The Coase theorem is a famous theorem in environmental economics. Many economists are, however, confused about it, it seems. (See for example Economics Is Hard) Tim Haab at Environmental Economics has tried to clear things up:

The Coase-Theorem: The free-market version
As long as both [the polluter and the polluted] are free to bargain, the final amount of pollution will be independent of the initial allocation of property rights.

That is, when bargaining is free and transaction costs are zero. Are they ever?

But, there are a lot of assumptions embedded in [the] simple version of the Coase Theorem.  So many that Coase himself wrote a piece in 1988 to debunk the simple version.  In effect he wrote ‘That’s not what I meant.’

Now we’re talking. Let’s get down to business.

The Coase Theorem:  The fair market version
In the presence of transactions costs, the final amount of pollution depends on the initial allocation of property rights.

Why the ‘fair’ market version? What’s fair with it? It’s more realistic? And, the final amount of pollution will depend on the size of the transaction costs relative to the size of the externality (the damage of the pollution).

The Coase Theorem:  The wealth effects version
The two versions of the Coase Theorem presented above ignore the possibility that the bargaining outcome creates wealth for the owner of the property right.  If I have the right to clean air, any income I receive from selling that right might increase my demand for clean air.  Just like getting a raise at work increases my demand for eating out, getting more money from selling my right to clean air might increase my demand for clean air.  Likewise, increased profits to the polluter from selling pollution rights might increase the demand for emissions.  Similar to the transactions cost case, the final outcome depends on the initial allocation of property rights.

Is this the Kuznets stuff again? Get rich and care more? No, I don’t think that is what Haab means. But if the polluted demands more clean air, he is less willing to sell the right to pollute; we get less pollution than without the wealth effect, right?

The Coase Theorem:  The free entry version
Further, the increase in profits from selling the property right might lead others to want to take advantage.  If firms are free to enter the market, the assignment of property rights to the firms and the resulting profits from the sale of those rights might cause other polluting firms to enter the market.  Similarly, assigning property rights to the victim, and creating wealth through bargaining might entice new victims to enter the market–for example, more people might move into a polluted neighborhood as a result of the increased wealth from the sale of property rights.  The simple versions of the Coase theorem assumes away entry–by both new firms and new victims.

Is assuming away the same as not considering?

In a follow up post, guest blogger Jim Roumasset discusses yet another version of the Coase theorem; The Grand Equivalence Version of the Coase Theorem, apparently a version that ‘fits Coase’s agenda’:

[A] version of the Coase theorem is that absent transaction costs, alternative institutions such as markets and contracts are equivalent.

[…] When Coase famously presented the ideas behind, “The Problem of Social Cost” at a 1959 Chicago seminar, and pursuant dinner at the home of Aaron Director, he revealed that he had in mind situations of a priori competitive bargaining […]. If bargaining is costless, then the farmer can be viewed as selecting among several ranchers to bargain with; likewise the rancher.

After some further digression, the Equivalence Version can be stated as:

[T]ransaction costs aside, if property rights are commensurate and competition prevails, then any bilateral externality will be equivalently internalized by markets, contracts, and Pigouvian taxes. The Pigouvian tax solution is equivalent to a competitive market in pollution rights where polluters must buy rights from victims. And the core of a competitive contracting economy shrinks to the same market solution — ergo all three institutions are equivalent.

I think the core of an economy is the set of potential bargaining solutions which bargaining parties can agree on, that is, where noone is worse off (or something like that).

The equivalency result also underlies Coase’s (1937) proposition that the boundaries of the firm are chosen to minimize transaction costs. Aside from the “marketing costs” of using outside suppliers and the agency costs of central direction inside the firm, whether to put Fisher Body inside or outside of General Motors would have been a matter of indifference.

Is it valuable to know that if it weren’t for marketing costs or agency costs, a decision would be superfluous? Is it interesting to assume away something that’s always there? I don’t see it, I don’t get it. (Oh, I get it, it’s about philosophical interest; I care because other care; when other works on a problem, it justifies spending time on the problem; you might save others time if you figure it out faster than them, and we might all be better off.)

Anyway, I’m not so sure this is what Coase had in mind. Coase was interested in the real world. If you go back to Haab’s initial post and look at the comments, a Dan Cole (the last comment) has valuable insights:

This post [Haab’s post, that is] participates in many common mistakes about the “Coase Theorem,” and creates one or two new ones. […] Coase was absolutely clear in that article that his example of a zero-transaction cost world was (1) purely hypothetical; (2) intended to highlight problems with standard assumptions of neoclassical theory; and (3) without relevance in the real world, in which transaction costs are always positive and often quite high.

The fundamental purpose of “The Problem of Social Cost” [Coase’s article] was absolutely not to highlight how all social cost problems would be avoided or resolved by costly contracting in a world of zero transaction costs. In such a world, after all, the legal rules (including property rules) would be thoroughly unimportant. Rather, Coase’s goal in the article was to stress the importance of legal allocations of entitlement for resolving social-cost disputes in the real world of costly transacting.

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