When there is a negative externality problem like air pollution or noise problems, Coase theorem believes that assigning property rights to either party involved will result in an efficient outcome without the intervention of a third party such as the government or environmentalist. Through negotiations, both parties will reach a solution (one compensating the other) which will be also efficient.
However, in order to reach a solution, certain conditions are needed to be met. First, there has to be not many people involved. Secondly, a property right has to be clearly set and easily enforceable. Thirdly, transaction cost in reaching the agreement has to be near zero. However, such ideal circumstances are not necessarily realistic. In the real world, there are far more complex factors that fall under the equation. For instance, determining one’s property right is a complicated matter on its own; at times it is very difficult to determine who has the initial right to a property. Moreover, when there are numerous actors are involved, huge transaction costs make trades or negotiations impossible at times.
For example, when it comes to global warming, “there is no way to assess accurately all the possible impacts and to assign economic values to alternative courses of action. A greenhouse warming impacts are so broad, diverse, and uncertain that conventional economic analysis is practically useless” (Jamieson, 1992). Furthermore, often the decision making process have their basis on narrowly economic grounds. Surely there are other important factors such as the environment and the distribution of benefit in total welfare that Coase theorem and the market economy system is not taking into account because management approaches are solely concerned in net economic benefit.
Bottom Line: The Coase theorem and the property right solution do not work perfectly in the real world. In order to rectify this issue we need another solution that can internalize costs into the private action, such as the pigouvian tax system.
* These guest posts are from students in my resource economics class at Simon Fraser University. Please leave feedback on their logic, ideas and style and suggestions of how to improve.