Negotiations

The Coase Theorem

As described in part one, where externalities are present, the uncorrected market mechanism leads to misallocations. The causer of the externality will, at an uncorrected equilibrium, produce an emission level x* at which his profit (utility) is maximized, but the interests of those damaged are left entirely out of account. Perhaps the intuitively readiest response to this calamity is for the government to affect the polluter's emission level through direct controls.

In sharp contradistinction to this approach, Ronald Coase (1960) put the view in his famous essay that the misallocation could be rectified by direct interaction among those involved after the government has defined the rules of this interaction. This idea is often regarded as counterintuitive, but the basic notion can nonetheless be directly derived from the concept of the suboptimality of the uncorrected equilibrium. That is, if the uncorrected emission level x* is not Pareto optimal, then this means by definition that changes in this starting position that leave at least one of those involved better off without any other being worse off are possible. There is thus potential here for welfare improvements, and a clever distribution arrangement can take advantage so as to make all participants better off. This potential runs out only at the optimum allocation. According to Coase, the prospect for achieving these potential improvements in condition, then, constitutes the motor for collaboration by the parties, with the object of bringing about optimality.