Significance of Coase Theorem to Environmental Economics

Significance of Coase Theorem to Environmental Economics


Coase theorem has been considered as one of the most significant contribution to the field of environmental economics. Conceived by Ronald Coase, the theory summarized the situations in which markets alone can solve the externality problems. The theorem contribution to the field of environmental economics stems predominantly from its contribution on the importance of property rights and their relevance to externality problems and as a basis for private negotiation. According to Callan & Thomas (2013), the Coase theorem is viewed as one of the most invaluable application of theorem in the field of environmental economics, the other being the Pigouvian Theory. In general terms, the theorem holds that as long as someone is assigned property rights, no government intervention is required to deal to deal with externalities. It asserts that if allowed to function freely, the market will achieve an efficient allocation of resources. The Coase theorem is central to understand the policy implications of externalities. It does this through indicating those situations in which market activities will eliminate the effects of externalities and suggests new perspectives on why market solutions to externalities may fail and appropriate policy responses. This paper presents the Coase theorem, exploring its interpretations, application and implications with regards to environmental economics.

Coase Theorem

The Coase theorem is one of the solutions to the problem of externalities, the other being government solutions through the imposition of a Pigouvian tax.Competitive markets fail to produce the socially efficient quantity when there are externalities. Externalities are a cause of market failure and occur when the private market fails to produce society’s preferred outcome. When there is market failure, alternatives to the achieve efficiency in the market come about. One such alternative is the interventions by the government using laws, taxes, and permit systems so that market participants pay for external costs. However, while government policy can potentially improve efficiency, there is no guarantee. The Coase theorem application comes into play in such a situation. It cautions against the assumption that government intervention in the environmental arena would improve upon private sector environmental performance. According to Cowen & Tabarrok(2012), the theorem posits that in environmental externalities, the private sector can achieve social efficiency with minimal government intervention, the role of the government being limited to the legal establishment of property rights, with environmental disputes being resolved in court. That is, private market negotiations can achieve social efficiency and market equilibrium regardless of the initial definition of property rights or the presence of externalities. This is to say, as long as the courts establish clear property rights, markets may achieve social efficiency regardless of the initial assignment of property rights (Turker, 2016). The underlying ideology is that the role of the government should be minimal. It should only establish courts and then let markets negotiate.

The Coase theorem is one of the basic results of the property-rights approach to environmental allocation. It counterpoints the public goods approach theorizing that if property rights can be adequately defined, optimal allocation will be attained through private decisions, and government intervention will be necessary only to define and secure property rights. The Coase theorem shows that under specific conditions the allocation result is independent of the attrition of property rights (Siebert, 2008).The theorem presents analysis of social costs considering the problem of externalities from the perspective of both their recipient and their originator, and legitimizes the role of the market in arriving at a least-cost solution to such problems. The theorem was based on the proposition that disputes among property owners would be solved with little or no loss to social welfare, as long as property rights are protected, transaction costs are minimal, and the parties are allowed to negotiate with each other.

According to Coase, assuming perfect competition and disregarding transaction costs and income effects, voluntary agreements among different affected parties results in a socially optimal output, even where externalities exist. That is, private and social costs will be equal. When applied to environmental considerations, pollution-cost problems are argued to be non-persuasive, and can be dealt with by redefining the existing structure of property rights. The theory thus rejects and refutes the Pigouvian approach where the polluter or creator of the social externality  should be liable for the damage caused to those who suffer from it, should be taxed by an amount equivalent to the damage caused, or should otherwise be banned from operating in the areas where the damage is caused. Coase argued that the delimitation of rights is an essential prelude to market transactions, the ultimate result, which maximizes the value of production, is independent of the legal decision. The theorem put forward the proposition that the problem of an externality resides with both parties. Rather than just identifying the polluter as the cause of the damage and attributing a cost to it, the harm to the polluter of preventing his action should also be investigated in order to judge which party incurs the more serious harm.

Significance ofCoase theorem

In environmental economics, the Coase theorem is of central importance as at its core are the legal rules of entitlement, or property rights. These rule determine the rights of the agent in the economy, for example the right to unpolluted air or the right to enjoy silence, and determine the direction in which compensation payments will be made if the right is violated. If valid, the implication of the Coase theorem is that there is no need for policy intervention with regard to externalities except to ensure that property rights are clearly defined. When they are, private agreements over compensation will generate a pareto-optimal outcome. This conclusion naturally runs counter to the standard assessment of the consequences of externalities and explains why the Coase theorem is of considerable application in the field of environmental economics. The Coase theorem has also been applied by many scholars as a starting point for discussing the role of environmental law, and more generally, the need for legal instruments to control environmental pollution (Faure, 2009).

The insights of the Coase theorem have been used to understand the formation and importance of property rights. Property rights are the rights to use, derive income, exclude others and transfer property. Rules concerning property are central to the institutional environment, and the state must define, interpret and enforce these rules. Since frictionless markets and well defined property rights lead to the efficient allocation of society’s resources, a policy prescription drawn from the Coase theorem is that the state should reduce transactional costs and have clear rules regarding the assignment of property rights in order to increase social wealth (Whaples & Parker, 2013).

Coase theorem is also important due to the contribution of its invariant thesis. That is, a natural expectation would be that the assignment of rights will determine the equilibrium level of an externality, for example that the level of pollution under a polluter-pays system will be less than that under a pollutee-pays one. The invariant thesis of the Coase theorem states that this is incorrect and that the equilibrium level of externality is independent of the assignment of property rights (Maler & Vincent, 2003). For example, when a firm has the rights to pollute, the householder can only reduce the pollution by paying the firm a sufficient amount of compensation to make it worthwhile to stop production or to find an alternative means of production.

Coase theorem is important in environmental economics for various reasons. First, it demonstrates a different way of looking at a large range of problems, those resulting from the transaction costs that prevent the parties affected from bargaining their way to an efficient outcome. The Coase theorem addresses the question as to which bundling of rights would lead, under various circumstances, to an efficient outcome, and if a particular initial bundling of rights leads to an inefficient outcome, how easy it would be for the parties to negotiate a change, with the party who has a greater value for one of the rights in a bundle purchasing it from its initial owner. Second, while the Coase theorem suggests that markets alone might solve externality problems , the importance of the Coase theorem does not lie in solving the externality problem, but in suggesting a solution- the creation of new markets. If property rights can be clearly defined and transaction costs reduced, then a market for externalities might develop. If such a market does develop, Coase theorem posits that such a market will have all the efficiency properties of ordinary markets maximizing social surplus (Cowen & Tabarrok, 2012).

Third, The Coase theorem criticizes the pigouvian approach which holds that divergences from the optimum are to be reduced by creating a system of taxes and subsidies that serve to discourage or encourage, depending upon the nature of the externality (Lai, 2011). Coase demonstrates and stresses the reciprocal nature of any externality. Advocating for a new approach based on the allocation of property rights-a necessary condition for private negotiations to start between beneficiaries and victims, allowing them to be compensated orremunerated. This theory opened the way for the new research movement called law and economics

Criticism/limitations of the Coase Theorem in Environmental Economic

Coase theorem was instrumental in raising concern about government solutions.The model yields a powerful result that underscores the importance of property rights to the market process, regardless of who is assigned those rights. However, the model’s prediction of an efficient outcome depends on two very limiting assumptions: that transactions are costless and that damages are accessible and measurable(Callan & Thomas, 2013).These two assumptions have been the basis for criticismof the practicability of the theorem.

First, the Coase theorem assumes that there are no transaction costs. Transaction costs are the monetary outlaysfor monitoring, negotiating and enforcing contracts and property rights. These processes are costly, both in terms of money and time. Therefore, this assumption is erroneous. Also dealing with the source of the externality has its own costs.However, it is argued that there are also costs associated with government solutions, and as such, Coesean negotiations may be preferable to government intervention even when there are substantial transactional costs.Secondly, Coase assumes that there are only two parties in the negotiation. For the theory to hold in practice, at minimum it must be the case that few individuals are involved on each side of the market. The reality of most environmental issues is that there are many affected parties on both sides of the market. The sources of a pollution are usually multifaceted and their impacts quite diffuse. In addition, environmental disputes normally involve several parties, as Externalities are typically third-party problems, and there may be third parties. Therefore, the Coase theorem is most relevant for cases in which only a few parties are involved and the sources of the externalities are well defined.

Third, according to the Coase theorem, the optimal level of pollution can be achieved irrespective of which party was given the initial property rights, the polluter or the pollutee. However, the theorem does not address the impact the initial assignment of property rights has on income distribution. In general, the income position of the party empowered with property rights is positively impacted (Hussen, 2004).Lastly, there are no differences in willingness to pay (WTP) and willingness to accept (WTA) under the Coase theorem.Turker(2016) states that many studies have found that people’s willingness to pay to acquire a property right, such as an improvement in air quality, is less than the compensation they require to give up a property right, such as accepting lower air quality. Therefore, in regards to this, the Coase theorem is erroneous.

Other limitations of the Coase Theorem as it apply to environmental economics concerns with the problem of identifying the sources of a damage and assigning a value to that damage. As more parties get involved accessibility and measurability of damages becomes increasingly difficult.Also, the theory’s proposition that private markets would efficiently resolve environmental problems is limiting. Only a small number of environmental problems readily qualify for Coase theorem solutions.


Evidently, Coase theorem is a significant contribution to the field of environmental economics.Noted for its contribution in demonstrating the significance of transaction costs and property rights, the theory’s proposition that as long as property rights are clearly established, the markets will achieve a social efficiency and a pareto-optimal equilibrium notwithstanding the initial assignment of rights, is unparalleled. While it has attracted criticism from its assumptions, its advocating for a restricted role of the government, limited to only the establishment of courts and letting the private sector to negotiate to pareto-optimality is genius.



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Cowen, T., & Tabarrok, A. (2012). Modern Principles of Economics (2 ed.). New York, NY: Palgrave Macmillan.

Faure, M. (2009). Tort Law and Economics. Northampton, MA: Edward Elgar Publishing.

Hussen, A. M. (2004). Principles of Environmental Economics. New York, NY: Routledge.

Lai, L. W. (2011). The Ideas of Ronald H. Coase: Market Failure and Planning by Contract for Sustainable Development. New York, NY: Taylor & Francis.

Maler, K.-G., & Vincent, J. R. (2003). Handbook of Environmental Economics: Environmental Degradation and Institutional Responses. Amsterdam: Elsevier.

Siebert, H. (2008). Economics of the Environment: Theory and Policy (7 ed.). Berlin: Springer.

Turker, I. (2016). Microeconomics for Today (6 ed.). Mason, OH: Cengage Learning.

Whaples, R., & Parker, R. E. (2013). Routledge Handbook of Modern Economic History. Abingdon, Oxon: Routledge.

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