Though potentially an attractive solution, it is unlikely that the Coase Theorem can solve many of the inefficiencies associated with externalities. In reality, there are a number of problems that would limit the success of a Coasian Solution. These shortcomings are found in the difficulty in assigning property rights, the holdout problem, the free rider problem, and "higher than zero" transaction costs.

Difficulty in Assigning Property Rights

The decrease in fishable fish may not be fully caused by the textile mill. In fact, it is foreseeable that the decrease in fish is also a result of natural causes such as disease or more natural predators. Moreover, consider the possibility that the lake we described earlier is at the mouth of a river hundreds of miles long. If this is the case, it may be difficult/impossible to know that the textile mill inflicts $50 worth of damage itself when there may be many other polluters up stream. In fact, it may be that a local government up stream gave the property rights to a steel mill to dump into the river.

A common result of this assignment problem is water wars. "Water Wars" are particularly common when there is a river that flows through many states. In the southeast, the states of Georgia, Alabama, and Florida all fight over the use of the Chattahoochee River that begins in the Mountains to the north of Atlanta and flows into the Gulf of Mexico.

If we face this assignment problem with rivers that flow through just a handful of states we may imagine that this same problem is an even larger obstacle when it comes to issues concerning air quality and pollution.

Holdout Problem

Imagine that we have found a way to overcome the assignment problem; we will likely be met by another difficult challenge. If the fisherman are assigned the property rights, the textile mill cannot dump unless all the fisherman give permission. If there are 10 fisherman on the lake and nine have given permission, the 10th has an incentive to demand more money to give his permission.

The Free Rider Problem

Consider the example where the textile mill has the property rights; we can look at the reduction of dumping as a public good to the fisherman. As with any public good, we expect to see underinvestment. What may cause this? Suppose there are 10 fishermen who would each have to pay $10 to get the mill to reduce dumping by 10 units (suppose this is socially efficient). However, once eight have paid the $10, the mill will reduce dumping by eight units which is "almost" as good as the efficient 10 unit reduction. Because the benefits of pollution reduction are enjoyed by all fishermen (dumping reduction is a public good) the cost (in lower fishing output) of underinvestment is spread across all 10 fisherman. In other words, because the marginal benefit of individual investment is low compared to cost, there is an incentive for the two remaining fishermen to free ride off the other eight's investment. This can lead to a vicious cycle, when the other fishermen realize that others are coasting on their efforts. So they start to under-invest as well.

"Higher than Zero" Transaction Costs

When there are a large number of people involved, coordination is typically difficult. Imagine the difficulty of getting all 10 fisherman and the mill operator together to negotiate; even if the only "cost" is time, it is important to remember the opportunity costs associated with time spent. It is also important to remember that our example may be overly simple compared to the "real world" in terms of time and travel costs; the costs would be much higher than negligible to organize negotiation (or a law suit) between all interested parties in the use of the Chattahoochee River. There is also information asymmetry where that neither the polluting firms nor those hurt by pollution know what each other's cost are. The firm doesn't know what the marginal damage is to individuals and other businesses, and these harmed entities don't know the production and abatement costs of the polluting firms. This incomplete information (which will be discussed later on in market failures) can lead to strategic behavior by both sides in the negotiations, and ultimately, an inefficient solutions.

Where the Coase Theorem May Work

In situations where there are only a few parties involved and assigning property rights is possible, we will likely see a solution similar to the one Coase has suggested. For example, my neighbor's property has a steep hill perfect for rock climbing. But, because my neighbor is worried about being liable if someone is injured on his hill, he has built a tall fence. Now, with no access to the rock, the climbers receive no benefit from climbing; this may not be socially efficient. There may be room for negotiation; the rock climbers may be willing to pay my neighbor to allow them to rock climb. In turn, my neighbor may be willing to accept this payment to hedge his risk if a climber is injured and my neighbor is found liable. A similar Coasian solution is reached if the neighbors sign a 'no-liability contract' with the owner of the hill. They are exchanging something in value- their ability to sue- in order to gain the benefit of climb the rock.



In cap - and - trade markets for dealing with the negative externalities created by pollution, we can see the permits as the assignment of property rights; in this type of market we may see Coasian outcomes. However, full participation in these markets is difficult to achieve. For example, India, The United States, and China, some of the world's top polluters, do not participate in the Kyoto Treaty (there are a variety of reasons for this). The United States is not a member and India and China are exempt as "developing nations".

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