Private Solutions to Externalities: The Coase Theorem

Learning Objective: Discuss the Coase theorem and explain how private bargaining can lead to economic efficiency in a market with an externality.

Although government intervention may increase economic efficiency in markets where externalities are present, it is possible for people to find private solutions to the problem of externalities. Ronald Coase made this argument in a 1960 article. To understand Coase’s argument, it is important to understand that completely eliminating an externality is usually not economically efficient.

A.The Economically Efficient Level of Pollution Reduction

The optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost. This applies to reducing pollution just as much as other activities. As pollution declines, society benefits, but the marginal benefit from eliminating another unit of pollution declines as emissions are reduced. As pollution declines, the marginal cost of further reductions rises. The net benefit to society from reducing pollution is equal to the difference between the benefit of reducing pollution and the cost. To maximize the net benefit to society, any type of pollution should be reduced to the point where the marginal benefit from another ton of reduction is equal to the marginal cost.

B.The Basis for Private Solutions to Externalities

In arguing that private solutions to the problem of externalities were possible, Ronald Coase emphasized that when more than the optimal level of pollution is occurring, the benefits from reducing the pollution to the optimal level are greater than the costs.

C.Do Property Rights Matter?

Ronald Coase pointed out that the amount of pollution reduction will be the same whether polluters or the victims of pollution are legally liable for damages. Bargaining between the parties will result in the same reduction in pollution, where the marginal benefit of the last unit of reduction is equal to the marginal cost.

D. The Problem of Transactions Costs

There are frequently practical difficulties in the way of a private solution to the problem of externalities. For example, if many people suffer from the negative effects of pollution, bringing all the victims together with all the producers of the pollution to negotiate an agreement often fails due to high transactions costs. Transactions costs are the costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services.

E. The Coase Theorem

The Coase theorem is the argument of economist Ronald Coase that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities. Private bargaining is most likely to reach an efficient outcome when the number of bargaining parties is small and all parties are willing to accept a reasonable agreement.