Coase theorem is a concept in economics that explains how private parties can solve problems related to externalities without the intervention of the government. This theorem is named after Ronald Coase, a British economist who introduced the concept in his paper titled “The Problem of Social Cost” in 1960. In this article, we will discuss the definition of Coase theorem in relaxed English language.
What is an externality?
An externality is a cost or benefit that affects a third party who is not involved in the transaction. For example, if a factory produces pollution which harms the environment and the people living nearby, this is an externality. The factory is not paying for the cost of the pollution, while the people are suffering from its effects.
What is Coase theorem?
Coase theorem states that if property rights are well-defined and transaction costs are low, private parties can bargain and reach an efficient outcome regardless of the initial allocation of property rights. In other words, if the parties involved in an externality can negotiate and make a deal that is better for both sides, they will do so without the need for government intervention.
How does Coase theorem work?
Let’s take the example of the factory that is causing pollution. If the property rights to the environment are well-defined, the people living nearby can negotiate with the factory to reduce the pollution. If the cost of reducing pollution is lower than the cost of suffering from its effects, the factory will agree to reduce the pollution. This will result in an efficient outcome where both parties benefit.
Assumptions of Coase theorem
Coase theorem makes some assumptions that need to be met for it to work. These assumptions include: – Property rights are well-defined – Transaction costs are low – Parties involved have perfect information – There are no externalities involved in the bargaining process
Examples of Coase theorem
Coase theorem has been applied in various situations, including: – Pollution control – Noise pollution – Land use disputes – Water rights – Intellectual property rights
Criticisms of Coase theorem
Coase theorem has also faced criticism from some economists. Some of the criticisms include: – It assumes that property rights are well-defined, which may not always be the case – It assumes that transaction costs are low, which may not be true in some situations – It ignores the issue of power imbalances between the parties involved in the bargaining process – It assumes that the parties involved have perfect information, which may not be true in some situations
In conclusion, Coase theorem is a concept in economics that explains how private parties can solve problems related to externalities without the intervention of the government. It is based on the idea that if property rights are well-defined and transaction costs are low, parties involved can negotiate and reach an efficient outcome. While Coase theorem has its limitations, it has been applied in various situations and has contributed to the understanding of how private parties can solve problems related to externalities.