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Introduction to Coase Theorem

Law and economics are a wide subject of study. Scholars in this field have found a lot of areas where the law is useful in explaining economics and vice versa. And even the field is more useful to a student of law; economic students cannot complete their studies for higher learning institutions without looking at laws that apply to economics. In other words, economics and law are separates subjects that find common ground under the economic analysis of law. This is not a very easy subject to understand, though there seems to be nothing complex about it.

The easiest way to understand this concept is to look at where the relationship may arise. Note that human beings are social beings, who must make choices in their daily lives. Without these choices, there simply is not life. However, the choices we make also affect the people around us directly or indirectly and positively or negatively. Different economic theories have been designed to explain why human beings behave the way they do and why they make certain decisions. The consumer theory holds that people are naturally rational decision-makers. This means they make decisions based on what makes them happier. Any decision that does not seem to favor them the most is toast aside because they look for maximum benefit.

When, for instance, households are trying to choose between saving and spending, they look at the current economic conditions. If they are favorable and the economy seems to be booming, they will go on spending. But if things are not good within the current economy, saving seems to be more beneficial for the sake of the unknown future. These decisions are simply based on the most immediate need and the most immediate benefit.

On the other hand, society is guided by rules and regulations. These are guidelines and principles that define what is right and what is wrong. It is law and order that defines these virtues. In economics, deontology and utilitarianism are the two theories that explain how people make decisions based on what is good and what is right. According to the deontology theory, every person should always do good, even if that good leads to bad results. It focuses more on the process than on the results. For instance, such things as lying, not keeping promises, and other negative actions are defined as wrong. If someone lies false testimony in order to vindicate their best friend from murder charges, that person has done something wrong.

On the other hand, the utilitarian theory is based on the statement “the end justifies the means.” In other words, what you do does not matter, as long as the end results are good. If you lie to armed robbers to escape from death, you have done something right, and that calls for a good course.

Even though these two theories try to explain what is good and right and seem to be on the same page, they differ in their ethics explanation. And this is where a law may come in to assist, particularly concerning specific matters. Economic analysis of law is a subject that handles why people make certain mistakes and the incentives that may encourage or discourage them from doing so. Law deals with the justice system, and economic theories like the game theory explain the reason behind rational decisions. Hence, on many occasions, courts have used these examples to argue cases on what leads people to specific directions. Most importantly, economics and law are mostly concerned with contracts, tort, and criminal laws.

The Coase theorem is a model that tries to establish the right link between economics and law. The history of economic analysis of law dates back to the early 1960s, but its real establishment began in the 70s when the Coase Theorem was established. This theory tries to explain efficiency within a market system, and the actions lead to complete competitiveness. Law is crucial to an economy since it can shield markets from failures. A perfect example is where rules and regulations are established to discourage market monopolies, who would otherwise create a bad competition by gaining more profits from the market that is allowed by logic.

Coarse Theorem Explanations

The Coase Theorem is a model relating to law and economics. Economist Ronal Coase developed it. The theory affirms the presence of complete competitive markets with no transaction costs, an efficient set of inputs and outputs to and from the production -maximum distribution will be chosen, no matter how property rights have been shared. Understanding property rights can be hard sometimes since, in some situations, it does not matter very much about the rights two parties agree to something. Coase theorem continues to further denote that conflicts arise over property rights under these assumptions, in which case, the parties involved try to find a solution based on the set of efficient inputs and outputs.

In other words, property ownership is quite complex. It is hard to know who owns the property and what rights they have against such properties in some systems. For example, some parties run a company as if they own it, but they cannot sell and use the company's proceeds. Different laws and regulations are necessary during different situations, further explaining the need for law and economic relationships. The subject may not be very useful to economics scholars as it is law students, but it is still an important part of the general system, which needs to be observed well.

The Coase theorem states deal with the best decisions that should be taken under a certain economic condition to bring about balance and good relationships among the parties involved. That, under ideal economic conditions, where conflict of property rights exists, the dispute parties have a right to bargain or negotiate terms that echo the full cost and underlying value of the property rights in question. But this will not happen unless the conditions conventionally assumed in the analysis of efficient, competitive markets are in place. And they are particularly useful in the absence of transaction costs.

Contracts are very important when two people are coming up with an agreement. These parties have the freedom to create and undersign their own contracts. Sometimes people change their minds, and that is just something about human beings that cannot be changed. Therefore, it can be very hard for one company if two firms have agreed on something, and one goes ahead to fulfill their end of the bargain, but the other party finds a change of heart. Under contract laws, courts come in to ensure that the terms of such contracts are observed, and the other party does not feel at a loss when tries to walk out.

In these cases, there must be free, perfect, and symmetrical information. Also, bargaining must be costless, where anything that goes beyond the maximum cost of reversing a transaction is ignored. Also, note that the cost of rectifying an error in a contract can be very high. Any information relating to the meetings or enforcement affects the outcome, and must therefore be observed carefully. Parties in the rights of property disputes must be willing to share all information with the legal systems to facilitate proper transactions. None of the parties can possess market power similar to the other, but bargaining power has to be equal enough that influences the outcome of a settlement. Markets in all final goods and productive factors with economic relation to the property in issue have to be efficient. This allows for the market price on the property to ascertain with accuracy. As stated above, information is fundamental to these transactions and must be approached with uttermost care. Sometimes it becomes hard for parties to agree, but they still need to observe respect for one another if they are in a contract.

Coase Theorem is crucial where property rights are involved, showing that participants involved do not necessarily consider the division procedure for property rights if the condition applies. This extends into if the parties only care about how the flow of current and future incomes is divided up without regard for issues such as personal views, social equity, or other factors far from economic ones. Coase Theorem has become such an important aspect in explaining the relationship between economics and law that it is today applied across the fields. If there were no laws in the world of economics, companies and individuals would behave in any way they wished, even if it meant hurting other people. Deontology theorists hold that human beings are naturally evil, and cannot be trusted to make the right decisions at any given time. Hence, systems are more trustworthy than individuals. This is the same case here where judicial systems are used to ensure people respect others and fulfill the promises that may have made to other people. And this means it would be very hard to achieve perfect balance in economics without the existence of these laws.

How Is The Coase Theorem Applied?

The best way to understand Coase Theorem is to look at conditions under which it is applied and what makes the difference where it is not. Generally, the thought creates the balance between law and economics, making it possible for people to respect contracts and that every party is satisfied. Of course, conditions may change even after an agreement has been made. For instance, if one person was to build a property that costs $1000 but later discovers that cost may increase to $2000, such a person can agree to compensate the property owner with cash rather than continue with the project.

Coase Theorem is applied in such conditions and many others where economic activities threaten one party with a cost on or damage another participant's property. In these cases, two parties must sit down and bargain for the most appropriate solution. Based on the type and extend of bargaining that occurs where Coase Theorem is applied, there may be an offer of funds as compensation for one party because of the other’s activities. Or, it may be in order to pay the party whose actions inflicts damages where they forego that activity. Either way, the two parties have to agree on the best mode of compensation so as to look like they have done what is right in the face of society.

For instance, let’s say a business has loud machines that attract noise complaint from the neighboring households, the Coase Theorem can be applied, in which case there are two possible settlements. One, the business may decide to offer a financial settlement to the affected people to allow them to continue with the noisy activities. And second, the business can stop procuring the noise, if the complaining party can be incentivized to pay the business for the same. In the second case, the other party compensates the business for additional costs or loss of revenue linked to noise abatement.

In case the full market value produced by the activity that is making the noise is more than the market value of the damage caused by the noise to the neighbors, then the efficient market outcome to the argument is the former. In this case, the company discovers that making the noise is more beneficial to the company through the revenue acquired. Hence, it compensates the neighbors from the same revenue while continuing to gain more. However, if the cost of the additional output by the business concerning the offending noise is less than the cost imposed on the other party, then the most efficient outcome is later, where the neighbors pay the business enough to abandon the noise, and the revenue is forgone. This payment has to be less than the value of the place on the absence of the noise.


Coase Theorem has been for long and wide, been seen as an argument against legislative preemption of conflicts over property rights, especially in the private sector, including the negotiated settlement. It was developed by Coase as he was considering the regulation of radio frequencies, stating that it was not necessary to regulate the frequencies since the stations with most gain from broadcasting on particular frequency could pay incentives to another broadcaster to stop interfering. TodayCoase Theorem, the same idea is applied to inefficient competitive markets.

Author: James Hamilton

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