Challenging Economics – Coase Theorem

One of the fundamental problems with neo-classical economics is its lack of reality. In university students are taught theories that bare little similarity with the real world. I have learned a lot about economics and society during my time in university, unfortunately very little of that happened in the classroom. So I will run a series of posts where I challenge mainstream economics and debunk the unrealistic theories. Myself and my classmates are well able to explain abstract theories but can say little about the state of the economy or what to do about the recession.  First up is the Coase Theorem, a particularly ridiculous theory that only an economist could take seriously.

(My textbook is Microeconomics (4th ed) by Jeffrey Perloff and Principles Of Economics by Robert Frank and Ben Bernanke. I’ll use my lecture notes to show that I’m not debating a straw man.)

The theory was developed by Ronald Coase in two economic papers, “The Nature Of The Firm” (1937) and “The Problem Of Social Cost” (1960). He saw it as an example of a world of zero transactions, something he admitted was quite unrealistic. Despite having the theorem named after him, Coase disliked it himself,  which should be a warning about its robustness. Coase won the Economics (fake) Nobel Prize partly for this work, which is part of the reason the Economics Nobel Prize isn’t held in high regard. Free marketers have taken the theorem further than Coase ever intended and took it further than he envisioned.

The Coase Theorem holds that disputes can be solved not by the government or use of courts but by bargaining on the free market. It is portrayed as an alternative to rigid and blanket government regulations or pollution taxes which are described as inefficient. It is argued that if both parties have established property rights and there are no transactions costs then the free market will lead to the most efficient outcome. It is drawn in response to market failures in the case of pollution where people suffer

I’ll use an example from my textbook. Imagine there is a chemical company (called Abercrombie) and a fisherman (called Fitch). The chemical company wants to dump its chemicals unfiltered into the lake, whereas the fisherman obviously doesn’t want that. If there are no property rights, then the chemical firm will dump the toxic chemicals and the fisherman will lose business. The obvious (and realistic) solution is for the government to intervene and prevent chemicals from being dumped without a filter. However, this is where the Coase Theorem comes in.

A situation where Abercrombie (chemical company) wants to dump toxic waste but Fitch (fisherman) wants him to install a filter

A situation where Abercrombie (chemical company) wants to dump toxic waste but Fitch (fisherman) wants him to install a filter

Free marketers hate even the thought of government so they use the Coase Theorem as a free market alternative. This estimates how much each firm values the use of the lake and then allows them to bargain over whether or not to install a filter. Let’s say both sides would gain £100 per day if a filter is installed. However if the filter isn’t installed then the chemical company makes £130 per day while the fisherman makes only £50. The fisherman will then pay the chemical company £40 to install the filter, making him better by £50 (net gain £10) and the chemical company better by a net gain of £10. Therefore everyone is better off thanks to the free market.

The Coase Theorem says that they should bargain/bribe each other

The Coase Theorem says that they should bargain/bribe each other

Then there are some hypothetical numbers thrown at you to imply that if the government got involved by imposing a pollution tax or forcing the chemical company to install a filter, this would be inefficient and make everyone worse off. Moral of the story is that the free market can solve our problems without pesky government interference. What is interesting is that there is little difference between how the Coase Theorem is explained in 1st year and in final year. It doesn’t begin simple before adding complicated details, it literally is that simple.

Thanks to the magic of the free market everyone is better off. Yay!

Thanks to the magic of the free market everyone is better off. Yay!

Obviously there are a host of problems with this theorem. Why should fishermen pay for the right not to lose their livelihood? Isn’t that extortion? Won’t this lead to moral hazard where companies have an incentive to threaten to pollute the lake unless they receive a bribe? This could also work in result with people pretending to be fishermen in order to claim compensation for “lost earnings”.

Second of all, what about the people who don’t have an economic stake in the lake but still use it? For example what if I enjoy swimming or water sports in the lake? Seeing as I don’t derive any economic benefit from this, how do I pay off the chemical company? What about the marine life? What if a deal is reached that is economically efficient but involves the death of all life in the lake? If the lake is reduced to a toxic pit, in what sense is this efficient? What if the bargaining is not between equals, but between impoverished fishermen and a giant multinational?

The theorem doesn’t hold well even on its own ground, but it collapses if you take it elsewhere. What if instead of one fisherman, there were hundreds? How do we efficiently bargain then? What if there aren’t clear property rights or they are impossible to implement?What if instead of a lake we are dealing with the Atlantic Ocean? What about toxins in the air, how can they be divided into property rights?

The theory is based on the assumption that people have perfect information about the world. It is assumed that everyone knows the cost and benefit of every action to everyone else. The whole theorem is based on the assumption that we can easily measure the costs and benefits of an action, yet in the real world we don’t. It is near impossible to put a monetary figure on the effect of chemicals on a lake and harder still to measure how much this will cost all the people who use the lake. There are many chemicals whose effects are unknown and far too many actions to make a reasonable estimate.What if instead it was a factory emitting toxins into the atmosphere? How do you measure the effect it will have on millions of people in many countries? How do you separate it from the other toxins in the air? Suggesting that people can simply sit down with a major factory (who has every interest not to comply) and measure the costs of the pollution and then bribe it to stop is too absurd to be taken seriously.

The Coase Theorem is supposed to show how the free market can operated without the need for government intervention. Instead it only shows what desperate lengths and unrealistic assumptions neo-classical economics will go to in defence of the market. It is an example of the kind of absurdities students waste their time on rather than learning how the economy really works. It truly is a bunch of “neo-classical mumbo-jumbo”. At the end of the discussion on the Coase Theorem my textbook (Perloff 2007:619) notes that: “For these reasons, Coasian bargaining is likely to occur in relatively few situations.” Then why bother mentioning it?


Filed under Economics

17 responses to “Challenging Economics – Coase Theorem

  1. Egad, Young Economist!
    “Myself and my classmates are well able . . .” Get Ye to a grammarian!

    • I phrase that way deliberatively out of an irrational stubbornness. I long ago decided that “Jim and I” sounded wrong, so I always say “Me and Jim” grammar be damned. I have no idea why.

  2. I’m pleased to see someone who is studying the voodoo of “economics” actually refuting some of its holiest absurdities.

    I’ve found PDF versions of the Coase papers you’ve mentioned and added them to my library for reading later. They should be “interesting”.

    Please see the comment I left at “Promises We Cannot Keep”. It applies to nearly any discussion of Mammonism, or “economics” as it’s called.

  3. Austrian School of economics is especially notorious for shunning empirical evidence. All about them is strictly theory – that’s why they can never be proven wrong.

    • Yes the problem with it and libertarianism is that the excuse to any counter evidence is the claim that wasn’t true libertarianism, that there was still too much government interference. This can be claimed in any possible situation.

      It is interesting to contrast this with the other conservative icon, Milton Friedman. He did make predictions and his proposals were implemented. they failed and as a result no one talks about monetarism anymore. Austrian economics avoids this danger

  4. It’s been ages since I’ve taken an economics class, but I don’t recall covering this. Is your professor especially conservative?

    • No, actually I’d say few of my lecturers are ideological in any particular direction. That’s the worst part of it, its not stated as ideology, but as fact

      • I’d be a little suspicious of a denial of any ideological biases in and of itself. In the video, the economic historian mentions that Coase didn’t think the Coase theorum was valid, a point you mention as well. Any professor that talks about this without mentioning that fact has an ideological bias, whether he acknowledges it or not.

        Heck, I have an ideological bias. I like to think I’m fairly lucid and I also like to think my ideas are amenable to change when confronted with fact. Yet, I’ll be the first to admit that intellectually I owe a lot to liberalism and I have a somewhat leftward leaning interpretation of it.

        But then, I’m in my late forties and far more cynical than I was when I was your age. If I had any idealism left, it was killed during the 2008 banking crisis. At the risk of having you think I’m paranoid, I really suspect that the bank bailout was a shocking power grab on the part of wealthy people who don’t like democracy. That the Irish people accepted the imposition of austerity is something I’ll never quite understand. I followed it in the newspapers here at the time and I was just flabbergasted, especially, considering the economic and colonial history of the country. (I have, to my knowledge, no Irish ancestry, so this isn’t a personal or emotional connection, just the opinion of someone who likes politics and economics.) If your professors weren’t advocating deficity spending instead of austerity in respons to the economic downturn, then they are ideological, even if they don’t want to admit it.

        Then again, my first economic professor was an admitted socialist, but at least I knew his biases.

        • Well the professors naturally ignore Coase’s opinion of his own theorem. The textbooks pretend they are ideology free, which of course is nonsense, Everyone has an ideology and a bias. I include myself in this. I am left wing and consider myself open minded, but doesn’t everyone.

          What you propose is noway paranoia, in fact many have suggest something similar. Whatever the case, it is clear that an unholy trinity of bankers, property developers and politicians had disproportionate influence on society. They collectively crashed the economy. Why do we accept this? This is one of the great mysteries of Irish society and the former Minister for Finance once remarked that if the policies implemented in Ireland were implemented anywhere else there would be riots. This is probably due to the legacy of colonialism, lack of strong trade unions, the avoidance of controversy and ideology. Irish society is remarkably free from divisive ideological debates which has its advantages but also means we don’t question decisions, especially when made by authority.

  5. I don’t mean to be patronizing. You seem like a bright student and congrats on your 2012 award. But since you say your blog is about debating I’ll add my $0.02 (not much even if you convert it to Euros!).

    You badly misunderstand Coase and Stigler’s translation of it into a Theorem. Coase well understood that we live in a world of transaction costs and where perfect competition isn’t reality. As he said in his Nobel lecture ( – ““…I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transaction costs. The significance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion; let us study the world of positive transaction costs.”

    The point of the Coase’s argument is not that there should be no government interference when negative externalities occur. It is that the Pigouvian solution that the state should automatically interfere is not true.

    I don’t know who your professors are, and do not want to defend them. But your position, “First up is the Coase Theorem, a particularly ridiculous theory that only an economist could take seriously” means that the rest of mankind will be under analytic delusion more often than not. For our sake, i hope you are wrong about how serious non-economists will take Coase. The Coase Theorem is to the analysis of externalities, what perfect competition is understanding market deviations, or what the Ten Commandments or Buddha’s Eight Fold path are to understanding the human condition. That no one follows them, does not suggest that they are pointless. And you do not have to be religious to hold that view.

    • “You badly misunderstand Coase and Stigler’s translation of it into a Theorem.”
      Actually I clearly said that not even Coase fully backed the theorem named after him. I mention in the post that later people gave it meaning that Coase had never intended. I actually linked to his Nobel Speech, in fact the exact same link you used.

      Yes Coase theorem is used as an alternative to Pigouvian taxes and government intervention in general, but I felt I explained why it is a poor excuse. What if the externality affects too many people who cannot band together into one negotiating team? What if the cost of the externality is unknown? Pollution is the clearest example and I feel it shows the limits of the Coase Theorem and the necessity of government intervention.

      Could you further explain your final paragraph as I don’t fully understand your point. The Coase Theorem is completely unworkable. It is not a reflection of how the world works or how it possibly can work. It can never be implemented nor should it. I’m not sure if you concede this point, but you still argue it has some uses. Could you please explain what they are?

      • Stan

        Robert, I’m not sure, but I think you miss the point of Coase, maybe from a bad textbook. Not only did he not “fully back” it, he never even proposed any “theory” that markets have low transaction costs and are efficient. On the contrary, his point was that free markets always have transaction costs. And that sometimes these costs are so high, government regulation can make markets more efficient! Most people completely miss these points simply because one of Coase’s papers spends so many pages talking about a fictitious world of zero transaction costs – a world Coase constructed in order to rip to shreds later on in the same paper. Please read the conclusion of this other paper, by another author trying to clear Coase’s name: .

        Here’s my example of where free markets fail, due to high transaction costs, as Coase might agree. In the early 2000s, investment bankers marketed Collatoralized Debt Obligations (CDOs) made from subprime loans. It was enormously difficult to analyze these opaque financial derivatives, a prohibitive transaction cost for the buyer, intentionally made so by the seller. The result was catastrophic inefficiency, and a market meltdown. The only solution was government activism and regulation, as I believe Coase would agree.

        Sorry if I misunderstand you. I only learned about Coase tonight, by reading the PDF cited above!

        • Oh its absolutely true that Coase disliked the theorem that bore his name and it was really other people who took the theory and pushed it much further than he ever planned. In this post I’m criticising the theory as it is propagated, not as Coase originally meant.

  6. Well written. It was amazingly easy to understand from this blog. You can be a great teacher, I conclude.

  7. Is much of capitalism in its current form, a form of extortion?

  8. Safa

    Robert, I am an 18 year old A-Level student from Oxford. I was wondering if you could email me as I need someone with apt economic knowledge to discuss a project I’m doing on the privatisation of prisons.


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