Jan 10 2008

The Coase Theorem, clear and simple, kind of…

Environmental Economics: What is the Coase Theorem, really?

John Whitehead at Environmental Economics and I have something in common; we both struggle to clearly explain the Coase Theorem. This is a minor topic in AP and IB Economics courses, part of the Market Failure and Externalities units. Basically, the Coase Theorem presents individuals involved in a property rights dispute a market based mechanism for correcting the existence of an externality, as opposed to turning to the government or the legal system. Whitehead’s article linked here goes into a bit more depth than the typical principles text book, but clarifies some of the misconceptions and shortcomings of the basic theorem introduced in those texts.

In all likelihood, high school econ students will never need to know more than the basic version of the Coase Theorem, so this article is most useful for students (or teachers) who want to extend their understanding beyond the basic level. But while we’re on the topic, I thought I’d share my own method for illustrating Coase. This represents the basic version, but I think it illustrates the concept more clearly than the typical example from a text. I tell them a story, here it is:

When I was a kid we lived in this little yellow house outside of Minneapolis, where summers are brutally hot and humid. Our next door neighbor had a huge old oak tree in his yard with branches that spread out over our yard and provided us with shade for playing outside on hot summer days. One day, after a bad lightening storm, our neighbor became afraid that this huge oak tree might someday get struck by lightening and fall on his house, so he decided to cut it down.

When my dad saw our neighbor going out in the yard with a chainsaw, he went out to plead with our neighbor not to cut down this tree. The problem was, the shade provided by the tree fell mostly in our yard, while the tree itself was in our neighbor’s yard! He had no incentive to keep the tree standing; in fact due to the threat it posed to his roof in the case of a major storm, he actually had an incentive to cut it down!

Okay, so what’s the market failure here? This relates to property rights. My family feels we have the right to a shaded yard, while our neighbor feels he has the right to cut down a tree that he believes threatens his roof. The continued existence of the tree creates a spillover benefit for my family, therefore the tree’s full benefit to society is not taken into account when our neighbor goes to cut it down. If he does so, my family will suffer.

In a way, the removal of the tree would represent an “under-allocation” of resources towards trees and shade in my family’s yard. Cutting it down would lead to a less than socially optimal level of shade. How can the Coase Theorem help resolve this failure to achieve a socially optimal outcome? Let us continue our story:

My dad approached our neighbor under the tree. Our neighbor hesitated starting the chainsaw as my father approached, and paused to listen as my father proposed a deal. What if we agreed to pay him NOT to cut down the tree? Our neighbor thinks this over for a moment. “Hmm… that’s an interesting proposition,” he thinks. The question is, how MUCH should he ask for?

Clearly, to answer this questions our neighbor had to consider the likelihood of the tree actually falling, the approximate cost of repairing a damaged roof, and by multiplying these figures together he can determine the minimum amount he should try to get from my father. And my father, well he has to consider how much utility the shade provided by the tree actually provides our family? What is the monetary value of that shade? How much would we be willing to pay to keep that shade? If the value of the shade is equal to or greater than the amount our neighbor would require to keep the tree standing, then perhaps our family can settle with the neighbor without relying on the legal system or any sort of government intervention.

In this way, as long as the initial property rights are clearly defined, the Coase Bargaining Theorem results in a socially optimal outcome . My family pays the neighbor an amount he’s willing to accept to not cut the tree down, he leaves it standing, and we keep our shade! A potential market failure is averted using a purely market-based tool, without relying on government or the legal system. I find when I explain Coase using this story, the kids seem to get it more than they did after reading about it in the textbook.

Discussion questions:

  1. Does the story above represent the existence of a positive or a negative externality? Explain.
  2. Do you think the Coase Theorem presents a realistic tool for solving externality problems? Why or why not?
  3. Have you ever been in a situation where you’ve considered actually paying someone not to do something? If so, did your negotiations result in a more desirable outcome than would otherwise have been reached? Explain.

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

32 responses so far

32 Responses to “The Coase Theorem, clear and simple, kind of…”

  1. Helenon 13 Jan 2008 at 4:18 am

    The story represents a positive externality as the boy's family, who does not hold property rights to the tree, benefit from the tree's existence. As positive externalities are associated with underallocation of resources, the tree's absence (which would result from the neighbor cutting it down) would induce a shift left from the socially optimal level of shade.

    The Coase theorem is not a realistic tool for solving externality problems because such "perfect" conditions of clearly defined property rights, small number of people involved, and small bargaining costs rarely exist in real life. There are many cases where community property is involved (tragedy of the commons), and therefore there can be no clear "who pays whom". Also, it is very rare to have only two individuals involved; the higher the number of people, the more specific and personal demands, and the more difficult it is to arrive at an agreement.

    I have paid my 5-year-old brother in candy not to draw in my notebooks. It was a win-win situation because he derived more utility from candy than he would have from drawing in my notebooks, and I prefer clean notebooks over candy.

  2. Alice Suon 13 Jan 2008 at 4:54 pm

    1. The story represents the existence of a positive externality, because the neighbor's tree provided a spillover benefit of shade in your yard.

    2. I think it does present a realistic tool for solving externality problems, but only to a very limited extent; this is because the externality problems that can realistically be solved by the Coase Theorem are limited to those under specific conditions such as defined property rights and small bargaining costs. While it could be effective in these situations, most of the more important externality cases, such as those of global warming and air pollution, are much more complex and require government involvement to effectively address.

    3. In middle school I paid my mom in promises to study hard on my own so that I wouldn't have to have a math tutor. The outcome was that I got good grades independently and my mom saved money, so it turned out well.

  3. ElaineLungon 14 Jan 2008 at 7:30 pm

    1. A positive externality, in the form of an oak tree's shade, exists in the story.

    2. As Alice and Helen have both said, the Coase Theorem, if it has any applicability to "the real world," has only a limited one. While stories like this and that of the hypothetical logger/resort owner do, undoubtedly, exist somewhere in the world, the largest of our problems do not involve a place to play in the summer (although you could argue that climate change and such would eventually impact that).

    3. Although I've never had to pay in money, per se, for somebody to not do something, I've definitely given up other material goods or time. Case in point: I gave my cat treats to keep her from chewing up my headphones. Again.

    Oh wait. That doesn't really count.

  4. KatherineYangon 14 Jan 2008 at 8:19 pm

    1. Positive externality because there is an underallocation of resources (the tree's shade)

    2. In some cases, yes, the coase theroem is a realistic tool. But in the real world things get more complicated, the coase theroem only applies if property ownership is clearly defined, the number of people involved is small and when the bargaining cost is negligible. If not, then things start to get complicated and government intervention may be useful.

    3. I think this works too much in reverse, but I had a tutor when I was in primary school and I made a deal with my mom NOT to have her only if I could keep my grades. My grades improved…It's a win-win situation for me and my mom, but not so much for the tutor.

  5. Kristie Chungon 14 Jan 2008 at 9:50 pm

    1.) A positive externality — the boy's family benefits from the tree's shade (spillover benefit)

    2.) The coase theorem is not realistic in many cases as it only applies to cases when there are clearly defined property ownership, small number of people involved, and negligible bargaining costs. Most real-case scenarios won't fulfill all of these requirements. For example, air and the oceans don't have clearly defined property ownership (tragedy of the commons).

    3.) I never actually paid someone not to do something, but I have considered paying my brother to leave me alone. My brother got money, while I had time to myself without anyone bothering me. I'd say that's a win-win situation.

  6. optional.xuon 14 Jan 2008 at 11:31 pm

    It has a positive externality in that there are spillover benefits that are underallocated.

    The Coarse theory is realistically limited to solving problems. Most things people cannot put a price on like security and safety. So to an extent, it will work to solve small problems, but the bigger ones out there cannot be solved by a simple pay-off.

    I have ethics so no I have never paid anyone not to do something. Isn't that basically blackmail or bribery? Neither of which is legal. Tsk tsk.

  7. Christina Huon 15 Jan 2008 at 3:18 pm

    1)The story above represents the existence of a positive externality, because there is an underallocation of resources towards trees and shade.

    2)Yes, the Coase Theorem presents a realistic tool for solving externality problems because it provides a way of resolving disputes so that both parties' marginal benefits from the resolution are greater than their marginal costs. Using the Coase Theorem would provide a win-win situtation (provided that property rights are clearly defined and there are few affected parties).

    3) I once paid my brother (in haggen-daaz ice cream mooncakes) not to tattle to our parents when I spent an entire school night watching TV and sleeping instead of doing homework. He got more satisfaction from the ice cream than I would have, and I got more satisfaction from getting away with doing nothing than he would have from tattling on me.

  8. Nicole Wongon 15 Jan 2008 at 7:19 pm

    The story represents a positive externality because the shade provided by the tree is a benefit to the family. However, is there not also a negative externality, thinking in terms of the family's neighbour? There is a spillover cost to the neighbour as he must with the possibility of the tree falling on top of his house. The Coase Theorem may have been successful in solving an externality problem in this case, but it may not be as applicable to the real world as we would like. Problems like global warming and the pollution of rivers cannot be simply solved using the Coase theorem because the marginal costs are much higher in this case. I've never been in a situation where I considered paying someone to not do something. I have, however, been paid by my sister to get her a glass of water.

  9. Soyeon Yoonon 15 Jan 2008 at 11:49 pm

    In perspective of the family, there is positive externality of shade coming from the tree because they get to rest in the shade without paying for it or caring tree. But keeping the tree in neighbour's yard is a spillover cost, or negative externality in perspective of the neighbour because they might have to pay for damaged roof if the tree falls on the roof caused by big storm. In this case, the Coase Theorem solved problem easily, without government's intervention. In this case property ownership was clearly defined, number of people involved was small and the bargaining cost were negligible. It would have been inefficient if the government tried to remedy the situation. I have bought my sister lunch not to tell my mom that I was watching television while my mom was outside. The negotiation turned out successfully and we both gained profits from the deal.

  10. Chan Min Parkon 16 Jan 2008 at 12:07 am

    Looking from the perspective of the writer, there is a positive externality because there are spillover benefits from the tree. It provides the family shade. Looking form the perspective of the neighbor, there is a negative externality. There are spillover costs from this tree, as it might fall someday on his house and destroy it.

    The Coase Theorem can be useful to some extent, like solve the problem here. However if looked upon closely, there probably still are externalities that are existent. You can't exactly and precisely use the Coase Theorem, but it still provides and probably even eliminates externalities to some extent.

  11. Alex Goldmanon 16 Jan 2008 at 11:33 am

    A positive externality because the author receives spillover benefits (shade), even though the tree belongs to his neighbor.

    The Coase Theorem applies to small groups of people, however, conflicts as the one in the story are uncommon in reality. When it comes to large resources property rights aren't clearly defined, in many cases there are many people involved, and bargaining costs typically aren't negligible. Hence, the Coase Theorem is not commonly applicable.

    I pay my parents not to beat me. Kidding. Sometimes I give my brother candy so he will stop watching cartoons early on the weekends. I benefit more from the sleep than I would have from the candy, and he benefits more from the candy than he would from the cartoon, that fatty.

  12. kevinchiuon 16 Jan 2008 at 1:25 pm

    1. The positive externality is that the writer receives shade from the tree, which he did not own.

    2. The Coase Theorem is useful in real-life situations to a certain extent; its limited to the degree that it can only deal with situation in which the bargaining cost is doable, which is unlikely among a large number of people.

    3. Yes, I paid my brother to buy me products only available in the U.S. I benefit from the unique goods, while he benefits from the extra tax he places on the goods he sells to me.

  13. jacqueszhangon 16 Jan 2008 at 7:58 pm

    This situation can reflect both a positive and negative externality. Having the tree there provides a positive externality of shade for the Welker family, while it provides a negative externality on their neighbor's house. By cutting it, it would remove both these externalities.

    The Coase Theorem is unrealistic in most situations because there are often more than two parties involved. When there are four, five, or six parties involved, bargaining to reach a viable solution is virtually impossible, as a consensus must be reached between six parties. The issue of global warming is definitely an example where the Coase Theorem simply does not work, because the negative externalities apply to the approximate 6 billion people in the world.

    Being the younger brother in the family, I haven't really had to pay my older brother anything to have him stop doing something. I don't see why I would have to pay something to someone for them to not do something to me. This is getting really confusing. Basically, no, I haven't really been in such a situation, although I would probably resort to something other than financial/material benefits.

  14. kevinyehon 16 Jan 2008 at 9:05 pm

    The growing of the tree represents a positive externality to your family through the pleasure of shade, but then at the same time represents a negative externality to the neighbor because of the risk he runs of the tree falling onto his roof.

    The Coase theorem is very relevant for situations involving only two groups of people. The way I see it, it's common sense for it to work, because naturally both parties will want to find a beneficial solution in which both groups benefit. The biggest problem is that there are often more than two parties involved.

    One time, I offered to pay my brother if he would not bother me for an entire afternoon. In this way, he was happy about the money he received, while i was happy about the peace and quiet in which I could do my homework.

  15. Mondon 16 Jan 2008 at 11:46 pm

    The story above represents a positive externality to the family living next to the tree that enjoys the comforting shades it provides and a negative externality to the family that owns the tree because the tree could possibly collapse.

    The coase theorem is not applicable real life problem solving tool, because the situation has to fit the three specific requirements, which is in most cases, is highly unlikely.

    I remember paying my friend in elementary school money so he would stop bugging me. The outcome was desirable, I could now eat my lunch in peace.

  16. yunqimokon 16 Jan 2008 at 11:48 pm

    1) The tree is clearly a positive externality for the author's family as it provides shade. For the neighbour's family, the tree is a negative externality as the tree does not provide the shade, but also acts as risk factor as it might fall down on the rooftops!

    2)The Coase theory only works when there are very few parties in dispute, so that an agreement can possible be worked out. In cases where there are many many different people involved, as in reality, the Coase theory can never work as no one will agree to anyting.

    3) I paid my college-graduated-have-nothing-to-do-but-irritate-me brother to turn down his music and leave me alone. In the end, he gave me back my money, so it was doubly worth it for me.

  17. Jessica Ngon 17 Jan 2008 at 2:19 am

    1. There is a positive AND a negative externality. For the family, the tree is a positive externality , because it provides them with spillover benefit. However, the tree is a negative externality to the neighbor, as it has spillover costs to him.

    2. The Coase theory only works to a certain extent. More complex cases such as global warming cannot be resolved with the Coase theory, as there is no clear definition of property rights. A perfect example is the "commons", the public resources in which nobody is willing to take responsibility for. Who is going to pay for the air? There is no clear answer.

    3. I remember offering to give all my class notes to my brother so he can do all my chores for the rest of the year. I guess he thought he benefits more from the notes, so I ended up not having to wash any dishes or take out any trash for the rest of the year 😀

  18. robertwangon 17 Jan 2008 at 7:39 pm

    1. The tree represents a positive externality to the family as they do not need to water or take care of the tree in order to enjoy the shade that the tree provides. However, for the neighbor, the tree poses as a negative externality in that the shade lies mostly in the yard of the family and not the neighbor, and the neighbor runs the rist of having the tree damaging the house.

    2. Whether the Coase theory will be successful depends on the situation. First of all the 3 requirements that we discussed in class need to be met, and then a workable compromise must be agreed upon by the parties involved. Personally, I feel the coase theory is a realistic approach for the simpler conflicts, whereas complex issues cannot be solved via the coase theory.

    3. I… don't remember having to pay anyone for them to not do something. Hehe. =P

  19. Charlie.Gaoon 18 Jan 2008 at 10:00 pm

    R0b n0b.

    1. There is a positive externality for the author's family as the tree provides shade for them. However there is a negative externality for the neighbor whose land the tree is on because there is the risk of the tree getting hit by lightning and then falling on top of the house.

    2. I don't think the Coase theorem is valid because there are usually more than two parties in dispute, in real life. But if there were only two parties, then the Coase theorem would work fine.

    3. I gave my brother all my candy that I got trick-or-treating on Halloween in exchange for him throwing a baseball with me outside for the whole winter. It was a win-win situation for me because I don't want to get fat in the first place and I guess he wanted candy and would get it any way possible.

  20. jeewonon 19 Jan 2008 at 11:50 pm

    1. This story represents the existence of a positive externality, because the author is benefiting from the neighbor's oak tree that provides shades. On the other hand, negative externality is occuring for the neighbor, as the tree may destroy the house in the future.

    2. The Coase Theorm is not a realistic took for solving externality problems, because it requires property ownership, small number of people involved, and negligible bargaining costs. Although this story only involves the author's family and the neighbor, in reality, there are a vast number of affected parties. It usually involves high bargaining costs and sometimes a community property.

    3. Back in elementary school, I paid a friend to carry my backpack. I didn't have to carry around my heavy bag for the entire day, and my friend was happy from the money he received, although it wasn't worth a lot.

  21. TimChuon 20 Jan 2008 at 11:06 pm

    1. There exists a positive externality which is the tree's shade. It is positive externality because the neighboring family is benefiting from the shade.

    2. It does not seem very realistic because such bargaining would only be possible in a small community. In real large markets, bargaining would be close to impossible to coordinate.

    3. I've offered to pay my brother 100 RMB to shut up for a whole day. He didn't….

  22. Taka Onoon 21 Jan 2008 at 10:32 am

    1. This story could actually represent both negative and positive externalities. For the family which obtains most of the shade, the tree will represent a positive externality because it is benefiting the family by providing shade. For the neighbor it will represent a negative externality because there will be chance where the tree may destory the neighbors house or threaten his life.

    2. I think it can work but there will be a lot of loop holes. As mentioned above it seems like there is alot of math involved in settling the price in which the family could pay the neighbor to keep the tree. What if the neighbor or the family was not as highly efficient in their math skills or for that matter well educated. There will be a chance where the price will either be too high or too low. Also there is a chance for scamming. The neighbor could make a bunch of random numbers up and ask for more than what is required. To make it really work there should be a professional that could settle these disputes. Almost like a lawyer that is proficient at calculating probablities of the tree falling on to the neighbors house and the price that is needed to be paid.

    3.Good question. Usually I'm the one that gets paid not to do anything. But sadly the price usually don't exceed more than 50 kuai. Still the fact about getting paid to do nothing is awesome.

  23. kevin maon 21 Jan 2008 at 7:46 pm

    There is a positive and negative externality. The positive one is the shade provided by the tree to the neightbors. The negative one is the risk of the tree getting struck by lightning and falling on the house.

    The Coase Theorem in this case does not work because it does not fit the three requirements.

    I don't really remember paying anyone to not do anything.

  24. Michael Dailyon 21 Jan 2008 at 8:55 pm

    In this situation a positive externality exists because there is a spillover cost in buying the shade from the tree. Since a positive externality is associated with an underallocation of resources and cutting the tree down would under-allocate this resource, the shade of the tree represents a positive externality.

    Secondly, the Coase Theorem is a practical way of solving your small every day externality problems. It is good because it conveniently fixes the problem quickly without requiring any government involvement. However, with problems of a higher scale, government involvement is obviously required and the simple bargaining of the Coase Theorem is rather ineffective.

    Lastly, I've considered paying the little kids on my bus to not talk the entire ride. If that worked, I could sit in peace, while the young ones could enjoy their new source of income. However, I don't think I could afford that, and I doubt they would actually abide by the rules. So as an alternate solution I just listen to my ipod every day, which is still a win-win because I get my quiet and they get to talk.

  25. Jessica Chiangon 21 Jan 2008 at 9:24 pm

    1. The above situation illustrates a positive externality because the family benefits from the shade of the tree; for the neighbor, the tree is considered a negative externality as it is a danger to his safety.

    2. I think the Coase Theorem is a good way to solve externality problems, as it basically only requires the two parties to compromise. Unfortunately, the coase theorem only works when property rights are clearly defined, there is only a small number of people involved, and it would cost them very little to negotiate. Actually, come to think of it, the coase theorem can solve many problems even though it requires all 3 points to be met.

    3. Hmm I don't think I've ever paid anyone not to do something, but if I did, I would probably pay this kid on my bus to not swear for a day.

  26. jenniferchoion 22 Jan 2008 at 6:16 am

    1)The story shows the existence of a positive externality because there is an underallocation of resources (tree).

    2)I think, in a situaton like this, the Coase Theorem is a good way to solve externality problems. There are three conditions to be satisfied: 1) property ownership is clearly defined, 2) small number of people are involved, and 3) ther bargaining costs are negligible. Because this case satisfied all the conditions, the family did not have get government intervention to solve this externalities problem, but only had to use the Coase Theorem.

    2)Yes, the Coase Theorem presents a realistic tool for solving externality problems because it provides a way of resolving disputes so that both parties’ marginal benefits from the resolution are greater than their marginal costs. Using the Coase Theorem would provide a win-win situtation (provided that property rights are clearly defined and there are few affected parties).

    3) I once paid my brother (in haggen-daaz ice cream mooncakes) not to tattle to our parents when I spent an entire school night watching TV and sleeping instead of doing homework. He got more satisfaction from the ice cream than I would have, and I got more satisfaction from getting away with doing nothing than he would have from tattling on me.

  27. radhikaon 26 Jul 2012 at 8:38 am

    could anyone have examples on coase theorum and construction safety situations??

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