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The Coase Theorem and the role of transaction costs

What is the role of transaction costs in the Coase Theorem? Transaction costs can take several forms. To illustrate the main ideas, we will classify transaction costs according to the following two types:

  • Lump-sum transaction costs, which do not depend on the volume of trade; and
  • Per unit transaction costs, which consist of a cost for each unit of a good that is either supplied or demanded. These can be further classified into ad valorem transaction costs, which are a percentage of the market price, or specific transaction costs, which are a fixed dollar amount for each unit of the good that is supplied or demanded.

Lump-sum transaction costs

Lump-sum transaction costs shrink the length of the Edgeworth Box by the amount of money that each party incurs in paying for the transaction. Thus the pure efficiency version of the Coase Theorem will not hold, in the sense that the utility possibilities that were previously available in the absence of transaction costs are no longer available in the presence of transaction costs. Nevertheless, the outcome that the parties reach is constrained efficient; that is, it is efficient conditional on the existence of transaction costs.

The important point here is that the initial legal rule or property right may affect the size and distribution of the lump-sum transaction costs, and therefore may affect the gains from trade. This means that the presence of such costs could affect the efficiency properties of various legal rules, and that legal rules can, in principle, be ranked according to their efficiency properties.

For example, suppose that the factory initially enjoys the legal right to produce as much as it desires, but the residents must incur transaction costs of C in order to reach a bargain with the factory. However, suppose that no such transaction costs must be incurred when the residents have the right to choose the level of production. Then clearly, in the presence of such lump-sum transaction costs, the legal rule matters for efficiency. Furthermore, since transaction costs are not incurred when the residents have the initial property right, an efficient legal rule will assign them the property right and allow the parties to bargain (costlessly, in this example when the residents have the property right) until the efficient level of production is reached. Thus, a further important implication of this analysis is that when transaction costs are sufficiently high enough for legal rules to matter, the efficient legal rule minimises the effects of transaction costs.

Note, however, that in the absence of income effects, these kinds of costs will have no effect on the level of production that the parties agree upon, since that level does not depend on the level of money that each has. The only exception to this is if the lump-sum transaction costs are so large as to 'eat up' all possible gains from trade. In other cases, however, the only question for the design of legal rules is to find the rule that minimises the transaction costs.

On the other hand, in the presence of income effects, the existence of lump-sum transaction costs will affect the level of production that the two parties agree upon. We therefore obtain an invariance version of the Coase Theorem in the presence of lump-sum transaction costs: Suppose that there are no income effects. In the presence of lump-sum transaction costs which do not vary with the legal rule and are not large enough to exhaust all possible gains from trade, then bargaining between the parties will always lead to the same level of production of Q, irrespective of the initial legal regime or assignment of property rights. In other words, the legal rule has no relevance for determining the level of production of Q that will eventually be chosen by the factory.

 
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