The Coase Theorem

How effective is the private market in dealing with externalities. A famous result called the coase theorem after economists Ronald Coase Suggests that it can be very effective in some circumstances. According to the Coase theorem if private parties can bargain without cost the allocation of resources then the private market will always solve the problem of externalities and allocate resources efficiently.

To see how the Coase theorem works consider an example. Suppose that 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. Should Dick be forced to send Spot to the pound or should Jane have to suffer sleepless nights because of spot’s barking.

Consider first what outcome is socially efficient. A social planner considering the two alternatives would 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.

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