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Coase Theorem

In: Business and Management

Submitted By akeneipp
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In 1959, Ronald Coase introduced what is now known as the Coase Theorem, which suggests that absent transaction costs, any initial property rights agreement leads to an economically efficient outcome. Straying from previous models supported by most economists, this position was initially met with skepticism.

Prior to 1959, the standard economic understanding held that government regulation enhances efficiency by correcting for claimed imperfections. This thinking was in keeping with A. C. Pigou’s contention that was developed in 1920. Pigou called claimed imperfections, “market failures”. In 1959, Ronald Coase authored an article for the University of Chicago’s Journal of Law and Economics entitled, “The Federal Communications Commission”. In this article, Coase suggested that in the absence of transaction costs, any initial property rights arrangement leads to an economically efficient outcome (McTeer 2003).
In Coase’s discussion, he changes the way torts are viewed. In Pigou’s model, one party does harm to another; therefore, government regulation is necessary to ensure that the party filing the claim of harm is no longer harmed. Coase’s model expands the view of harm to include the party accused of inflicting harm on the other party. Specifically, Coase demonstrates that if government regulation is put into place to prevent harm to a party, the entity that is now subjected to the regulation is now being harmed.
For example, Company A and Company B are situated on adjoining properties with a shared waste-water treatment facility. Company A manufactures a product that is in high demand and recently improved their production capacity by installing equipment that increases the amount of heavy metals discharged to their waste-water treatment plant to speed the process. Company B files suit against Company A claiming harm from excessive heavy metals in the shared waste-water treatment plant that impacts their production capacity. Pigou’s model would say that government regulation is necessary to ensure that Company A no longer harms Company B by limiting the amount of heavy metals both Company A and Company B individually discharge to the waste-water treatment plant. Coase would argue that in this example, restricting the amount of discharge by Company A, and thereby its manufacturing capacity, by government regulation is harming Company A. This situation would require an evaluation of the overall harm to both companies to determine appropriate solution.
In Coase’s theorem, he would argue that absent a transaction cost, the most economically efficient outcome would result without government regulation (Skousen 2014). In the example provided, the companies would be determine the amount each could discharge to the waste-water treatment plant without government regulation.
Although the Coase Theorem was initially met with great skepticism, the revelation of the reciprocal nature of harm has resulted in a better understanding of the impact of government regulation on economic efficiency.

McTeer, B. (2003). Ronald Coase The Nature of Firms and Their Costs. Economic Insights.
Skousen, M. (2014). The Fundamentals of Economic Behavior. In Economic logic (Fourth ed.). Washington, D.C: Regnery Publishing.

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