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Article Summary

Hahnel, R and Sheeran, K.A. (2009). Misinterpreting the Coase Theorem. Journal of Economic Issues. Vol 43. No 1. March. pp 215-238. 


The Coase theorem is considered a paragon for understanding collective bargaining in the case of polluters and victims. The common interpretation of this theorem is that markets fail when property rights are poorly defined, and the way to combat this problem is to allow individuals to negotiate among themselves until they reach an ideal solution. This interpretation lends support to a conservative, pro-market view of polluter-victim situations.

The article argues that this interpretation of the Coase theorem is essentially incorrect; in fact it misses some of the aspects that Ronald Coase considered key in formulating his idea. Several of his assumptions are ignored in the discourse. For example, the theorem assumes there is only one polluter and one victim. It also assumes that the, “right to pollute/to be free from pollution,” is clearly defined, which it often is not. Finally, Coase acknowledged negotiations are likely to fail in the presence of high transaction costs and that property rights are difficult to assign, especially for natural resources.

Pro-Coase economists often choose to ignore these caveats and state that this theorem proves the key to facilitating discussion between polluters and victims: let them figure out their own rights and decide on the optimal solution amongst themselves. However, upon further analysis it is clear the Coase Theorem actually says nothing about markets. Establishing property rights is not the same as creating a market for externalities. Further, there is no competitive market present here. According to Coase, this theorem involves a one-to-one transaction. A competitive market, by definition, has more than one buyer and one seller. Even in markets that are not perfectly competitive, there are more than two actors. This sort of interaction is not a market process; it is a one-to-one negotiation.

According to Hahnel and Sheeran, treating Coasian negotiations as if they were a market leads to analysis errors. Those who view the Coasian situation as a market process seek to find an equilibrium price. However, it is impossible to find an equilibrium price if there is no market to regulate. There is a basket of prices they could agree upon depending on personal feelings and negotiation styles. Efficient outcomes are not achieved in these sorts of negotiations unless strict assumptions are upheld: both parties care only about their own payoff, both parties are rational, neither party suspects the other to be irrational, and early results will not be available in later negotiations. These assumptions seldom apply to real-world negotiations. Finally, there is the issue of imperfect information in negotiation. One player often holds more information than others, making it an unfair negotiation. Players cannot make market-driven decisions based on imperfect information.

The final piece of Hahnel and Sheeran’s critique examines the Coasian situation with more than one victim. In this case, negotiations are even less likely to yield efficient outcomes. This is especially true when each victim negotiates separately. In this situation, there is a free rider problem. Thus, collective bargaining rises as a potential solution. However, it is difficult to identify and recruit victims in a pollution situation. If victims have the property rights Coase emphasizes as key, some people will falsely claim themselves as victims. Even if victims are accurately identified, it is difficult to predict if negotiations will lead to a truly efficient solution.

Because of the aforementioned misrepresentation of Coase’s theorem as market driven, as well as the problems inherent to negotiation (especially among a group of victims), it is impossible to determine if Coase’s theorem adequately supports utilization of the free market to regulate pollution-victim relationships. Instead, it seems to support that government intervention is necessary to make sure negotiations are fair and do not suffer from a mismatch of information or the free rider problem.