Editing Coase theorem (section)

=== 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>
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