Coase Theorem - Equivalence Version

Equivalence Version

In his UCLA dissertation and in subsequent work, Steven N. S. Cheung (1969) coined an equivalence version of the Coase theorem: aside from transaction costs, all institutional forms are capable of achieving the same efficient allocation. Contracts, extended markets, and corrective taxation are equally capable of internalizing an externality. To be logically correct, some restrictive assumptions are needed. First, spillover effects must be bilateral. This applies to the cases that Coase investigated. Cattle trample a farmer's fields; a building blocks sunlight to a neighbor's swimming pool; a confectioner disturbs a dentist's patients etc. In each case the source of the externality is matched with a particular victim. It does not apply to pollution generally, since there are typically multiple victims. Equivalence also requires that each institution has equivalent property rights. Victim rights in contract law correspond to victim entitlements in extended markets and to the polluter pays principle in taxation.

Notwithstanding these restrictive assumptions, the equivalence version helps to underscore the Pigouvian fallacies that motivated Coase. Pigouvian taxation is revealed as not the only way to internalize an externality. Market and contractual institutions should also be considered, as well as corrective subsidies. The equivalence theorem also is a springboard for Coase's primary achievement—providing the pillars for the New Institutional Economics. First, the Coasean maximum-value solution becomes a benchmark by which institutions can be compared. And the institutional equivalence result establishes the motive for comparative institutional analysis and suggests the means by which institutions can be compared (according to their respective abilities to economize on transaction costs). The equivalency result also underlies Coase's (1937) proposition that the boundaries of the firm are chosen to minimize transaction costs. Aside from the "marketing costs" of using outside suppliers and the agency costs of central direction inside the firm, whether to put Fisher Body inside or outside of General Motors would have been a matter of indifference.