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

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 Ј100, and the cost of erecting and maintaining a fence around his fields is Ј50 per year, there is a net benefit of Ј50. If the cost of erecting a fence around the ranchers' farm is Ј75 per year and this option is taken under the second legal rule, a net benefit of only Ј25 is achieved. Therefore the most efficient outcome is to take the first legal rule and achieve a net benefit of Ј50 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 cheapest way of stopping the damage is for the farmer to build a fence around his fields, and so the rancher should offer to pay for this to be done - i.e. Ј50 per year. In doing so she is saving herself from paying for a fence to be built around her property which would be Ј25 more, and so to be truly efficient, she should pay the farmer half of this amount as well. In other words, she should pay the farmer Ј62.50 per year to build and maintain a fence around his crops. Therefore, although it seemed that the first legal rule was most efficient as it gave a greater net benefit, it is the second legal rule which is actually most efficient under a scenario of cooperative bargaining.

The bargaining system is quite different if the law adopts the first rule where the farmer is liable for any damage that befalls him. In these circumstances, there is no benefit for the rancher to bargain and so the farmer will go ahead and build the fence without bargaining. This would be the outcome in a world without a legal system, and so economists could argue that this doesn't matter, because apparent efficiency is achieved. However, this assumes that they are not worried about the equitable distribution of income, which would be understandable for the purposes of an economic model and is one of Coase's conclusions. Lawyers, however, care about justice rather than the equitable allocation of resources and hence would strive for the fairer scenario brought about by using the second rule. This rule therefore agrees with the statement that externalities do not matter as an equitable distribution of income and resources is achieved, because costless transaction opportunities allow suitable modifications of the transactors' behaviour so that all undesirable side effects are properly internalised.

Now, however, consider the outcome if the case involved previously unrecognised rights. Different criteria for assigning ownership of these rights would seem in this case to lead inevitably to a different distribution of wealth. However, many economists argued that, through its influence on demand, a change in the criteria for assigning ownership to previously unrecognised resources could bring about a change in the allocation of resources. Coase uses the example of a newly discovered cave, and states in his original article "The Problem of Social Cost" that the ownership of the cave, whether it be used for storing bank records, as a natural gas reservoir, or for growing mushrooms depends on which would pay the most in order to be able to use the cave. However, critics then said that the decision concerning ownership of a newly discovered cave would affect the demand for banking services, natural gas, and mushrooms, with the result that their prices would change. Such a change may affect the