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The Coase Theorem: Key Economic Components Essay

Coase Theorem: A New Way of Looking at Entrepreneurship

Though the technological breakthrough made in the 21st century has redefined the strategies adopted in business and economy, to the point where the above-mentioned fields have been reinvented almost entirely, the key economic theories still provide a solid basis for the strategies of both large corporation and SMEs to be built on. Among these theories, the Coase Theorem takes a special place. Often doubted and considered rather unconvincing, the theory, nevertheless, still exists and, more to the point, often proves to be quite viable (Hahn & Stavins 2012, p. 293). Though the Coase Theorem presupposes that an entrepreneurship should exist in the environment where the transactional costs could be driven to zero, i.e., demands ideal conditions for its implementation, it still may boost the profits of an entrepreneurship considerably, since it helps isolate and embrace every single factor, or externality, that may affect the performance efficiency of the organization in question.

Definition: Coase Theorem as It Is

The essence of the Coase Theorem is rather hard to nail down; according to the existing definition, the Coase Theorem is traditionally referred to as the concept of economic efficiency achieved through the decrease of transaction costs (i.e., the so-called externalities), no matter what the initial property allocation was. It should be kept in mind, though, that different renditions of the theorem exist; originally, the principle of organization’s efficiency was outlined by Coase by saying that “if nothing obstructs efficient bargaining then people will negotiate until they reach Pareto-efficiency” (Farrell 1987, p. 113). However, as the economy evolved under the influence of the globalization process, the Coase Theorem was reconsidered several times until it took its final shape: “under certain conditions, the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights” (Hahn & Stavins 2012, p. 267).

Again, the aforementioned interpretation can be considered a slightly simplified version of the theory, since the initial definition included the necessity to include such elements as two agents, knowledge of convex productions, competitive markets, no costs for transaction or weight effects, and the integration of profit maximizing producers, as well as utility maximizing customers, in the analysis (Hoffman & Spitzer 1982, p. 73).

Historical Background: Across the Sands of Time

Surprisingly enough, the Coase Theorem was developed not by Coase, but by George Stigler in 1966. Though Coase had his hand in the creation of the theory, Stigler should also be given credit for putting the theory together. Working on The problem of social cost in 1960s, Coase provided the bulk for the theorem to be based on (Coase 1960, p. 2). Stigler, in his turn, not only summarized the key argument of the Coase Theorem, but also suggested that transaction costs should be neglected, which Coase himself never considered possible (Olson 1996, p. 4).

Key Economic Components: Externalities

As it has been stressed above, the Coase Theorem presupposes that the company’s efficacy can be raised by bringing the transaction costs down. However, the theorem also includes a number of external factors that facilitate the success of the given operation.

Also known as the so-called “externalities,” or the additional effects that the third parties may possibly have on the efficiency of an entrepreneurship (Harrison & McKee 1985, 653), they can be considered the essential components of the theory. Among the key externalities that the Coase Theorem is based on, the “two agents to each externality” (Harrison & McKee 1985, 653), perfect knowledge of production and profit, competitive markets, “zero transactions costs” (Harrison & McKee 653), “costless court system” (Harrison & McKee 1985, 653), “profit-maximizing producers and expected utility-maximizing consumers” (Harrison & McKee 1985, 653), absence of any wealth effects and most importantly, the environment in which agents could strike “mutually advantageous bargains in the absence of transactions costs” (Harrison & McKee 1985, 653) should be named. The aforementioned externalities are the conditions for the Coase Theorem to work and, therefore, can be regarded as positive ones.

It is essential to keep in mind that each of the aforementioned externalities plays a crucial role in the process of increasing the profits of an entrepreneurship. To be more exact, the absence of transaction costs allows for a more profitable allocation of the financial resources, e.g., a more adequate insurance strategy. The perfect knowledge of production, which can be achieved by incorporating new forms of media into the array of tools used by the company, provides essential data concerning the company’s competitiveness and position in the target market, as well as the current demand. The wealth effects, which have been mentioned above, include the alterations in the financial resources distribution. The appearance of transaction costs is traditionally viewed as a negative externality. The spill-over effects, which include environmental concerns, health issues and high rivalry rates, are usually referred to as negative externalities and pose a tangible threat to the success of the Coase Theorem implementation. It could be argued, though, that the aforementioned negative externality can be internalized, so that their effect could be neutralized (Harrison & McKee 1985, 653).

Counterarguments: The Numerous Holes in Coase Theorem

Despite its innovativeness and the uniqueness, the theory has a range of holes, which Coase himself, nevertheless, denied despite the obvious fact of their existence. One must admit, though, that the key arguments, which the critique of the Coase Theorem is traditionally based on, are not quite adequate either.

According to the existing sources (Harstad 2012, p. 81), the very premise of the Coase Theorem is often doubted. As the official definition says, the theory is based on the situation, in which no transaction costs are taken. Critics, in their turn, argue that such a situation is practically implausible.

True, the aforementioned issue is not the only problem with the Coase Theorem, yet it is clearly the biggest one, since it questions its very premise, thus, allowing for a possibility of the theory being faulty. Other argument include the discussions of isolated cases, in which the theory may fail to work, such as the conflict between a major enterprise and the local landowners (Hoffman & Spitzer 1982, p. 76); the significance of resources allocation, which is neglected in the Coase Theorem (Hahn & Stavins 2012, p. 272), and so on.

Conclusion: Coase Theorem and the Economic Environment

The Coase Theorem is not perfect – far from it; it contains several inconsistencies, which a range of critics have pointed out. Nevertheless, it offers admittedly impressive economic outcomes and can be considered rather plausible provided that the required economic factors have been arranged properly before the execution of the procedure suggested by Coase.

Reference List

Coase, R H 1960, ‘The problem of social cost,’ Journal of Law and Economics, vol. 3, no. 1, pp. 1-44. Web.

Farrell, J 1987, ‘Information and the Coase Theorem,’ Economic Perspectives, vol. 1, no. 2, 113–127. Web.

Hahn, R W & Stavins, R N 2012, ‘The effect of allowance allocations on cap-and-trade system performance,’ Journal of Law and Economics, vol. 54, no. 4, pp. 267–294. Web.

Harrison, G W & McKee, M 1985, ‘Experimental evaluation of the Coase Theorem,’ Journal of Law and Economics, vol. 28, no. 3, pp. 653-670. Web.

Harstad, B 2012, ‘Buy coal! A case for supply-side environmental policy,’ Journal of Political Economy, vol. 120, no. 1, pp. 77-115. Web.

Hoffman, E & Spitzer, M L 1982, ‘The Coase Theorem: some experimental tests,‘ Journal of Law and Economics, vol. 25, no. 1, pp. 73-98. Web.

Olson, M 1996, ‘Distinguished lecture on economics in government: big bills left on the sidewalk: why some nations are rich, and others poor,’ The Journal of Economic Perspectives, vol. 10, no. 2, pp. 3-24. Web.

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IvyPanda. 2020. "The Coase Theorem: Key Economic Components." May 22, 2020. https://ivypanda.com/essays/the-coase-theorem-key-economic-components/.


IvyPanda. (2020) 'The Coase Theorem: Key Economic Components'. 22 May.

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