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Coasian bargaining

Coasian bargaining is based on the ideas of Ronald H. Coase who earned the 1991 Nobel Prize in economics ‘for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy’. In his article, The Problem of Social Cost (1960), he proposes that well-defined property rights can overcome the problems of externalities, because many environmental problems arise from poorly defined, or a lack of, property rights. Assuming that property rights are held by the polluter and that transaction costs are zero, the Coase theorem states that a polluter and a victim can reach a mutually beneficial bargain if the damage from pollution is higher than the polluter’s net return from the sale of the good generating the pollution. In this case, a payment from the affected party to the polluter would reduce the pollution.

Thus, the Coase theorem states that the most efficient solution to resolving interdependent uses of the environment, including pollution cases, is a bargaining process among relevant property holders. If property rights are given to polluters, victims can pay them not to pollute, creating a market-like solution akin to a scheme for payments for ecosystem services. Alternatively, if property rights are given to the victims, the polluters may compensate the victim or buy the right to pollute. Thus, the cost of the negotiated outcome is shared between the parties without any external intervention. If transaction costs are minimal, the resulting allocation of resources will be efficient (that is, the resource will be dedicated to its highest valued use) regardless of the initial allocation of property rights. The creation of a market in the Coase solution internalizes externalities; however, it does not necessarily bring pollution to a zero level. In addition, obviously it cannot be applied to externalities affecting future generations or other species.

As an example, consider a chemicals factory producing useful products but also polluting smoke. If the initial legal framework gives people the right to breathe clean air, they could make the factory produce less or nothing at all. However, assume that the factory is willing to pay up to USD 5 per unit for the right to pollute enough to produce its output. If this amount is considered of greater value than that of clean air, people will take the money and put up with (the economically optimal level of) pollution. On the other hand, if the right to pollute lies with the firm, people can bribe the firm to pollute less.

The Coasian bargaining approach is an attractive one to some: an economy may be able to achieve Pareto-efficient resource allocation (that is, no individuals can be made better off without making someone else worse off) without pervasive government regulation. Moreover, Coasian bargaining solutions can be particularly interesting for international externalities, since there is no supranational environmental protection agency with the necessary authority to impose abatement directives or pollution taxes.

However, the number of situations for which Coasian bargaining is feasible and desirable is limited. First, Coasian bargaining does not eliminate the role of government in assigning initial property rights. This process will be subject to special interest group lobbying and rent seeking. In addition, because many environmental externalities are indirect, cumulative and uncertain and because resorting to the legal system involves inefficiency, the costs of enforcing or striking a Coasian bargain may be large. Moreover, as many externalities are intertemporal, future generations are simply not present in any bargain.

Another limit to Coasian markets comes from the fact that many environmental externalities, like car emissions or noise in the vicinity of airports, or global effects such as climate change and ozone layer destruction, involve a large number of people. For example, a farmer who pollutes his water supply may be one of numerous upstream farmers affecting thousands of downstream neighbors’. Bringing all the relevant agents to the negotiating table would be difficult and expensive. The transaction costs (of aggregating the interests of all the affected parties, hiring lawyers, negotiating an optimal abatement level, and enforcing a market agreement) will prevent a private bargain even with a clear allocation of rights. Moreover, individuals will be tempted to act as free riders in negotiations, undermining the negotiations themselves. Individuals would treat the outcome of negotiations as beyond their control and therefore, be unwilling to bear any transaction costs (Baumol and Oates, 1988). Thus, when externalities take place in future, or when transaction costs are important and when the number of participants is large, Coasian solutions to environmental externalities must be ruled out.



Coase, R. H. (1960) The Problem of Social Costs, Journal of Law and Economics 3(1): 1-44.


Baumol, W.J. and Oates, W.E. (1988) The Theory of Environmental Policy, Cambridge University Press, Cambridge, UK.


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This glossary entry is based on a contribution by Tom Bauler.

EJOLT glossary editors: Hali Healy, Sylvia Lorek and Beatriz Rodríguez-Labajos.

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