Coase theorem

In law and economics, the Coase theorem (/ˈkoʊs/) describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem is significant because, if true, the conclusion is that it is possible for private individuals to make choices that can solve the problem of market externalities. The theorem states that if the provision of a good or service results in an externality and trade in that good or service is possible, then bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property. A key condition for this outcome is that there are sufficiently low transaction costs in the bargaining and exchange process. This 'theorem' is commonly attributed to Nobel Prize laureate Ronald Coase (quotations noting that Coase's theorem is not a theorem in the strict mathematical sense).

In practice, numerous complications, including imperfect information and poorly defined property rights, can prevent this optimal Coasean bargaining solution. In his 1960 paper,^[1] Coase specified the ideal conditions under which the theorem could hold and then also argued that real-world transaction costs are rarely low enough to allow for efficient bargaining. Hence, the theorem is almost always inapplicable to economic reality but is a useful tool in predicting possible economic outcomes.

The Coase theorem is considered an important basis for most modern economic analyses of government regulation, especially in the case of externalities, and it has been used by jurists and legal scholars to analyze and resolve legal disputes. George Stigler summarized the resolution of the externality problem in the absence of transaction costs in a 1966 economics textbook in terms of private and social cost, and for the first time called it a "theorem." Since the 1960s, a voluminous amount of literature on the Coase theorem and its various interpretations, proofs, and criticism has developed and continues to grow.