What is the Coase Theorem?

by Robin Fontaine

The Coase Theorem in Brief

Imagine that a new neighbour with questionable taste moves in next door and decides to install an excessive number of garden gnomes right by your windows: this would surely negatively affect your enjoyment of the view. Economist Ronald Coase argued that in such a situation, one would only have two choices [1]. Either your neighbour would compensate you for installing top quality curtains to avoid seeing the sculptures, or you would compensate your neighbour for the costs of moving or covering the statue, your neighbour compensates you.

Ronald Coase argues that when two individuals or groups are in conflict about property rights, bargaining between the two actors will lead to an optimal socially desirable outcome for everyone involved- as long as there are no costs associated with the negotiation process [2]. This theorem challenged the idea that in case of conflicts between two bystanders, government regulation and a traditional justice system (I sue you, you sue me) were the only possible outcomes.

Coase theorem for Climate Policies

This theory is key in environmental economics because it provides a format to deal with pollution issues and other environmental actions that might affect another bystander [3]. The actors involved will generally involve a polluter. This can be a firm or an individual, and a bystander facing environmental, economic or health consequences of said pollution. According to the Coase theorem, the polluter and the bystander could resolve these actions negatively affecting other people even without government intervention [4].

Imagine an industry using 100% of its right to pollute. This will surely affect the neighbouring inhabitants’ health and they will have to pay money for their health insurance and treatments. In this case, the neighbours could offer money to the industry in exchange for reducing their levels of pollution. This way, the industry earns money from its neighbours and from selling its leftover “right to pollute”.  Even with decreased productivity, it would keep the same revenues. Although the situation will be better for the neighbours who are giving the same amount of money but will reduce health hazards [4]. In this example, the two actors are clearly defined as the industry and the neighbours and the cause of the negative impact is attributed to the industry. The essential factor in this negotiation is that it was mutually beneficial and that it did not entail any costs [5]. 

Conclusion and pitfalls

Unfortunately, the Coase theorem is quite flawed by default. It is not always easy to negotiate between private parties without an impartial justice system. All negotiations are based on the actors’ subjective estimations, studies and research. It is crucial that the negotiations take place outside the traditional justice system for the theorem to be valid. In a more formal setting, negotiations and lawsuits lead to piling costs this financial burden favours actors like big corporations who are often the polluters whereas it disadvantages communities and individuals with fewer means. Furthermore, traditional legal systems can take a long time to come up with results [6], and these results can be very disappointing [7] (for a good depiction of this problem, I recommend the film Dark Waters [8]).

In practice, the relation between stakeholders is often unbalanced, the Coase theorem is hard to apply as a workable solution to real relations [4]. Although, in the case of international relations where no international authority has the power to bind countries to act, bargaining between countries remains the primary option to develop new environmental policies [9]

We are facing a climate crisis, and we need to make decisions fast. Unfortunately, we cannot always rely on traditional justice systems because of the slow pace of their decision-making processes and because the balance of powers is often biased. In this context, it is always good to remember that the Coase theorem, while imperfect, offers a potential solution to complex multi-stakeholders environmental problems [3].


[1]  Investopedia. 2021. Coase Theorem. URL: https://www.investopedia.com/terms/c/coase-theorem.asp [last accessed on 12/08/2021]
[2] One Minute Economics. The Coase Theorem Explained: Coasean Bargaining Definition, Conditions/Assumptions and Examples. URL: https://www.youtube.com/watch?v=BcGoPQe3-ls  [last accessed on 11/08/2021]
[3] Taylor, J. Significance of Coase Theorem to Environmental Economics. URL: https://www.essaytyping.com/significance-coase-theorem-environmental-economics/  [last accessed on 12/08/2021]
[4] Permit markets. Britannica. https://www.britannica.com/topic/environmental-economics/Permit-markets [last accessed on 12/08/2021]
[5] Deryugina, T., Moore, F. and Tol, R., 2021. Environmental applications of the Coase Theorem. Environmental Science & Policy, 120, pp.81-88. https://doi.org/10.1016/j.envsci.2021.03.001 
[6] Meltzer, J. The Decade-Long Legal Battle over Chlorpyrifos and the EPA’s Next Steps. URL: https://www.law.georgetown.edu/environmental-law-review/blog/the-decade-long-legal-battle-over-chlorpyrifos-and-the-epas-next-steps/ [last accessed on 12/08/2021]
[7] Environmental NGOs lose 14-year battle over 2006 building zones extension. The Independent. URL: https://www.independent.com.mt/articles/2021-07-22/local-news/Environmental-NGOs-lose-14-year-battle-over-2006-building-zones-extension-6736235409 [last accessed on 12/08/2021]
[8] Dark Waters. Imdb. URL: https://www.imdb.com/title/tt9071322/ [last accessed on 10/08/2021]
[9] Smith, S. Environmental Economics: A Very Short Introduction. Oxford University Press. https://doi.org/10.1093/actrade/9780199583584.001.0001 
Categories Economic Concepts

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