Coase Theorems on Property Rights: Meaning and Significance!

Meaning​:
Prof. R. Coase points out that if property rights are clearly defined, the affected parties will adopt
policies to internalise the externality. In other words, if property rights and liability are properly
defined and there are no transaction costs, then people can be held responsible for any
negative externalities they impose on others and market transactions will produce an efficient
outcome.
Coase explains property rights in two theorems:
First Theorem:
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Assumptions:
The first theorem is based on the following assumptions:
1. It assumes that the number of contracting parties is very small.
2. The cost of negotiating by the interested parties is also small.
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3. There are no transaction costs.
4. There are no income or wealth effects.
5. There is no government interference.
Let us take Coase’s famous example of only two parties—a cattle raiser and a wheat producing
farmer. They are operating on neighbourhood properties without any fencing. The externality is
the damage done by cattle roaming on the unfenced land of the farmer. As the cattle raiser
increases the size of the herd, the damage to the farmer’s crop increases.
According to Coase, property rights should be properly defined and enforced. First, the farmer
has the right that his wheat be not destroyed. Therefore, the cattle raiser will then be forced to
pay damages to the farmer for the crop destroyed.
These will be added to the marginal costs of the cattle- raiser who will reduce the number of
cattle to be raised to a manageable level. Second, if the law is that the cattle raiser has no
liability for damage done by his herd to the farmer’s crop, it will now be advisable for the farmer
to bribe the cattle raiser to keep his herd to a minimum level.
The coase theorem is explained with the help of Figure 16.1.
Initially, the condition of raising cattle is Dc = (ARc = MRc). The marginal cost of raising cattle
curve MC cuts the Dc curve at point L and the rancher would raise OQ cattle per year.
Therefore, the marginal social cost of wheat is MSC and a loss to wheat crop is OW . If a bribe
equal to damage is added to marginal cost (MCc + OW ) then the optimal solution will be at
point L where (MC + OW ) curve cuts the Dc curve, and the cattle number will restricted to OQ .
ADVERTISEMENTS​:
According to Coase, market failure due to property rights can be eliminated through private
bargaining among the affected parties. He points out that if property rights are clearly defined
and marketable and transaction costs are zero, a perfectly competitive economy will allocate
resources optimally even under conditions of externalities.
By transaction costs he means costs of negotiating or enforcing a contract. The existence of
differential transaction costs creates opportunities for one person’s choice to impact on others. It
is property rights that direct and control these choices.
Second Theorem:
On the other hand, if bargaining becomes costly, then property rights matter significantly. In the
words of Coase, “If bargaining is costly and information is imperfect, then liability rules help to
achieve optimality and the party that has the least costly way of dealing with the harmful effects
of an externality should be made responsible for paying the costs associated with the
externality.” Thus the second theorem of Coase provides a natural link between economics and
law, offering an efficiency rationale for deciding externality liability rules.
Coase has related his second theorem to the problems caused by the sparks emitted by coal
and wood-power steam engines. The problem is that fires sometimes caused by the sparks
damage nearby agriculture fields. In the absence of rules governing compensation for firm’s
damages, it creates negative externalities since rail companies have little incentive to prevent
sparks.
On the other hand, rail companies may pay full compensation that may leave property owners
with little or no incentive to protect themselves. Is it better for rail companies to take defensive
measures or for farmers to take defensive measures? Which is done, depends on whether
farmers can sue for damages?
The problem of sparks can be solved in the following ways:
(a) Limit the amount of train traffic;
(b) Rail companies should install some type of spark- inhibiting device; or
(c) Farmers should plant their crops several yards further away from the railway tracks.
There are some Pareto optimal rules that make someone better off without any change in the
welfare position of others. If a stable set of rules is maintained, most parties stand to gain. Also,
there are some efforts involved in coming to an agreement with another party.
In certain cases, the cost of negotiating the agreement can be more than the value of the rights
to produce. A buyer must pay contractual cost as well as the cost of the right to the resource
use desired. It is not enough merely to know who owns a particular resource. The example of
conflict over airport noise can be illustrated. Jet airplanes flying low to approach a runway create
disutility for nearby residents and lower the value of their property. The costs faced by the
airlines depends on the character of rights.
If the air space is owned by the airlines, it will be costly for the large number of residents to
organize a bid. But even where the residents have some rights, the character of the right makes
a difference. One alternative is for the residents to have the right to an injunction, which means
that the airlines must deal with each individual homeowner and obtain permission to fly over.
Thus a high transaction cost is put on the airline which must deal with large numbers and face
the possibility of exhorbitant holdouts.
Significance of Theorems:
Many economists have explained the significance of Coase theorems:
1. Institutional Base:
S. Baker has pointed out many aspects of first Coase theorem which signify a new area of
economics. According to him, the Coase theorem tells us that in a world with zero transaction
costs and well defined property rights institutions neither foster nor prevent allocative efficiency.
Of course, the importance of this observation rests on the reverse conclusion that if transaction
costs (information costs, bargaining costs, administrative costs etc.) are significant as in the real
world, institutions do matter. Hence, different institutions will have different impacts on efficiency
and distribution, which, in turn, make comparative institutional analysis indispensable.
2. Need for Policy Measures:
The Coase theorems signify that well defined and marketable property rights help in promoting
economic efficiency. Further, the market mechanism can lead to a Pareto optimality despite the
presence of externalities because it is possible to devise a private bargaining solution to remove
the externalities.
Today, there is general agreement that assigning property rights clearly may take care of some
externality problems, particularly those concerning environmental problems. They require more
active government intervention. Some forms of this intervention might include regulatory
measures, financial penalties, subsidization of corrective measures and creating a market for
externality.
3. Interdepence of Economics on Law:
According to J. Hirshleifer, given an assignment of proper rights and if there are no transaction
costs, the final outcome will be efficient. It implies that in addition to removing artificial barriers to
transaction costs, the law ought to assign well defined property rights to all resources of
economic value. Moreover, a free market would redistribute initial legal ownership rights in
efficiency. It is only possible through judicial manner which would facilitate such transfers.