All About Coasian Bargaining Theorem. Assumptions, Examples and Limitations

Previously we've been talking about how negative externalities can create a problem because we've got one person imposing costs on another person but not reimbursing him or her for the harm that's being done. In a pigouvian tax and cap and trade are different ways that we can think about bringing about the socially efficient outcome, the socially efficient amount of pollution, or whatever the externality is.

What is Coasian bargaining?

A guy named Ronald Coase came up with a really innovative idea which is that a negative externality can just be resolved by bargaining between the parties. So the person that's creating the externality and then the person that's being affected by the externality can bargain and come up with a deal where they basically achieve this socially efficient outcome.


The assumptions of the Coase theorem?

So they can just work this out on their own but there are two really important assumptions to Coase's argument. One is that property rights are clearly defined. If somebody says "Look I'm polluting this river" then the other person is able to say "I have a right to clean water" property rights have to be clearly defined and the transaction costs have to be low and I'll define it a little more when we talk in the example but basically it's a cost of coming to an agreement the time and effort it would take to come to this agreement and to do the bargaining and that's going to become evident in our examples to come.

Coase Theorem example

Let's say let's think about pollution here for a minute, let's think about a factory that pollutes and they're polluting a nearby river. Maybe they're manufacturing steel or some chemical and they dump sludge into this river and there happens to be somebody who lives on the other side of that river and that person likes to fish in that river but the chemicals that are being dumped in the river are killing some of the fish. Now this person has fewer fish that he can catch, he's been harmed so there's been some harm. What Coase is basically saying is "Look on the one hand yes this Factory is doing something wrong but also this person is choosing to live here and so these two parties if we say we can define their property rights they can come to an agreement on their own, absent any kind of government intervention.


So let's say that this person's property right is a right to clean water and a right to fish. So now that the factory is violating this person's property rights so the person could say "Look I have a right to clean water here and so you're violating my right and so, therefore, we have to come to some kind of agreement." and so maybe the factory says "Well look we will give you let's say $50,000 a year for the fact that you are being inconvenienced." and now this person could choose to accept that or they get used to reject that and move away from any number of things but the idea is with Coase bargaining is that these two parties come to this agreement on their own.

Limitation of Coase Theorem

Now transaction costs are low here and the reason that transaction costs are low is that there's just one person who's being harmed and then there's one factory and so they can bargain with one another but what if you had a situation where there was a factory and let's say Los Angeles that was putting off all kinds of pollution in the air and it was creating smog and so it's creating smog and that's making it difficult for people to breathe. So there are costs being imposed on millions of people. So there are millions of it now, it's not just one person that happens to live on the other side of the river, now it's millions of people who are being harmed. Now you could say "These people have property rights they have a right to clean air and that factory is violating their rights so then those people have to stand to say "Look we've got an issue where you're creating this pollution which is violating the property rights we need to come to an agreement." but the problem is that in such a situation Coase bargaining wouldn't necessarily work because transaction costs are going to be high. You've got millions of people here for each one of those people to go and work out some kind of agreement with the factory would be basically almost impossible because one person might say 'Look if you give me $100 a year I'm happy with it" and then another person says "Well I want $10,000." and they for millions of people to individually come and strike some kind of bargain with this factory and to determine how much each of them has been harmed there's just so many people to work out a solution that. In such a case Coase bargaining just really wouldn't work.