Editing Coase theorem (section)

==Criticism==

=== Criticisms of the theorem ===

In his later writings, Coase himself expressed frustration that his theorem was often misunderstood. Some mistakenly understood the theorem to mean that markets would always achieve efficient results when transaction costs were low, when in reality his point was almost the exact opposite: because transaction costs are never zero, it cannot be assumed that any institutional arrangement will necessarily be efficient. Others have argued that because transaction costs are never zero it is always appropriate for a government to intervene and regulate, though Coase believed that economists and politicians "tended to over-estimate the advantages which come from governmental regulation."{{sfnp|Coase|1960|p=18}} What Coase actually argued is, that it is important to always compare alternative institutional arrangements to see which would come closest to "the unattainable ideal of the world of zero transaction costs."{{sfnp|Merrill|Smith|2017|p=38}}

While most critics find fault with the applicability of the Coase Theorem, a critique of the theorem itself can be found in the 1981 work of the critical legal scholar [[Duncan Kennedy (legal philosopher)|Duncan Kennedy]], who argues that the initial allocation always matters in reality.<ref name="DKennedy">{{Cite journal|year=1981|title=Cost-Benefit Analysis of Entitlement Problems: A Critique|url=http://duncankennedy.net/documents/Photo%20articles/Cost-Benefit%20Analysis%20of%20Entitlement%20Problems_A%20Critique.pdf|journal=Stanford Law Review|volume=33|issue=3|pages=387–445|doi=10.2307/1228354|jstor=1228354|author=Kennedy, Duncan}}</ref> This is because psychological studies indicate that asking prices often exceed offer prices, due to the so-called [[endowment effect]]. Essentially, a person who already has an entitlement is likely to request more to give it up than would a person who started off without the entitlement. The validity of this theoretical critique in practice is addressed in a later section.

An additional critique of the theorem comes from [[New institutional economics|new institutional]] economist [[Steven N. S. Cheung]] who thinks that private property rights are institutions that arise to reduce transaction costs. The existence of private property rights implies that transaction costs are non-zero. If transaction costs are really zero, any property rights system will result in identical and efficient resource allocation, and the assumption of private property rights is not necessary. Therefore, zero transaction costs and private property rights cannot logically coexist.<ref>{{Cite journal |last=Cheung |first=Steven N. S. |date=2020-12-01 |title=On a Fallacy in the Coase Theorem and the Theorem of Transaction Costs Substitution |url=https://www.degruyter.com/document/doi/10.1515/me-2020-0013/html |journal=Man and the Economy |language=en |volume=7 |issue=2 |doi=10.1515/me-2020-0013 |issn=2196-9647}}</ref>

Lastly, using a game-theoretic model, it has been argued that sometimes it is easier to reach an agreement if the initial property rights are unclear.<ref>{{Cite journal|last=Schmitz|first=Patrick W.|date=2001|title=The Coase Theorem, Private Information, and the Benefits of Not Assigning Property Rights|journal=European Journal of Law and Economics|language=en|volume=11|issue=1|pages=23–28|doi=10.1023/A:1008709628107|s2cid=195241480|issn=0929-1261}}</ref>

=== Criticisms of the applicability of the theorem ===

====Transaction costs====
Ronald Coase's work itself emphasized a problem in applying the Coase theorem: transactions are "often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost."{{sfnp|Coase|1960|p=15}} This isn't a criticism of the theorem itself, since the theorem considers only those situations in which there are no transaction costs. Instead, it is an objection to [[Applied economics|applications of the theorem]] that neglect this crucial assumption.

So, a key criticism is that the theorem is almost always inapplicable in economic reality, because real-world transaction costs are rarely low enough to allow for efficient bargaining. (That was the conclusion of Coase's original paper, making him the first 'critic' of using the theorem as a practical solution.) [[Neo-Keynesian economics|Neo-Keynesian]] economist [[James Meade]] argued that even in a simple case of a beekeeper's bees pollinating a nearby farmer's crops, Coasean bargaining is inefficient (though beekeepers and farmers do make contracts and have for some time).<ref name="Johnson">{{Cite journal|year=1973|title=Meade, Bees and Externalities|journal=The Journal of Law and Economics|volume=16|issue=1|pages=35–52|doi=10.1086/466754|author=Johnson, David B.|s2cid=154681709}}</ref>

[[Chicago school of economics|Chicago school]] economist [[David D. Friedman]] has argued that the fact that an "economist as distinguished as Meade assumed an externality problem was insoluble save for government intervention suggests...the range of problems to which the Coasean solution is relevant may be greater than many would at first guess."<ref name="Friedman">{{Cite book|year=2000|title=Law's Order|publisher=Princeton Paperbacks|pages=41–42|last=Friedman |first=David D. |isbn=9781400823475}}</ref>

In many cases of externalities, the parties might be a single large factory versus a thousand landowners nearby. In such situations, say the critics,  the transaction costs rise extraordinarily high due to the fundamental difficulties in bargaining with a large number of individuals.

However, transaction costs are not only a barrier for situations with large numbers of involved parties. Even in the simplest of situations, with only two individuals, social costs can increase transaction costs to be unreasonably high so as to invalidate the applicability of Coasean bargaining. As economist [[Jonathan Gruber (economist)|Jonathan Gruber]] described in 2016,<ref name =gruber>{{Cite book|title=Public Finance and Public Policy|last=Gruber|first=Jonathan|publisher=Worth Publishers|year=2016|isbn=978-1464143335|location=New York}}</ref> there are strong social norms that often prevent people from bargaining in most day-to-day situations. Whether it is the awkwardness of the exchange or the fear of greatly under-valuing someone else's property rights, transaction costs can still be quite high even in the most basic interactions that could make use of the Coase Theorem.

====Assignment problem====

Gruber described three additional issues with attempting to apply the Coase Theorem to real-world situations. The first is known as the assignment problem, and stems from the fact that for most situations with externalities, it is difficult to determine who may be responsible for the externality as well as who is actually affected by it. In the case of a polluted river that reduces the fish population as described by Coase, how can the involved parties determine which factories may have contributed the pollution that specifically harmed the fish, or whether there were any natural factors that interfered in the process. And even if one can determine who exactly is responsible and who is harmed, it is cumbersome to accurately quantify these effects. People cannot easily translate their experiences to monetary values, and they are likely to overstate the harm they have suffered. At the same time, the polluters would likely underestimate the proportion of the externality that they are responsible for.

====Game-theoretic critique: hold-out, free-rider problems, complete information assumption====

Second, in situations where multiple parties hold the property rights, Coasean bargaining often fails because of the holdout problem. Once all the property owners except for one have accepted the Coasean solution, the last party is able to demand more compensation from the opposing party in order to part with the property right. Knowing this, the other property owners have the incentive to also demand more, leading to the unraveling of the bargaining process.

Lastly, if the side with only one party holds the property rights (so as to avoid the holdout problem), Coasean bargaining still fails, because of the free-rider problem. When the multiple parties on the other side all benefit fairly equally from the results of the negotiations, then each of the parties has the incentive to free-ride, to withhold their payments and withdraw from the negotiations because they can still receive the benefits regardless of whether or not they contribute financially. In 2016, Ellingsen and Paltseva<ref>{{Cite journal|last1=Ellingsen|first1=Tore|last2=Paltseva|first2=Elena|date=2016-04-01|title=Confining the Coase Theorem: Contracting, Ownership, and Free-Riding|journal=The Review of Economic Studies|language=en|volume=83|issue=2|pages=547–586|doi=10.1093/restud/rdw001|issn=0034-6527}}</ref> modelled contract negotiation games and showed that the only way to avoid the free-rider problem in situations with multiple parties is to enforce mandatory participation such as through the use of court orders.

In 2009, in their seminal JEI article, Hahnel and Sheeran highlight several major misinterpretations and common assumptions, which when accounted for substantially reduce the applicability of Coase's theorem to real world policy and economic problems.<ref>{{Cite journal|last1=Hahnel|first1=Robin|last2=Sheeran|first2=Kristen A.|date=2009|title=Misinterpreting the Coase Theorem|journal=Journal of Economic Issues|volume=43|issue=1|pages=215–238|doi=10.2753/JEI0021-3624430110|s2cid=17711874|issn=0021-3624}}</ref> First, they recognize that the solution between a single polluter and single victim is a negotiation—not a market. As such, it is subject to the extensive work on [[Bargaining Problem|bargaining games]], [[negotiation]], and [[game theory]] (specifically a "divide the pie" game under incomplete information). This typically yields a broad range of potential negotiated solutions, making it unlikely that the efficient outcome will be the one selected. Rather it is more likely to be determined by a host of factors including the structure of the negotiations, discount rates and other factors of relative bargaining strength (cf. [[Ariel Rubenstein]]).

If the negotiation is not a single shot game, then reputation effects may also occur, which can dramatically distort outcomes and may lead to failed negotiation (cf. [[David M. Kreps]], also the [[chainstore paradox]]). Second, the information assumptions required to apply Coase's theorem correctly to yield an efficient result are [[complete information]]—in other words that both sides lack private information, that their true costs are completely known, not only to themselves but to each other, and that this knowledge state is also [[common knowledge]]. When this is not the case, Coasean solutions predictably yield highly inefficient results because of [[perverse incentive]]s—not "mere" transaction costs.

If the polluter has the ownership rights, it is incentivized to overstate its benefits from polluting, if the victim has the ownership rights, (s)he has the incentive to also misrepresent her/his damages. As a result, under incomplete information (probably the only state of knowledge for most real world negotiations), Coasean bargaining yields predictably inefficient results.

Hahnel and Sheeran emphasize that these failures are not due to behavioral issues or irrationality (although these are quite prevalent ([[ultimatum game]], [[cognitive biases]])), are not due to transaction costs (although these are also quite prevalent), and are not due to absorbing states and inability to pay. Rather, they are due to fundamental theoretical requirements of Coase's theorem (necessary conditions) that are typically grossly misunderstood, and that when not present systematically eliminate the ability of Coaseian approaches to obtain efficient outcomes—locking in inefficient ones. Hahnel and Sheeran conclude that it is highly unlikely that conditions required for an efficient Coaseian solution will exist in any real-world economic situations.

Unconstrained Coasean bargaining ex post may also lead to a [[hold-up problem]] ex ante. Thus, even though it is often claimed that Coasean bargaining is an alternative to Pigouvian taxation, it has been argued that in a hold-up situation Coasean bargaining may actually justify a [[Pigouvian tax]].<ref>{{Cite journal|last1=Rosenkranz|first1=Stephanie|last2=Schmitz|first2=Patrick W.|date=2007|title=Can Coasean Bargaining Justify Pigouvian Taxation?|journal=Economica|language=en|volume=74|issue=296|pages=573–585|doi=10.1111/j.1468-0335.2006.00556.x|issn=1468-0335|hdl=10419/22952|s2cid=154310004|hdl-access=free}}</ref><ref>{{Cite journal|last1=Antràs|first1=Pol|last2=Staiger|first2=Robert W|date=2012|title=Offshoring and the Role of Trade Agreements|journal=American Economic Review|volume=102|issue=7|pages=3140–3183|doi=10.1257/aer.102.7.3140|issn=0002-8282|url=http://nrs.harvard.edu/urn-3:HUL.InstRepos:3374525}}</ref> Alternatively, it may be efficient to forbid renegotiation.<ref>{{Cite journal|last=Tirole|first=Jean|date=1999|title=Incomplete Contracts: Where do We Stand?|journal=Econometrica|language=en|volume=67|issue=4|pages=741–781|doi=10.1111/1468-0262.00052|issn=1468-0262|citeseerx=10.1.1.465.9450}}</ref> Yet, there are situations in which a ban on contract renegotiation is not desirable.<ref>{{Cite journal|last=Schmitz|first=Patrick W.|date=2005|title=Should Contractual Clauses that Forbid Renegotiation Always be Enforced?|journal=Journal of Law, Economics, and Organization|language=en|volume=21|issue=2|pages=315–329|doi=10.1093/jleo/ewi019|issn=8756-6222|hdl=10419/22932|hdl-access=free}}</ref>
[[File:Endowment Effect and Coase.jpg|right|369x369px]]

=== Behavioral criticisms of the Coase theorem ===
Unlike Hahnel and Sheeran, the economist [[Richard Thaler]] highlights the importance of [[behavioral economics]] in explaining the inability to effectively use the Coase Theorem in practice.<ref>{{Cite book|title=Misbehaving|last=Thaler|first=Richard|publisher=W.W. Norton & Company, Inc.|year=2015|isbn=978-0393352795|location=New York}}</ref> Thaler modified his experiments with the Ultimatum game and showed that people were more likely to be concerned with ensuring fairness in negotiations when negotiating over their own tangible property rather than in an abstract sense. This suggests that in practice, people would not be willing to accept the efficient outcomes prescribed by the Coasean bargaining if they deem them to be unfair. So, while the Coase theorem suggests that parties who lose out on property rights should then pursue the property according to how much they value it, this does not often happen in reality. For example, Professor Ward Farnsworth has described how in the aftermath of twenty observed legal [[nuisance]] cases, none of the parties ever attempted to engage in Coasean bargaining (as would be expected to reach the most efficient outcome) because of anger at the unfairness of having to bargain.<ref>{{Cite journal|last=Farnsworth|first=Ward|date=1999-01-01|title=Do Parties to Nuisance Cases Bargain after Judgment? A Glimpse inside the Cathedral|jstor=1600470|journal=The University of Chicago Law Review|volume=66|issue=2|pages=373–436|doi=10.2307/1600470|url=https://chicagounbound.uchicago.edu/uclrev/vol66/iss2/2|url-access=subscription}}</ref> It is possible that Coase and his defenders would simply view this as a non-pecuniary transaction cost, but that may be an unreasonable extension of the concept of transaction costs.

Thaler has also provided experimental evidence for the argument that initial allocations matter, put forth by Duncan Kennedy (as previously noted), among others. When students were trading cash-equivalent tokens, the negotiations resulted in the students who would receive the most cash from a token (as told by the researchers) holding the tokens, as would be predicted by the Coase Theorem. However, when the students were trading property (mugs in this case) that were not directly equivalent to cash, proper Coasean bargaining did not occur as depicted in the adjacent diagram. This is because people generally exhibit an [[endowment effect]], in which they value something more once they actually have possession of it. Thus, the Coase Theorem would not always work in practice because initial allocations of property rights would affect the result of the negotiations.

===Coasean bargaining in the presence of Pigouvian taxation===

Ian A. MacKenzie and Markus Ohndorf have conducted research on Coasean bargaining in the presence of a Pigouvian tax.<ref>{{cite journal |last1=MacKenzie |first1=Ian |last2=Ohndorf |first2=Markus |title=Coasean bargaining in the presence of Pigouvian taxation |journal=Journal of Environmental Economics and Management |date=January 2016 |volume=75 |pages=1–11 |doi=10.1016/j.jeem.2015.09.003 |bibcode=2016JEEM...75....1M |url=https://www.sciencedirect.com/science/article/pii/S0095069615000741 |access-date=12 September 2020 |ref=21|url-access=subscription }}</ref> This research stems from the common belief within Coasean perspectives that Pigouvian taxation creates distortions and therefore inefficiencies, instead of effectively resolving the problem in question. The research conducted shows that in the presence of a pre-existing Pigouvian tax, Coasean bargaining may be superior.<ref>{{cite journal |last1=MacKenzie |first1=Ian |last2=Ohndorf |first2=Markus |title=Coasean bargaining in the presence of Pigouvian taxation |journal=Journal of Environmental Economics and Management |date=January 2016 |volume=75 |pages=1–11 |doi=10.1016/j.jeem.2015.09.003 |bibcode=2016JEEM...75....1M |url=https://www.sciencedirect.com/science/article/pii/S0095069615000741 |access-date=12 September 2020 |ref=21|url-access=subscription }}</ref> The implications of this policy are regulation at both the federal and state level and environmental litigation and liability. This is because dual regulatory environments exist.

In order to examine whether the hypothesis that Coasean bargaining in the presence of a Pigouvian tax is superior to a scenario without taxation, MacKenzie and Ohndorf had to make certain assumptions. Firstly, they relaxed the assumption of property right allocations, and in doing so had a new take on the Buchanan – Stubblebine – Turvey Theorem.<ref>{{cite journal |last1=MacKenzie |first1=Ian |last2=Ohndorf |first2=Markus |title=Coasean bargaining in the presence of Pigouvian taxation |journal=Journal of Environmental Economics and Management |date=January 2016 |volume=75 |pages=1–11 |doi=10.1016/j.jeem.2015.09.003 |bibcode=2016JEEM...75....1M |url=https://www.sciencedirect.com/science/article/pii/S0095069615000741 |access-date=12 September 2020 |ref=21|url-access=subscription }}</ref> By relaxing this assumption, they are able to conclude that even with a Pigouvian tax levied, efficiency improvements can exist. By creating a more realistic environment with how property rights are allocated, MacKenzie and Ohndorf observed that gains from Coasean exchange are reduced by a Pigouvian tax. Furthermore, their research also shows that it is possible that a pre-existing tax can be efficiency enhancing in the case of environmental litigation and liability. This is because it softens the controversy and therefore, reduces overall spending in litigation.

Therefore, in summary, MacKenzie and Ohndorf's research provides an economic argument in support of Pigouvian taxation in the case where there is the potential for negotiation.