Q1. What is Wrong with the Coase Theorem?

Question: Q1. What is Wrong with the Coase Theorem?

Answer:

It is Tautological, Under the Standard Definition

The Coase Theorem is one of the most celebrated theorems in economics:

This theorem, along with his 1937 paper on the nature of the firm which also emphasizes the role of transaction costs, earned [Ronald] Coase the 1991 Nobel Prize in Economics. The Coase theorem is an important basis for most modern economic analyses of government regulation, especially in the case of externalities. (Source)

There are many interpretations of the theorem. The Glossary of Economics Terms gives the following definition of the Coase Theorem.

Informally the Coase Theorem states that in presence of complete competitive markets and the absence of transactions costs, an efficient set of inputs to production and outputs from production will be chosen by agents regardless of how property rights over the inputs were assigned to the agents.

This is the first in a series of articles showing why the Coase Theorem is inherently flawed and should be removed from the curriculum of Principles of Economics classes. The first criticism of the Coase Theorem is that the standard definition of the theorem is tautological and should not be called a "theorem" at all.

The Coase Theorem is Tautological

Gabriel Mihalache gives a standard example of the Coase theorem in action when dealing with the concept of externalities. The externality in question is two households, and the herbicides from one of the households is damaging the plants of the other household:

If household 2 has property rights, household 1 will buy those rights and pollute only if its valuation is higher than the willingness-to-sell of household 2.

In either case, the outcome is efficient.

This assumes we live in a world without transaction and enforcement costs. It also assumes we can treat property rights, such as the ownership of a car as being identical to property rights not to have your property damaged by an accidental externality. If you take all those assumptions, then the standard definition is correct.

It is also tautological, as pointed out by Dan Usher in his 1998 paper The Coase theorem is tautological, incoherent or wrong. (PDF)

The version of the Coase Theorem as described by Mihalache implies, in the absence of transaction and enforcement costs that all deals beneficial to both parties will be made. But this is inherently tautological, as described by Usher:

That resources will be employed efficiently in the absence of transaction cost is almost a tautology. What does it mean to say that transaction cost are zero? It means that people can bargain costlessly, and will, presumably, do so as long as bargains are mutually advantageous. But the absence of mutually-advantageous bargains is precisely what one means by efficiency, a state of affairs such that no change can make one person better off without making somebody else worse off. The strictly-correct version of the Coase theorem boils down to the proposition if people can agree upon an efficient outcome, then there will be an efficient outcome.

Not only is this tautological, but it is a point that goes back to at least these days of Adam Smith and David Ricardo - namely that trade makes both parties better off. Where is the insight? The Coase theorem is usually described in the context of externalities, but, using this definition, it applies to all voluntary economic actions. You could argue that the benefit of the Coase theorem is that it shows that, given the assumptions, that dealing with externalities, by, say, purchasing a pollution right is no different than a standard economic interaction, such as purchasing a car. But once again, it is a tautological argument, because that was one of the initial assumptions!

Next: The Coase Theorem is Misleading.