The Coase Theorem: A Review

I found an interesting post; John Lott, a economist of SUNY-Binghamton, gives the following comment:

When Greg (Gregory Mankiw) made the claim about the Coase theorem only applying when transaction costs are zero with the note that when transaction costs are positive it matters who we give the property rights to.

That is not quite right. The Coase theorem implies that if the transaction costs are less than the gains from trade it doesn't matter who we assign property rights to. Similarly, I wish that Russell (Russell Roberts) had raised the point that the market will solve externality problems, not just when transaction costs are zero, but when they are less than the gains from trade.

What does the Coase theorem mean?

Mankiw's famous introductory economics textbook says, "the Coase theorem* is the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own." [Mankiw(2007), Principles of Economics, 4th ed., pp210-211.]

There Mankiw considers a simple problem: Dick owns a dog named Spot. Spot barks and disturbs Jane, Dick's neighbor. Dick gets a benefit from owning the dog, but the dog confers a negative externality on Jane.

Question: Should Dick be forced to send Spot to the pound, or should Jane have to suffer sleepless nights because of Spot's barking?

To solve the above problem, we compare the benefit that Dick gets from the dog to the cost that Jane bears from the barking. If the benefit exceeds the cost, it is efficient for Dick to keep the dog and for Jane to live with the barking. Yet if the cost exceeds the benefit, then Dick should get rid of the dog.

According to the Coase theorem, if Jane can offer to pay Dick to get rid of the dog and if Dick accepts the deal(or if the amount of money Jane offers is greater than the benefit of keeping the dog), the barking problem will be solved.

Of course, we can consider another possible solution: if Dick can offer to pay Jane to allow him to keep the dog and if Jane accepts the deal(or if the amount of money Dick offers is greater than the benefit of peace and quiet), it will also be solved.

What makes difference between the two solutions? It is just only whether Dick has the right to a barking dog and Jane the right to peace and quiet. But in either case they can reach the efficient solution, according to the Coase theorem: Dick and Jane can always solve the barking(externality) problem and reach the efficient outcome by bargaining over the price whether Dick has the right to a barking dog and Jane the right to peace and quiet.

The Coase theorem says the efficient amount of the good involved in the externality(the barking or peace and quiet) is independent of the distribution of property rights (Dick's right to a barking dog and Jane's right to peace and quiet.) if there are no income effects.

That is, it means that the demands for the good causing the externality(Dick's dog) doesn't depend on the distribution of income (Dick's and Jane's income). Therefore a reallocation of endowments doesn't affect the efficient amount of the externalities. [Hal Varian(2003), Intermediate Microeconomics, 6th ed., pp607-608.]

However, if they incur some cost in the process of the agreement and the bargain, they sometimes fail to solve the barking problem. The cost is usually called transaction cost and is the question to ask here.

Here's the point that Lott raised: The Coase theorem implies that if the transaction costs are less than the gains from trade it doesn't matter who we assign property rights to.

Mankiw says in his text, "The Coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement."

In my sight, the statement that "no trouble reaching and enforcing an agreement" is no better than that "no transaction costs in reaching and enforcing an agreement". If it is right, Lott suggests that Mankiw state that the Coase theorem applies if there are "less transaction costs than benefit in reaching and enforcing an agreement."

However, Mankiw says later in his text that if the benefit of solving the barking problem is less than the transaction cost Dick and Jane might choose to leave the problem unsolved. [Mankiw, pp211] In this case it matters who we give the property rights to and the Coase theorem doesn't apply.

In this point, Lott is the same as Mankiw, I guess. I would like to listen to both about that.

* The Coase theorem comes from Ronald Coase, an emeritus professor at the University of Chicago Law School and a Nobel winner of economics in 1991.