Coase Theorem - Criticism

Criticism

Ronald Coase's work emphasised a problem in applying the Coase theorem: transactions are "often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost." (Coase, 1960—first paragraph of section VI.) This isn't a criticism of the theorem itself, since the theorem considers only those situations in which there are no transaction costs. Instead, it is an objection to applications of the theorem that neglect this crucial assumption.

So, a key criticism is that the theorem is almost always inapplicable in economic reality, because real-world transaction costs are rarely low enough to allow for efficient bargaining. (That was the conclusion of Coase's original paper, making him the first 'critic' of using the theorem as a practical solution.) Economist James Meade argued that even in a simple case of a beekeeper's bees pollinating a nearby farmer's crops, Coasean bargaining is inefficient. (Though bee-keepers and farmers do make contracts and have for some time.)

David Friedman has argued that the fact that an "economist as distinguished as Meade assumed an externality problem was insoluble save for government intervention suggests...the range of problems to which the Coasian solution is relevant may be greater than many would at first guess." Friedman is scathing of most critical attacks on the Coase theorem.

In many cases of externalities, the parties might be a single large factory versus a thousand landowners nearby. In such situations, say the critics, not only do transaction costs rise extraordinarily high, but bargaining is hindered by the basic incentive to free-ride and poorly defined property rights—classic public good problems. (Though these problems do not preclude a free market Coasian solution.)

A third critique can be found in the work of the critical legal scholar Duncan Kennedy, who argues that the initial allocation always matters in reality.

Steven N. S. Cheung thinks that private property rights are institutions that arise to reduce transaction costs. The existence of private property rights implies that transaction costs are non-zero. If transaction costs are really zero, any property rights system will result in identical and efficient resource allocation, and the assumption of private property rights is not necessary. Therefore, zero transaction costs and private property rights cannot logically coexist

In 2009, in their seminal JEI article, Hahnel and Sheeran highlight several major misinterpretations and common assumption, which when accounted for substantially reduce the applicability of Coase's theorem to real world policy and economic problems. First, they recognize that the solution between a single polluter and single victim is a negotiation—not a market. As such, it is subject to the extensive work on bargaining games, negotiation, and game theory (specifically a "divide the pie" game under incomplete information). This typically yields a broad range of potential negotiated solutions, making it unlikely that the efficient outcome will be the one selected. Rather it is more likely to be determined by a host of factors including the structure of the negotiations, discount rates and other factors of relative bargaining strength (cf. Ariel Rubenstein).

If the negotiation is not a single shot game, then reputation effects may also occur, which can dramatically distort outcomes and may even lead to failed negotiation (cf. David M. Kreps, also the Chainstore paradox). Second, the information assumptions required to apply Coase's theorem correctly to yield an efficient result are complete information—in other words that both sides lack private information, that their true costs are completely known not only to themselves but to each other, and that this knowledge state is also common knowledge. When this is not the case, Coasian solutions predictably yield highly inefficient results due to perverse incentives—not "mere" transaction costs.

If the polluter has the ownership rights, it is incentivized to overstate its benefits from polluting, if the victim has the ownership rights, (s)he has the incentive to also misrepresent her/his damages. As a result, under incomplete information (probably the only state of knowledge for most real world negotiations), Coaseian yield predictably inefficient results. Third, if there are multiple victims, victims who would be required to pay have incentive to pretend that they are not harmed (freeriding) or understate their harm. If the polluter is required to pay, victims overpresent, overestimate their damage, and/or hold out.

Hahnel and Sheeran emphasize that these failures are not due to behavioral issues or irrationality (although these are also quite prevalent (Ultimatum Game, Cognitive biases)), are not due to transaction costs (although these are also quite prevalent), and are not due to absorbing states and inability to pay, rather it is due to fundamental theoretical requirements of Coase's theorem (necessary conditions) that are typically grossly misunderstood, and that when not present systematically eliminate the ability of Coaseian approaches to obtain efficient outcomes—locking in inefficient ones. Hahnel and Sheeran conclude that it is highly unlikely that conditions required for an efficient Coaseian solution will exist in any real-world economic situations.