Coase Theorem

Reviewed by Apoorva | Updated on Aug 27, 2020

What is Coase Theorem?

Coase Theorem, developed by the economist Ronald Coase, is legal and economic theory. The theory argues that parties to a property rights dispute will be able to negotiate and conclude with an economically optimal solution under the right conditions, regardless of the initial distribution of the property rights.

Further, the theory states a potentially useful way to resolve the conflict the best possible way between business competitors or the economic way of using limited resources. The theory can be applied to the fullest if the conditions of efficient, competitive markets along with the zero transaction costs are fulfilled.

Understanding Coase Theorem

Applications of Coase Theorem

The Coase Theorem is applicable in situations where the economic activities of one party impose a cost on the other party. It is also applicable when one party damages the property of another party. You can understand the applicability of the theory better by considering the following example:

Say, a pub situated in a residential area is subject to a noise complaint by the neighbouring households. According to the theorem, there can be two possible settlements. 1. The owner of the pub can offer financial compensation to the affected parties so that they allow the pub to continue producing the noise.

  1. The pub may try to avoid the noise produced by reducing the volume of music if the neighbours can pay the business to do so. This can be thought of as compensation for the business from the neighbours' end to make up for the lost revenue associated with the noise.

The Coase Theorem is seen as an argument against legislative pre-emption of conflicts over property rights and privately negotiated settlements.