Why private Solutions Do Not Always Work

Despite the appealing logic of the coase theorem private individual on their own often fail to resolve the problems caused by externalities. The coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement. In the real world however bargaining does not always work even when a mutually beneficial agreement is possible.

Sometimes the interested parties fail to solve an externality problem because of transaction costs the cost that parties incur in the process of agreeing to and following through on a bargain. In our example imagine that Dick and Jane speak different languages so that to reach an agreement they need to hire a translator. If the benefit of solving the barking problem is less than the cost of the translator Dick and Jane might choose to leave the problem unsolved. In more realistic examples the transaction costs are the expenses not of translators but of the lawyers required to draft and enforce contracts.

When private bargaining does not work the government can sometimes paly a role. The government is an institution designed for collective action. In this example the government can act on behalf of the fishermen even when it is impractical for the fishermen to act for themselves. In the next section we examine how the government can try to remedy the problem of externalities.

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