The Coase Theorem

The Coase Theorem states “that when there are conflicting property right, bargaining between the parties involved will lead to an efficient outcome regardless of which party is ultimately awarded the property rights, as long as the transaction costs associated with bargaining are negligible.”

The cost for a lawsuit would be the same for the two parties in a suit, i.e., the fine that the defendant would pay is the same as the cost to take a different action. This cost means that the two parties are better off negotiating with each other to reach a compromise than file a lawsuit.

The Coase Theorem Example

There is a fish market next to a coffee shop and the smell from the fish market is hurting the coffee shop’s business. We will assume that this is costing the coffee shop $5 per pound of fish sold. When taken to court the judge has to decide whether the fish market is liable or whether the coffee shop is liable, i.e., who has the right to complain.

Possible Outcomes

Fish Market is LiableCoffee Shop is Liable
1) Pay Coffee Shop $5/pound1) Suffer from smell $5/pound
2) Install Air Cleaner$8/pound2) Pay Fish Market for Scrubber $8/pound
3) Fish Market Moves $10/pound3) Pay Fish Market to Move $10/pound
4) Pay Coffee Shop to Move $20/pound4) Coffee Shop Moves $20/pound

The cheapest option of $5 per pound is chosen.

  • However, if the cost to the coffee shop were higher, then the coffee shop would choose the air cleaner since it is the cheapest option.
  • If there is a difference in cost in putting the air cleaner, and say the fish market has the lower cost, then the fish market is liable and is the lowest cost avoider.

Lowest Cost Avoider Example

  • Car A hits Car B in an accident. Car A is liable for the accident because he could have avoided the accident more easily. It would be harder for Car B to avoid the accident because he has to drive looking forward. Therefore, Car A is the Lowest Cost Avoider.
  • Another example is murder. The murderer is the lowest cost avoider since he could have avoided the murder more easily than the victim could.

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