around the entirety of the rancher's farm will be more expensive than the erection and maintenance of a fence around the farmer's fields. Therefore, the most efficient legal rule to use is the first one whereby the farmer is responsible for keeping the cattle out. If it is supposed that the average annual damage to the farmers' crops totals £100, and the cost of erecting and maintaining a fence around his fields is £50 per year, there is a net benefit of £50. If the cost of erecting a fence around the ranchers' farm is £75 per year and this option is taken under the second legal rule, a net benefit of only £25 is achieved. Therefore the most efficient outcome is to take the first legal rule and achieve a net benefit of £50 per year. This however, is not the most efficient outcome.

For a truly efficient outcome to be achieved, argues Coase, cooperative bargaining must be used. Using these figures, and under the second legal rule where the rancher is liable for the damage, the following outcome would be most efficient. The...
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