Coase theorem

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In law and economics, the Coase theorem, attributed to Ronald Coase, relates to the economic efficiency of a government's allocation of property rights. In essence, the theorem states that in the absence of transaction costs, all government allocations of property are equally efficient, because interested parties will bargain privately to correct any externality. There are three factors which inhibit efficient allocation even using Coase bargaining. One is imperfect information or bluffing(for example if one party falsely portrays a higher value of his/her endowment this may hamper negotiations and prevent an efficient outcome). The second possible hindrance is high transactions costs. Thirdly negotiation may become more complicated or impossible if too many parties are involved. This theorem, which earned Coase the 1991 Bank of Sweden Prize in Economic Sciences, is an important basis for most modern economic analyses of government regulation.

What Coase originally proposed in 1959 in the context of the regulation of radio frequencies was that as long as property rights in these frequencies were well defined, it ultimately did not matter if adjacent radio stations would initially interfere with each other by broadcasting in the same frequency band. The station able to reap the higher economic gain of the two from broadcasting would in this case have an incentive to pay the other station not to interfere. In the absence of transaction costs, both stations would strike a mutually advantageous deal. Put differently, it would not matter whether one or the other station had the initial right to broadcast; eventually, the right to broadcast would end up with the party that was able to put it to the most highly valued use.

Coase's main point, clarified in an article published in 1960 (Coase 1960) and cited when he was awarded the Nobel Prize in 1991, was that transaction costs, however, could not be neglected, and therefore, the initial allocation of property rights mattered in the presence of side effects (externalities). Other major theoretical arguments against the theorem propose that in some situations different actors may have irreconcilable different valuations of property because of unique ability to use and that in some asymmetrical exchanges one party may be unable to procure sufficient capital because of the risk-aversion of financial institutions.

George Stigler summarised the resolution of the externality problem in the absence of transaction costs in a 1966 economics textbook in terms of private and social cost, and for the first time called it a "theorem". Since the 1960s, a voluminous literature on the Coase theorem and its various interpretations, proofs, and refutations, has developed and continues to grow.

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