Coase Theorem - The Theorem

The Theorem

Coase developed his theorem when considering the regulation of radio frequencies. Competing radio stations could use the same frequencies and would therefore interfere with each other's broadcasts. The problem faced by regulators was how to eliminate interference and allocate frequencies to radio stations efficiently. What Coase proposed in 1959 was that as long as property rights in these frequencies were well defined, it ultimately did not matter if adjacent radio stations interfered with each other by broadcasting in the same frequency band. Furthermore, it did not matter to whom the property rights were granted. His reasoning was that the station able to reap the higher economic gain from broadcasting would have an incentive to pay the other station not to interfere. In the absence of transaction costs, both stations would strike a mutually advantageous deal. It would not matter which station had the initial right to broadcast; eventually, the right to broadcast would end up with the party that was able to put it to the most highly valued use. Of course, the parties themselves would care who was granted the rights initially because this allocation would impact their wealth, but the end result of who broadcasts would not change because the parties would trade to the outcome that was overall most efficient. This counterintuitive insight—that the initial imposition of legal entitlement is irrelevant because the parties will eventually reach the same result—is Coase’s invariance thesis.

Coase's main point, clarified in his article 'The Problem of Social Cost', published in 1960 and cited when he was awarded the Nobel Prize in 1991, was that transaction costs, however, could not be neglected, and therefore, the initial allocation of property rights often mattered. As a result, one normative conclusion sometimes drawn from the Coase theorem is that property rights should initially be assigned to the actors gaining the most utility from them. The problem in real life is that nobody knows ex ante the most valued use of a resource, and also that there exist costs involving the reallocation of resources by government. Another, more refined, normative conclusion also often discussed in law and economics is that government should create institutions that minimize transaction costs, so as to allow misallocations of resources to be corrected as cheaply as possible.

• Version 1: A clear delineation of private property rights is an essential prelude to market transactions.
• Version 2: As long as private property rights are well defined under zero transaction cost, exchange will eliminate divergence and lead to efficient use of resources or highest valued use of resources.
• Version 3: The allocation of resources is invariant to the assignment of private property rights under zero transaction cost and zero income effect.