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UW-Madison ECON 522 - SECTION 2 - COASE THEOREM AND TRANSACTION COSTS

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ECON 522 - SECTION 2 - COASE THEOREM AND TRANSACTION COSTSI Coase TheoremThe point of the Coase Theorem is that if there are no transaction costs, then as long as property rights arewell defined and tradable, then for efficiency it doesn’t matter who owns property rights initially; people willtrade with each other until the individuals who value certain property the highest own that property (thisis the intuition behind Adam Smith’s “invisible hand” of the market). However, even with zero transactioncosts, who has initial property rights definitely matters for distribution; if I own a car that you value more,I will sell you the car and earn a profit, but it is just as efficient for you to own the car in the beginning andreap the entire surplus, leaving me with no wealth.II Transaction CostsThink of transaction costs as anything that makes it difficult to trade, or as any cost you have to pay thatyou’re not exchanging for something you value. For example, if you want to buy a car you have to findsomeone to buy it from. Searching for a seller is a real cost, but you don’t really gain any value from payingthat cost; you would have had higher net utility making the same purchase if you didn’t have to search for aseller. There are three cost categories:• Search: you have to find someone to buy from, educate yourself about a product, etc.• Enforcement: there must be ways to enforce the laws governing property rights and exchange.• Bargaining: this seems to be most relevant for the property rights segment of our class.– Private information is when individuals have secret but symmetric information, such as theirown valuations.– Asymmetric information is when one individual has more/less information than the other. Bothof these situations can lead to inefficiency. Remember the lemon example, but there are ”lemonlaws” that try to deal with this kind of problem.– Uncertainty about the law and property rights can be a problem, but one way to reduce thistransaction cost is by relying on precedent in rulings.– Large numbers of people can also lead to problems. Remember the smoking ban example: as faras the Coase Theorem is concerned, who has smoking rights is irrelevant for efficiency, but sincethere would be many people involved in any negotiation for smoking rights in a public area, itmay be more efficient for the government to try to give the rights to the people who value themmost (a normative Hobbs approach).Example from class: Take a look at the example from class with the electric plant and the laundromat. Thestory is that the electric company pollutes, and the pollution reduces the laundromat’s profits from $300to $100. Meanwhile, the electric company has profits of $1000. In order to stop the pollution, either theelectric company can install filters on its smokestacks, at a cost of $500, or the laundromat can install filtersin its vents at a cost of $100. Look at the notes to see the payoffs.1Things to note:• The electric company prefers the world where it has the right to pollute, but after that it prefers theworld in which it has to pay damages rather than the world in which the laundromat has an injunctionright to shut down the plant. The reason is that having to pay damages gives the electric companymore options versus facing an injunction; it can choose to pollute and pay damages, or install thefilters itself, or negotiate to have the laundromat install filters. When facing the injunction it can onlynegotiate or install the filters (or shut down).• The laundromat prefers the world in which it has the injunction right to the world in which the electriccompany must pay damages. This is for the exact same reason that the electric company prefers theopposite.• As Coase explains, as long as the two parties can negotiate, and transcation costs are low, the efficientoutcome results (in this case any outcome with $1200 total profit is efficient). The reason is that nomatter what, the laundromat will install filters in the efficient situation: if the polluter has rights topollute, the laundromat will install filters at cost to itself, and if there are injunction/damages rules,then the electric company will realize that it’s cheaper for the laundromat to install filters, so it willpay the laundromat to do so and give it some extra money to ensure that the laundromat


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UW-Madison ECON 522 - SECTION 2 - COASE THEOREM AND TRANSACTION COSTS

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