1. 1 Coase Theorem-Friedman Eric Rasmusen, erasmuse@Indiana.edu G604, lecture 6, February 5, 2003

2. 2 Coase Theorem Example A steel mill’s pollution reduces resort profit by $200,000 unless $100,000 is paid to control pollution. There is a real externality of $200,000. The Pigouvian tax would be to charge the steel mill $200,000 if it pollutes. It would then choose to control the pollution instead. Coase insight: Suppose the resort could switch to timber, earning $50,000 less. Then the Pigouvian tax is inefficient. Or, just let the steel mill and the resort negotiate with each other. If the “property right”– who has the legal right to decide pollution– is clear, the outcome will be efficient.

3. 3 The Coase Theorem “If transaction costs are zero, then any initial allocation of property rights leads to an efficient outcome. “ (Friedman’s statement) What is interesting is to figure out the implications of transaction costs. A function of law is to minimize transaction costs. Coase, Ronald H., "The Problem of Social Cost," Journal of Law and Economics, October 1960, 3:1-44 http://www.daviddfriedman.com/laws_order/

4. 4 The Train Sparks Example A railroad chooses whether to install a spark arrester or not. 100 farmers each choose whether to plant clover or not. Clover does not burn. Possible Rules (who decides? who pays?): 1. Railroad property right. The railroad can throw sparks if it so desires. 2. Farmer property right. Any one farmer can stop the railroad from throwing sparks. 3. Farmer liability right. The railroad can throw sparks if it pays the farmers for any damage that results. 4. Railroad liability right. Any one farmer can stop the railroad from throwing sparks, but he must pay the railroad’s cost of installing a spark arrester.

5. 5 Property and Liability Rules Calabresi, Guido & Melamed, Douglas, "Property Rules, Liability rules and Inalienability: One View of the Cathedral", 85 Harvard Law Review 1089 (1972). If you are protected by a property rule, you can go to court and get an injunction to stop someone from doing X. (court of common law) Examples: Patent infringement, someone building a house on your land, someone stealing your car If you are protected by a liability rule, you can go to court and get damages from someone who has done X. (court of equity) Examples: tort suits for personal injury, damages for breach of contract